Growing, managing, and starting a business is hard work. Every successful company out there would tell you that they weren’t able to do it alone!
In business, it’s essential to have mechanisms in place to smooth out these relationships.
An shareholders’ agreement is a legally binding document that spells out what shareholders can and cannot do, what they are allowed and not allowed to do, and their responsibilities towards each other. Whenever there is a conflict or major event, the company will refer to it. I think this is pretty important!
A Shareholder Agreement can contain a number of different types of terms, and these terms can have a huge impact on your business.
Why Should You Have One?
Shareholder and investor protection
As your business expands and you realize that you will need outside financing, it is likely that anyone who has the cash to invest will want to review your Shareholders’ Agreement. If you don’t have one and are looking for external financing, they’ll impose one to protect their investment.
Shareholders’ Agreements Unanimous
Do I need one, and what are they? We’re still unsure.
Unanimous Shareholders’ Agreements (USA) are Shareholders’ Agreements signed by every single shareholder at the time of inception and bind future shareholders, regardless of whether they sign. USAs have the effect of transferring much of the power normally given to directors and officers, to shareholders.
This effectively removes the possibility of shareholders being passive investors, taking over the company’s control.
Start-ups would normally be adversely affected by this. In the USA, decision-making is rigid, and the document itself is hard to get rid of. In this situation, shareholders have a fiduciary duty to the company, and they have very limited options – they cannot resign like directors. With many shareholders, efficient decision-making will be hindered, and new investors are automatically added, but they may not want to participate.
Term You Might See
The majority of legal documents, including shareholders’ agreements, can be customized and tailored to your business’s needs. You may not see every term listed below in your Shareholders’ Agreement, and not every term listed below may be in yours as well.
Issuance of shares
As long as the appropriate parties vote in favor, companies can issue new shares at any time. Typically, shares are issued when a corporation wants to raise more capital and decides to sell stakes rather than relying on debt. Often, shareholders are concerned their investments will get diluted or that other unsavoury people may attend the same meetings as them.
Shareholders’ Agreements often contain provisions dictating how new shares will be issued. A typical Agreement might include a clause allowing existing shareholders to exercise all kinds of rights like vetoes or preemptive rights to raise funds themselves instead of bringing in outsiders (eligible transferees).
Director and Officer Duties and Powers
Ordinary Shareholders’ Agreements can also mention the issue of limiting the overall power of a director or officer, although unanimity will be more prevalent.
The spectrum can be quite extreme, ranging from nodding to the powers Directors and Officers already have under Canadian law, to completely stripping their powers and giving them to shareholders. Shareholders who may have the right to vote on director and officer election protocols can also be affected by them.
Provisions for control
A covenant is a promise not to do or refrain from doing something without the consent of shareholders. A Board of Directors is typically able to make decisions on its own, but if you require approval from a certain percentage of shareholders, decision-making becomes more risky.
As a rule, start-ups should be as dynamic and flexible as possible, and control provisions go against that goal. Due to this, keeping covenants to a minimum frees up a lot of flexibility for pivots and crucial decision-making when needed. Nevertheless, they do have a place in Shareholders’ Agreements if limited to a few areas, such as financing and debt raising. Furthermore, the control provisions can also be sunsetted while the rest of the agreement continues on.
Right of Preemption
A pre-emptive right allows existing shareholders to participate in future financing on a pro-rata basis based on the number of shares they currently own. New shares issued to third parties dilute existing shareholders’ stakes if they are issued to third parties. The pre-emptive rights are a benefit to the existing shareholder and will likely be a key negotiation point. In some cases, these rights can be included in the first topic, issuance of new shares, or vice versa.
Usually, it is in the business’ best interest to talk the founders out of retaining such preemptive rights when separating the founders from the business. An investor who is necessary to grow and scale a business past the fledgling stage may balk when they see the power founders hold. As a founder, if you insist on such clauses, sunset provisions and preventing third-party money (banks) are usually a good compromise.
An existing shareholder who is a party to the Shareholders’ Agreement may exercise these rights when selling their shares. Before offering them to external parties, ROFRs require the selling shareholder to offer them to the other shareholders first.
A Right of First Refusal makes it difficult for a person to sell their shares, but you can include both soft and hard ROFRs in your agreement.
- Hard: These require the selling shareholder to find a buyer at an ascertainable price, and then offer the shares to the existing shareholders at that price. Startups are notoriously difficult to value, and no one will make a legitimate offer if it’s going to get snapped up by the other shareholders.
- Soft: They have a different process. Initially, the selling shareholder will notify the other shareholders that they intend to sell their shares on the open market. Other shareholders have a few weeks (depending on the Agreement) to decide whether to buy at the predetermined price. If not, the selling shareholder can take their offer externally.
The problems with ROFRs are that they cause hold-up risks in the decision-making process, and depending on the type of ROFR you have, can effectively consolidate voting power to a small handful of individuals, and can cause shareholders to be trapped in situations in which exiting may not yield them a good return.
To mitigate the problem, some shareholders’ agreements allow shareholders to sell up until a particular threshold before a Right of First Refusal kicks in, allowing for freer transactions with smaller percentages of shares. Another mitigation tactic is similar to pre-emptive rights — don’t allow any third party money to snap up any shares.
- Guide To Shareholder Agreements
- The Need For A Share Purchase Agreement Format
- Who Needs A Service Level Agreement (Sla)?