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The Most Important Things in a Shareholders’ Agreement

By Tienko Rasker | Startup Life

Did you read Leapfunder’s5 most important things startup founders need to know before raising capital“? In this article, Leapfunder’s CEO, Tienko Rasker will introduce you to the Shareholders’ Agreement (SHA) and the most important parts of it.

A Shareholders’ Agreement is a broad contract that contains the rules that govern relationships between all the shareholders of a  company, including the founders. Every company needs a Shareholders’ Agreement because there are key things that are not organised by law, nor in the articles of association of a normal legal entity. The SHA is a living document: every time there are shareholders added, they will need to sign to this agreement. The most important parts of the Shareholders’ Agreement are:

DRAG AND TAG ALONG

The ‘Drag Along’ is a rule that if X% of the shareholders want to sell the company, they can force the remaining shareholders to sell as well. That means you don’t need a 100% agreement to be able to sell the company: only X% of the shareholders need to agree. Opinions will vary about what the right percentage is. It can be as high as 80%, but it’s not uncommon for it to be as low as 40%. It simply depends on what you think is right: what % of shareholders should be able to sell the company without the permission of others?

The ‘Tag Along’ means that if one of the shareholders gets a cash offer to exit the company, they have to share this cash offer with all the other shareholders. All the shareholders get to participate in the cash exit offer pro-rata. That is just a general fairness regulation: it ensures that if there is a big pot of cash on offers, everyone can get their share of it.

GOOD/BAD LEAVER

The ‘Good Leaver/Bad Leaver’ clause regulates what happens if a founder leaves. It’s very crucial to have a written agreement about this before it happens! Often when a founder leaves things get emotional, and so it’s helpful if the rules are very clear.

Generally, a ‘Good Leaver’ is someone that leaves on friendly terms but hasn’t been with the company long enough to keep all their shares.

Normally, the Good Leaver clause stipulates that if a founder leaves within one year, they have to hand all their shares back. That period of one year is called the ‘Cliff’. If the founder stays beyond the Cliff, the proportion of shares they keep depends on how long they have stayed. Generally, the total Vesting Period is set at four years. That means that if someone leaves after one year, they can keep 1/4 of their shares, after two years 2/4, etc. If they leave after the end of the four year Vesting Period they can keep all their founder shares. You can adjust the Cliff and the Vesting Period to suit your particular situation.

A ‘Bad Leaver’ is someone who is sent away because they have broken the law or a critical piece of company policy. A Bad Leaver has to hand back all their shares.

It’s reckless to be running a company without a ‘Good Leaver/Bad Leaver’ clause in place. You don’t plan to break up with your co-founder, but when it happens, it’s too late. If you don’t have a Good/ Bad Leaver clause in place, you should add it immediately.

PREFERRED RIGHTS

Some of your shareholders will want additional rights. It’s more common with VCs that are investing a large amount of someone else’s money than it is with informal investors that invest their own money. All of those extra rights can be negotiated, but VCs normally require them. 

One set of additional rights that VCs often want are additional control rights over the management of the company. In particular, they will likely control management appointments, sign off on the budget and sign off on large expenditures. They may also want to be able to block big asset sales, fundamental strategy changes or future funding rounds, especially if those rounds are not to a market price. 

On top of the control rights, the VC investors will likely want some financial protection rights. In particular, they will likely want a ‘Liquidation Preference’, which is a simple rule that if there is ever a cash exit then they will get their cash investment back first, perhaps with a bonus. How big that additional cash bonus is can be negotiated. It can be negotiated whether they also get a share in the remaining cash along with the other shareholders even after they have received their investment back (‘Double Dip’). There will likely also be an ‘Anti-dilution’ clause, which states that a VC will get compensated with bonus shares if there is ever a funding round with a valuation below the price they originally paid. A severe form of that is the ‘Full Ratchet’ which promises full compensation during any down-round, however small. 

The Liquidation Preference, Anti-Dilution and control rights can take on a number of different forms. When you are negotiating with your VCs, you need to make sure you have someone experienced at your side of the negotiation. If you get these clauses wrong, even just slightly, you could lose out on a lot of the success of your own company down the road.

We hope you now know much more about the shareholders’ agreement. To learn about pooling, which is also important for startup founders raising capital, stay tuned for Leapfunder’s next blog!