Investment Documents - Shareholders' Agreement

Updated: Jun 4

A key document in investing in a startup is the shareholders' agreement. Known also as the SHA this document governs the roles and responsibilities of the parties from the investment all the way to the exit of the company (unless, of course, replaced with a new one, e.g. in connection to a funding round).


In this article, we take a look into key clauses that a typical shareholders agreement in a startup with external investors.


Shareholders' Agreement in a Startup

A shareholders' agreement is an agreement between the founders, investors, management shareholders and the company. In the agreement, the parties set out their agreement on the governance of the company, as well as pre-agreed actions and procedures in certain situations.


While many companies with multiple shareholders have shareholders' agreements in place, a shareholders' agreement is of utmost importance for startups. Since the external investors typically hold only a minority of the company, they need some additional insurance that the company is run as agreed. Also, since the founders are the most important element of an early-stage startup, their rights and responsibilities should be well defined, especially in unfortunate but sometimes inevitable leaver situations.


You should always use a shareholders' agreement model that is suitable for startups and has clauses for investors (even if you do not have any, yet). Shareholders' agreement models meant for traditional businesses typically miss some key elements that would be good to agree in a startup.


In many jurisdictions, there are shareholders' agreement templates available for startups (e.g. Series Seed is available in multiple jurisdictions and the local business angels networks are often providing their own templates). Make sure you use a template applicable to your jurisdiction, as different jurisdictions may have different requirements and best practices for the shareholders' agreements.


Key Shareholders' Agreement Clauses and Their Purpose

Parties of the Shareholders' Agreement

Obviously, the parties of the shareholders' agreement contain the shareholders of the company. In addition, holders of convertible notes, options and similar securities that can be converted into shares in the company are also requested to enter into the agreement.


The company is also often a party in the agreement, as this adds some security that the agreement is followed (E.g. it is possible that the board members of the company are not parties of the shareholders' agreement and are, thus, not bound by the agreement. But as the company is bound by the agreement, the board needs to follow it as well.)


Legal Proceedings If the company is a party in the shareholders’ agreement it has the right to take legal actions in order to enforce the agreement. But if the company is not a party in the agreement, someone else, i.e. some of the shareholders, needs to take the legal actions.

The parties are typically divided into groups based on their role in the company, such as founders, investors, management shareholders, etc. This allows assigning different rights (usually applying to the founders and investors) and different responsibilities (usually applying to the founders and management shareholders) to different groups.


Governance of the Company

Nomination of Board

One of the most important elements of the shareholders' agreement is to set up the framework for the governance of the company. As the key decisions in a company are done in the board of directors, the right to nominate board members is addressed in the shareholders' agreement.


Typically both the founders and the investors have the right to nominate one board member, with the rest of the board members to be nominated jointly. Some investors may also be entitled to appoint a board observer, i.e. a non-voting person participating in the board meetings.


Majority Decisions

The investors are typically minority shareholders in the company, yet they are the ones responsible for funding the company. Thus, in order to protect the investor minority, some decisions typically require a predetermined qualified majority.


The qualified majority can be e.g. over 50% of the founders' votes and over 50% of the investors' votes in the company. This is meant to ensure that the decision is in the best interest of both the investors are well as the founders. Obviously, involving all of the shareholders' in the decision making is burdensome and should only be applied in significant decisions. Typically qualified majority decisions are limited to situations like exiting the company, appointing new CEO, entering into a joint venture, significant investments and so on. It should be emphasized that under no circumstances actions under the normal course of business should be subject to qualified majority requirements.


As the company sought funding from the investors, it sought funding for a certain business idea and a business plan. While the plans naturally may change during the life of a startup, the investors want to have some confidence in that the founders are using the funds to execute the plans presented to the investors during the funding round. The requirement for majority decisions should be viewed in this light: The purpose of these requirements is to ensure that in case a material change to the business or the company would be proposed, making that kind of change requires sufficient support from all shareholders. In other words, qualified majority decision requirements act as minority protection clauses towards the investors.


As the majority decision clauses should only act as minority protection clauses, one should be careful that the clauses will not have unwanted harmful implications. One of the most common of these implications is that the decision making clauses disturb the decision-making process in normal business decisions. Another potential issue is that someone (ab)uses the decision-making rules to obtain unjustified benefits at the expense of the other shareholders. Thus, all majority decision-making requirements should be drafted taking into account the business of the company as well as the ownership of the company.


Poison Pills Poorly considered decision-making rules may cause issues. For example, if a shareholder has a veto-right on exit, the shareholder may require extra compensation in order to approve the exit. These kinds of shares with veto-rights are also called poison pills.

Information Rights

It is common (and also recommendable) to agree in the shareholders’ agreement on the information the company provides to its investors. This can be e.g. monthly or quarterly reporting. The minimum context of said reporting can also be specified in the shareholders’ agreement.


News Good news is no news Bad news is good news No news is bad News

I highly recommend agreeing on investor reporting in the shareholders’ agreement and building a sound reporting practice. An example of the structure I recommend for my portfolio companies on investor reporting can be found here. However, it should be noted that the reporting should be relatively light and not create an unnecessary burden for the company.


Future Financing

Existing Shareholders Participation

The rights and obligations of the existing investors to participate in the future funding rounds may be specified in the shareholders' agreement. This can be e.g. that the investors have right but no obligation to participate in the future funding rounds. The obligation to provide financing usually applies only when the investment is drawn down in tranches. However, this is typically agreed upon in the investment agreement and not on the shareholders' agreement.


Third-Party Financing

If the company is seeking further financing in the future, it may be stated in the shareholders’ agreement that the parties agree to use their best efforts for closing the new investments. As this financing may require entering into new agreements etc. the parties may agree to enter into all customary agreement as may reasonably be required.


Transfer of Shares

Having the right shareholders, or more correctly: not having the wrong shareholders, is critical for a startup, the transfer of shares is typically very limited compared to other limited liability companies. As a starting point, it is usually stated in the shareholders’ agreement that a transfer of shares is forbidden, unless specifically approved in certain situations. These can include e.g. transfer by investors subject to a right of first refusal, drag-along sale rights and tag-along rights.


Right of First Refusal

Having the opportunity to sell the share prior to the actual exit makes the investment somewhat more liquid for the investor and, thus, the startup more attractive as an investment target. However, it is in the interest of the startup to control how are its shareholders.


Foreign Agent If an investor would transfer the shares to a competitor, this competitor could get access to the decision making of startup through the selection of the board and can access the information given to the shareholders.

In order to exercise this control, the company may have limited the transfer by the investors with a right of first refusal. This means that prior to transferring the shares, the shares should be offered with the same terms for purchase to the other shareholders and/or redemption to the company.


Drag-Along

Drag-along sale clauses are meant to ensure effective exits. Drag-along means that if there is a purchase offer for all the shares of the company and a sufficient majority has approved the offer, the rest of the shareholders need to accept the offer on the same terms as well. Thus, these shareholders are “dragged” into the deal.


Tag-Along

Tag-along is sort of the opposite of drag-along. In case some shareholders are selling shares that amount to ownership specified in the shareholders' agreement, the other shareholders have a right to sell their shares in the same transaction. I.e. they have the right to “tag” into the original transaction. The purpose of a tag-along clause is to ensure that if a major part of the ownership in a company is sold, all of the shareholders have an opportunity to take part in the sale.


Liquidation Preference

Investors may require liquidation preference, especially in the later rounds. Liquidation preference means that in case of an exit or liquidation of the company, the party having the liquidation preference has some benefit on the proceeds over the other investors. This can be e.g. that the investor can choose either to take back their original investment or distribute the funds pro rata with the ownership (so-called non-participating 1x liquidation preference).


An important thing to note is the level of preference. While 1x (i.e. a return of the original investment) is quite common, liquidation preference of higher multiples (e.g. preference for 4 times the original investment), can have a significant negative impact on the value of the shares of the other investors.


Sometimes liquidation preference is defined as the original investment amount plus a certain percentage per year (e.g. original investment + 8% p.a.). One should note that in case the business does not go according to plans, and it rarely does, investors holding these shares may accumulate so much preference over the actual value of the shares that the company becomes non-investable.


Leaver Events

Founders and key employees are the most important part of the startup. However, it is a fact of life that things do not always go according to plans and people leave the company. As the founders are the key shareholders in a startup, it is important to agree on what happens to their ownership in case they leave the startup (a so-called leaver event).


Bad and Good Leavers

Bad leaver is a leaver who is fired from the startup for reasons relating to the leaver's performance or who resigns from the company without agreeing on the resignation beforehand. Good Leaver, on the other hand, is a leaver who resigns in cooperation with the startup or has to be let go due to the financial situation of the company.


Vesting and Redemption of Shares

Leaver events are linked to vesting. When investors make an investment into the company, they expect the founders to continue to push the company forward. In order to ensure this, the investors typically require some sort of vesting period. During this period, the shares become vested.


How vested and unvested shares are handled in a leaver event depends on what has been agreed, but in any case, in a bad leaver event, the leaver is generally in a worse position than in a good leaver event. For example, the shareholders’ agreement may state that the Good leaver is entitled to keep all vested shares and the unvested shares can be redeemed at fair value, while the vested and unvested shares of a bad leaver may be subject to redemption at fair value and nominal value respectably.


Bad Apple It usually makes sense to have an option to redeem all of the shares of a bad leaver, even if vested shares would be acquired at fair value. Having a bad leaver as a shareholder, or even worse as a major shareholder, can have a significant negative impact on the performance of other founders.

Authorization in Certain Situations

While the shareholders’ agreement governs decision-making in key situations, some actions require more for the shareholders than just the decision. For example, in case of an exit, after the exit decision, the shareholders need to execute other documents as well, e.g. signing the share purchase agreement. If some shareholder refuses to perform these activities or remains passive and does not perform the required activities, the exit could get terminated.


In order to avoid these kinds of issues, it may make sense to include clause authorizing e.g. the board to act on behalf of shareholders not performing their duties under the shareholders’ agreement in certain key transactions. Of course, as the kind of clause means a significant transfer of control away from the shareholders, one should be extremely diligent when applying the clause.


Intellectual Property Rights

Most startups are founded for the commercialization of some intellectual property rights developed by the founders. For the sake of clarity and for the investors' protection the shareholders’ agreement typically states that all of these intellectual property rights have been or will be transferred to the company.


Market Hedging In one case a founder had assigned only European intellectual property rights to the company while keeping the rights for North America with himself. Founders’ reasoning was to hedge his position in case the European business would not fly, he could still try to monetize the rights in the North America. This was problematic from the investors' point of view for a couple of reasons: For one, growing the European business would also grow the value of the North American assets, but the investor would not receive any compensation for this. Second, there is the risk that in case the North American business would become more lucrative for the founder may abandon the European business the investor would have invested in. Not so surprisingly, the investment did not happen.

Non-competition and Non-solicitation

The founders and key employees are the key assets of a startup. So not so surprisingly, typically the shareholders’ agreement forbids founders and management shareholders in competing with the firm or soliciting employees or customers for the period of the ownership as well as a certain period after the shareholder has disposed of the shares.


It should be noted that a non-competition clause in a shareholders’ agreement is typically more rash than a competition clause allowed in an employment agreement. The former is governed under contract law as a breach of the contract whereas the later is governed under employment law. Thus, both of these can become applicable at the same time.


Competition One of the most common legal disputes between startups arise from hiring between competitors; followed by the claims that the hiring company is illegally infringing the intellectual assets of the previous employees.

Adhering to the shareholders’ agreement

If the company is seeking new funding or gives shares or options to the employees in the future, the company will get new shareholders. Thus, the shareholders’ agreement should contain clauses on the requirement of the new shareholders to adhere to the shareholders’ agreement and how the adherence is made.


Typically, approval for the transfer of the shares is tied to the adherence to the shareholders’ agreement by the party receiving the shares. And the approval of the new shareholders’ adhering to the shareholders’ agreement is often delegated to the board of directors of the company, provided that the conditions for the adherence are met.


Breach of Agreement

Every good agreement contains clear clauses on what happens in case of breach of the agreement. (And a great agreement contains so clear rules on everything that no-one ever reads it.) Typically there are clauses on notification of a breach, cease of breaching activity, liquidated damages and dispute resolution. Hopefully one never needs it, but once it is in the agreement, the consequences of a breach are clearer and the likelihood of a breach is lower.


Conclusion

The shareholders’ agreement is typically the most complex of the investment documents. While it might be feasible for both the investors and founders to use legal help with the shareholders’ agreement, I see that it is of utmost importance that both the founders as well as the investors understand their rights and responsibilities under the agreement.


Interested in other investment documents? Find out more below:

Term sheet

Investment agreement

Syndication agreement


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