Shareholders Agreement Templates – How To Find The Best

Clients often ask about shareholders agreements – whether it is a good idea to create one, and how best to do so.

Because these documents are used so commonly, unless the ownership structure of the business is particularly unusual, most owners should be perfectly able to use a good quality shareholders agreement template as the basis for drawing their own document.

But be aware, some templates are better than others. The coverage of key issues, the style of language and the structure of the agreement should all be considerations when choosing to buy from any legal document publisher.

Why put an agreement in place yourself?

Many people think that they need a solicitor or an accountant to draw up a company shareholders agreement. That isn’t true.

Often, the shareholders themselves are in the best position to decide how the company should be operated.

The reason is that much of the subject matter of the document is not legal, but practical.

Of course, there is law that must be complied with, but much of the document covers practical matters which only the owners themselves can decide on.

The other common reason to write your own based on a template is cost.

 

A sample agreement created from a template

 

A solicitor (or an accountant) might charge from £300 to £2,000 for drawing a standard shareholders agreement. Compared to a charge-out rate of several hundred pounds per hour, this might seem reasonable – especially if the cost split between all the shareholders. But when you consider that the work that the professional does is essentially to customise a template, the value for money is much less.

Solicitors themselves use templates to draw documents. Traditionally, many used what are called “precedents”, template paragraphs of text covering a single matter, to build up the document. Commonly nowadays, they download an entire document template, just as you might, from a legal stationer.

How to judge the quality of a template

Coverage of issues

A long yet comprehensive agreement is better than a short one that fails to address sufficiently all issues of control and management. Any legal contract should be to the point, but being short is likely to compromise the quality. You just can’t fit in all the important content in a document that is only one or two pages long.

If you are worried that your fellow founders or owners are unlikely to sign up to an agreement that is more than a couple of pages long, you can do two things. The first is to summarise the key points of the agreement on the first page (sometimes, the key points are called heads of terms or a memorandum) before presenting the longer agreement behind. The second is to use a document that your fellow shareholders can read and understand easily and therefore gain trust in.

Plain English – simple language and structure

A legal document does not have to contain complicated words and legal jargon in order for it to be legally binding. The idea of any document is to make sure that all parties knew what deal they were agreeing to when the document was signed. Indeed, nowadays, the inclusion of legal jargon can actually act to the detriment of the strength of the agreement.

Find a template that is written in plain English. It will be much easier to edit, particularly if you want to add in more than the odd word yourself (likely with a shareholder agreement because so much of the content is personal to the owners). You will also be able to persuade your fellow owners to sign up to it more easily if they feel comfortable that they understand it. If they don’t insist on passing it by more lawyers to decode it, the overall cost will be kept down, and the agreement signed more quickly.

Linked in to this point is use of a simple structure. When solicitors use precedents to draw a document, they often cross reference paragraphs because these paragraph templates are independent to each other. A good full shareholders agreement template will have been written by a lawyer who has made sure that each point does follow on from the previous.

Help

Your document should come with help as to how to complete it. This might be in the form of notes with the template, or it might be a Q&A system, or it might be post-purchase support.

A shareholders agreement is a straightforward document. It should make sense as you edit the template. The inclusion of some form of guidance indicates quality – that the person who has written the template knows what he or she is talking about, and that he or she has put time into making a well-rounded, well considered product for the end user and hasn’t just knocked off a document quickly.

Price

Price is a good indicator of quality. Free templates are available, but rarely are reasonable quality, let alone good.

The price reflects the knowledge of the person who has drawn the document. The per hour cost of a solicitor is high. Drawing a good shareholders agreement takes time, as does maintaining it. There is a cost involved.

Free shareholder agreement templates are unlikely to be maintained, and unlikely to have been written carefully.

There may also be another catch with free templates. You may have to provide your credit card details and take up an expensive monthly subscription (if you don’t cancel in time).

You may have to provide personal information that is subsequently used for marketing other products and services to you.

By using a template, you are already saving considerably on the price of a solicitor. The benefit of the additional saving by using a cheap template is completely outweighed by the loss in quality. The scare stories about do it yourself documents are mostly as a result of poor quality, free templates being used rather than because of the DIY aspect.

Author

This is common sense, but do make sure that you know who has written the template that you use.

The qualification of the author is second to the experience that he or she has. Many legal document retailer businesses are run by ex-solicitors, who no longer can call themselves that because of the Law Society’s restrictions on what services solicitors may offer. But often these owners have many years of experience of the law.

If there is no mention of who has written the document, be very wary. It is easy to take a template and resell it as a download. The problem may be that the seller may not know (or care) whether the template is any good, or perhaps whether it is even valid for the laws of the UK. He or she is very unlikely to maintain it in line with changes in the law.

When it was last updated

Shareholder law does not change often, but nor does it stay still. Various changes to the Companies Act are brought out every couple of years.
Make sure that the template you download has been reviewed recently and updated for any new, relevant law.

Reviews

Any reputable document retailer will publish customer reviews. These should include those relating to how good the document was, but also how good the retailer’s service was.
Some customers (likely to be solicitors or accountants) should have enough experience to be able to leave expert reviews that will give you an insight as to whether the template is well written or not.

Number of years the retailer has been in business

Established retailers are likely to sell higher quality documents. Not only would mistakes in an agreement be noticed and corrected over time, but also subsequent revisions and improvements are likely to have been made.

Technology

There are two large law technology companies offering shareholder agreement templates.

Technology needs capital behind it, but technology itself isn’t an indicator of quality. In fact, these companies see themselves as tech companies that happen to operate in the legal industry, rather than lawyers who use technology.

Because shareholder agreements are so personal to the shareholders, technology can only go so far in producing a customised document. The basics will be covered, but from experience, the online shareholder agreement software tends to lack the coverage of issues that templates for download do.

Accessibility

Just as the provision of help is an indicator of a well thought out product, if a template can be edited without needing to be an expert in word processing, it shows that someone has thought about how to make a good quality document that anyone can use.

The best way of making sure there is no requirement to have your own software installed is to provide editing functionality online. That certainly is an advantage of the technology based retailers.

However, offline access also has advantages. You are likely to want to draft your shareholders agreement in stages, with consideration by all parties at each. You’re not likely to create it in a single session.

You will want to format it and style it.

You will also want to print it out or e-mail to other company owners for revision and approval.

Templates in file formats that are compatible with common word processors such as Microsoft Word, WordPerfect, Mac Pages, OpenOffice and LibreWriter give you access to the functions of those software products. For example, track changes functionality is very useful when collaborating on a legal document.

Note that you are going to have to edit your document. You won’t find one that fits out of the box, where you simply have to fill in your names and sign. Adobe Acrobat (PDF format) isn’t a good format to use because it can’t be edited easily.

What should your agreement cover?

Although your document can cover strategy and objectives, you shouldn’t confuse your shareholders agreement with your business plan. Your agreement should cover issues relating to ownership and control, not company objectives.

Most standard templates cover:

• issue of shares to new shareholders
• duties of company officers and directors – who runs the company day to day
• how board and shareholders meetings take place and under what circumstances
• what level of shareholder approval is required for key matters
• shareholders’ rights and responsibilities
• rights of first refusal (ROFR) to buy the shares of shareholders who are selling to others
• shareholders’ rights to information and dividends
• how exit is managed – what happens when shareholders sell, die or otherwise leave the company
• restrictions on ownership of other competitor companies
• restrictions on passing on shares to others, or the rights that other incoming shareholders acquire
• jurisdiction – make sure your agreement is valid under the law of the UK (England and Wales, Scotland or Northern Ireland), and not elsewhere

When to put a shareholders agreement in place

Every agreement balances the interests of shareholders differently. As such, they are usually best drawn up when interests change, such as:

• when the company is started (on incorporation)
• when minority shareholders want greater influence on decisions that are important to them
• to protect a shareholder who has lent the company money
• on the appointment or termination of directors (perhaps those who are not founders)
  as company strategy changes

The process for putting a shareholders agreement in place – how to do it

Putting a new shareholders agreement in place requires the approval of all shareholders.

Drawing up a new agreement can be started by just one person, but eventually all owners will want to give input.

Note that the agreement is private between the shareholders. The directors do not have any involvement (unless they are also owners), and the agreement is not required to be filed publically (such as at Companies House).

We find that the following process works well.

1. One shareholder proposes to the others the structure of the new agreement (effectively summary points). He or she might use a template to identify the key points. Usually, using several templates works best.
2. A working draft is circulated, and the other shareholders are requested to add any matters that may have been missed out. These newly incorporated points are usually those that are most important to each. It is a good idea to ask why they are being included.
3. The co-ordinating shareholder lists the changes that the others have made, such as “John Smith requests that if any decision about the appointment of additional directors to the board is done on a one person, one vote basis. This is because he feels that…”. Those changes are circulated.
4. Negotiations can then take place between shareholders based on principled positions.
5. The final summary of terms is written up and agreed.
6. The shareholders agreement is drafted, using a template as the basis. Each point agreed in summary is checked to be included accurately and fully in the final document.
7. The final shareholders’ agreement is circulated to the owners. Owners can then sign, or request further changes.

Shareholders do not need to call a meeting, or be together to sign. They can sign in private. However, it may be a good idea to insist on each signature being witnessed to ensure that the signature is that of the shareholder.

Further advice

Some shareholder agreement template providers also offer a final document review service, either using in-house lawyers, or outsourcing the work to a “panel” firm.
Having your final document reviewed can provide much reassurance to all shareholders that the agreement is above board and does what it is supposed to do.
It is also much less expensive than asking a solicitor to draw up the document from scratch, and is a good alternative proposition if one of the shareholders wants a solicitor to be involved in the production of the document.

Good & Bad Leaver Clauses In Shareholder Agreements

Good leaver/bad leaver clauses set out terms of transfer of all or some of the shares of a departing director-shareholder to the remaining ones based on the reason for departure.

If a founder is also employed as a director of the company, he or she has employment rights, which are quite separate to shareholder rights. Good leaver/bad leaver clauses provide a mechanism to tie the end of employment with the end of share ownership.

Good leaver clauses provide incentives to founders who are important to the business to stay working in it until milestones are reached, while bad leaver clauses act as a deterrent to leaving early or breaching another contract (such as a director’s service agreement).

Defining what a good or a bad leaver is

Leavers of both types can be defined by actions as broadly or as narrowly as the shareholders like, with one being the remainder of actions that the other isn’t. Typically, actions that would define a good leaver would be:

• death
• mental or physical incapacity that doesn’t allow the founder to continue working
• redundancy
• departure following change in the remuneration, duties or role of the founder as an employee
• the achievement of a particular event

Other shareholders may also be able to agree that a leaver is a good one at their discretion.

Retirement may also be an action, but since there is no longer a default retirement age, retirement as an action may be discriminatory against other non-departing shareholders.

A bad leaver may have acted in such a way as to damage the business – with evidence of loss likely to be already apparent. The definition of a bad leaver might be tied to actions such as:

• fraud
• dismissal from employment for gross misconduct or any other reason that is not unfair or constructive
• exceeding limits of authority
• disqualification as a director
• breach of the shareholders’ agreement
• failure to achieve certain targets before voluntarily leaving employment

A bad leaver clause may seek to penalise the founder for his or her actions, by forcing the sale of his or her shares at a discount to the current valuation. All shareholders should be aware that this may not be sufficient to compensate others for losses as a result of the actions of the departing shareholder, and that it may not be possible to pursue the leaver for further damages. In other words, these type of clauses do not provide insurance.

There may be several types of bad leaver, with different rules associated with each. The provisions don’t have to be as black and white as “good” or “bad”. Bad leavers are often named as “early” leavers in order to remove the negative connotations of leaving under what are perfectly reasonable circumstances.

Having multiple types of leaver does complicate arrangements.

Share valuations on departure

The price at which the shares are bought in any situation is a commercial matter, not a legal one.

Generally, good leavers will be bought out at fair market value, and bad leavers will have their shares bought at a discounted valuation. The price will be calculated as at the date of termination of employment.

A discounted price is effectively a penalty. A court may decide that a price is too punitive, unfair, and therefore is unenforceable. Recent cases suggest that if a bad leaver provision is clearly commercial in nature (and not personal), and has been negotiated by all shareholders (and not imposed), it is enforceable.

Valuation of a private company is always difficult because it is subjective. The adage that something is worth what someone else will pay doesn’t work in leaver situations.
So shareholders need to agree on how the company will be valued under different scenarios. For example:

• a particular valuation method or formula might be used
• an independent accountant may be asked to provide an opinion

A bad leaver may receive:

• the determined value of his or her discounted (which may vary depending on the circumstances of departure)
• the nominal value of the shares
• the lower of the two

Payment terms

As well as price, payment can be delayed so as to allow money to be found to buy the shares, and provide an incentive for the terms not to be triggered.

The question of who buys the shares also needs to be considered. Shareholders might not have cash to hand to pay for shares on the unexpected departure of a co-owner. Nor might the company. But the company may be able to arrange loans for a purchase more easily than individuals.

Payment might be delayed until another event is achieved (such as an IPO). However, shareholders need to be careful to make sure that this event will happen within a reasonable timeframe, otherwise such a delay could be deemed unfair.

Options to buy rather than requirements to buy

Because finding the money to buy out the leaver can be difficult, instead of the obligation to buy out, other shareholders could be given the right instead. In other words, other shareholders have the option to buy in certain circumstances, but do not have to exercise that option if they are not able to do so.

Options may also be more tax efficient for certain shareholders.

The need to consider leaver provisions alongside other documents

Shareholders need to make sure other documents do not conflict with the terms in the shareholders agreement. Leaver provisions may conflict with terms in directors service agreements (employment contracts), the articles of association, lending agreements where the directors are personally guarantors, and share option agreements.

Employment law is important to consider. A claim that a founder cannot carry out his duties as a director may be well founded, but employment law may require you to offer alternative suitable employment, rather than having him or her leave. You want to avoid claims for compensation for unfair dismissal or breach of contract.

It is important in any case that the terms are clear in order to avoid argument over meaning. Forced sale of shares, at any price – even a fair one, is likely to be contested, and litigation is expensive.

Should you include leaver clauses?

The argument for including leaver clauses is that other shareholders, particularly institutional ones such as venture capital firms, will not want founders who have left the business (who may now be working for a competitor, or who may have been dismissed as a director) to continue benefitting from holding shares, and to continue owning rights.

Depending on your view, this may not be a particularly strong argument.

A founder is likely to have put a lot of work into the business to get it to where it is. Share ownership is often regarded as a reward for risk taking. Business risks in a small start-up could be argued to be greater than once the company is established, and therefore keeping hold of shares is fair compensation for those earlier risks.

Additionally, a former director with experience of the business may be as likely to be able to contribute positively to shareholder decisions as any current director or intuitional investor.

The reason institutional investors like good leaver/bad leaver clauses is that they provide a mechanism to remove control from someone who no longer is a requirement in building the business. It may appear to be a cynical view that investors don’t want to cede power to anyone (let alone someone who doesn’t have any future role in increasing the investment’s value), but such a tactic is a commercially sound one.

Because a new investor will insist on having a new shareholders agreement written up, including good leaver/bad leaver clauses in an agreement between founders is probably unnecessary.

Incorporating A Dividend Policy In Your Shareholder Agreement

Value can be extracted from a company in two ways: sale of the shares and distribution of dividends.

The strategy that the shareholders agree is important for all owners. That might be to retain all profits, reinvest them, grow the business and sell out completely within 5 years, or it might be to distribute profits as a dividend each year indefinitely.

These two ways need further consideration:

A buyer usually prefers to buy the whole company so that he or she has complete control. Purchases of minority stakes do occur, but are less frequent and are less likely to value the shares highly. Drag along and tag along clauses generally are included in shareholders agreements in order to maximise the likelihood and price of a sale.

By default, dividends are decided each year by the board of directors depending on profits made.

As a result, the owners for whom control of rewards is likely to be a more important issue are those who are not directors (and who therefore cannot influence the board on a vote about declaring a dividend, and who may not receive a salary) and those who are not majority shareholders (and who cannot bring in others to sell the whole of the company).

The issue for the shareholders who do not have a day to day involvement in the company is that cash can be spent by the directors to the benefit of other shareholders (who may be directors). For example, the board of directors may increase salaries by paying bonuses in order to reduce profits available to pay dividends.

Terms in the shareholders agreement, in conjunction with changes to the company’s articles of association can change how decisions on rewarding ownership are made.

For example, owners may agree that:

• any board decision about the declaration of a dividend must be agreed by the shareholders (perhaps on a basis of a vote of hands rather than a vote based on shareholding)
• dividends can only be paid if certain conditions are met
• certain shareholders are entitled to a greater proportional share of dividends than others (perhaps under certain circumstances or for a limited time)
• certain shareholders waive their right to receive dividends (again, for a limited time, on a voluntary basis, or under certain circumstances)

There are tax implications to changing a dividend policy. Capital gains on the sale of the company are taxed at a different rate to dividends, which are taxed as income. The reason for a shareholder wishing to agree on a dividend policy might be to reduce a particular type of tax. Other shareholders should be aware that there are likely to be implications for them as well.

A dividend policy can also affect the value of shares. If a buyer knows that value can only be released in certain ways, he or she may be willing to pay less to acquire the shares.

A dividend policy may very well be a term you want to include in your shareholders agreement, even if your start-up is unlikely to pay dividends for a number of years. A dividend policy affects how investors value the company as an investment and is interlinked to your exit strategy.

You should also certainly look at how directors may propose and declare dividends in the articles of association so that the two documents are aligned.

Planning In Case Of The Death Of A Shareholder

This may seem like a very morbid subject to bring up with the other founders when you are discussing terms in a shareholders agreement, but as the (paraphrased) saying goes “death and taxes are certain”.

Unexpected death does happen, and as with any event that changes control of the company, you should consider what would happen. We assume that we are not planning in case of your death.

Like any property, who inherits the shares depends on the last will and testament of the person who has died. The legal term for a person who inherits is a “beneficiary”.

If there is no will, “rules of intestacy” decide who inherits. Generally, a wife or husband is the first person in line to inherit. If that is not possible, then children are next in line. Children under 18 can’t technically inherit – property is passed into trust on their behalf and managed by the executors of the will or someone else.

What you need to plan for is control moving to someone who may be inappropriate to deal with it. That may be anyone who cannot bring into the company the same skills as the person who has died, or it may be particular types of people such as young adults who may not yet be experienced enough to make business decisions, or a particular person, such as the husband of your co-founder who has always objected to the business.

It might also be a complete outsider. If the person who inherits does not want to be a shareholder, he or she may sell to someone else.

The ways of doing this are:

• limiting the rights of any new shareholder to make certain decisions about certain matters
• defining death as an event on which other shareholders have a right to buy the shares (similar to a right of first refusal)

Limiting the rights of a new shareholder is limited itself. Firstly, you cannot override the statutory rights of any shareholder. Secondly, the incoming shareholder may be able to deem the limitations “unfair” if they don’t end after a reasonable amount of time. A reasonable amount of time may not be enough to protect the company.

Defining a right to buy is generally preferable. You need to set out how the offer price should be calculated and who should have the right.

It could be the company that buys back the shares (in which case, all shareholders benefit in the proportions of their shares) or it could be individuals who have the right to buy a proportion no larger than their current proportional shareholding in the company.

Financing the purchase might be a concern. The buyers may not have the cash to hand. In which case, they could be given an extended time to pay.

Another alternative possibility is that there could additionally be a right that is triggered on death that allows the beneficiaries to buy the shares of the other founders (perhaps if none of the founders wants to, or can, buy out the beneficiaries). This may work particularly well if the shareholder who has died was a majority owner.

The great thing about such a right is that it can be backed by a life insurance policy (perhaps even paid by the company as an employment benefit) to provide the money required to do so.

Of course, having a “reversed” right isn’t for everyone. If your start-up has been your life for several years, you may not be happy to sell. However, you should consider whether the alternative of having someone else making decisions about your business is any better.

When considering what to cover in your shareholders agreement, do consider the unexpected. You need contingency plans for what happens to high level control, as well as what would change on a day-to-day basis from an operational point of view.

Why Investing With Sweat Equity Is Rarely Beneficial

Many projects are started between friends without a consideration of what each is putting into the business. The act of “starting”, of creating, is exciting

Sometime later, when the founders can see that the business has legs, they decide to incorporate it and put in place a shareholders agreement. That is the point at which ownership of the new company first becomes an issue.

Ownership and control is, by default, based on share ownership, which is in turn “considered” in terms of financial value. If you are dealing only in financial units, such as money, determining who will own what percentage of the business simply is a question of how much money each party is willing to invest as equity. The person who buys more, gets a greater say.

Any other input first has to be converted into a financial unit, and that is where problems start arising, particularly in relation to work contributed, or “sweat equity”.

In order to value someone’s contribution in time and effort, you need a comparison that is measured in financial units. Common ones used are wages foregone (a measure of what has been put in) and contribution to the value of the business now (a measure of what has been created). Neither are perfect.

The first stumbling block is that common equity gives both value and control. If you are looking to compensate or reward someone in place of paying a salary, then ideally you want to give shares in stock that has no voting rights attached.

The second hurdle is that the value of the company should grow over time, but perhaps not directly as a result of the initial work the founder. If initially, if Founder A creates the website and the Founder B creates the products, then at the point of incorporation, both might have contributed equally and an equal share of ownership might seem appropriate. But if Founder A then contributes little else, leaving B to manage and grow the company, is a 50:50 split fair a year on? Founder A might have been better to employ B to build the website using the capital he would otherwise use to buy the equity, and own 100% of the company.

If equity shares do reflect work contributed, then ideally shares need to vest over time. That is to say that founders take a growing stake in the company over time, or as projects complete. That won’t be perfect either, because one person’s contribution is unlikely to be the sole driver of growth.

Lastly, equity only has a value if there is someone to buy it (the shares and not just the assets in the business) or if the company is profitable enough to issue dividends. The value is also dependent on the buyer – it is worth what someone is willing to pay.

Full control of the company is often worth more than partial control – especially if the shareholding is a minority one with few rights. Therefore any founder with a minority of shares that have been “bought” with sweat equity may find himself or herself waiting for a long time before the company is sold, at a price that may not reflect his or her contribution and patience. A majority shareholder could block any outright sale that would value the company more greatly. The true value of the sweat equity when it is liquidated might not be as expected when it was agreed as compensation for not buying in with cash.
This could be mitigated, in theory, by options to have the company buy back the equity from the shareholder at a given price if a particular event happens. This might allow the sweat equity to be cashed out sooner. But it is unlikely to reflect the true value of the equity because the other shareholders will want to make sure that holding on is always more attractive.

Sometimes there is no alternative other than to let one of the founders invest with sweat equity. He or she might be critical to the project, but have no cash. But you should be careful, and you should look into alternatives such as loans.

Non-Compete Clauses In Shareholder Agreements

Many employment contracts contain non-compete clauses, which prevent an employee from leaving the company and either moving to a competitor or setting up themselves. The argument including these types of clauses is that an employee is likely to acquire significant knowledge about the company’s business plans and intellectual property (IP) during the course of his or her employment, that the business would not want a competitor to find out.

The protection of business secrets is a reasonable aim, but non-competition clauses are often difficult for employers to enforce because they can restrict too broadly the departing employee’s rights to employment elsewhere.

A lack of enforceability within employment contracts doesn’t help small companies when founders, who are often the best informed people in the business about secrets, fall out. Simply put, it isn’t easy to stop an executive director from setting up on his own just by including a non-compete clause in his service agreement.

A stronger alternative is to place such terms in the shareholders agreement instead – binding founders not as employees, but as owners. These types of terms in agreements are never infallible, but are generally better supported by courts.

A non-compete clause protects all the shareholders by preventing any other from starting a rival business or contributing to a direct competitor. One of the advantages is that it should not only bind departing shareholders, but also current ones, whether they are directors, non-executive directors, other employees or not employed.

One of these clauses also binds shareholders equally regardless of the size of the shareholding. Founders could be just as protected when bringing in a new manager who is rewarded with a small equity stake as well as pay, as when a significant owner sells out because he disagrees with the strategic direction.

Just as for employment contracts, the enforceability of such clauses in shareholder agreements depends on whether the terms are reasonable – something that only a judge can decide.

However, you can increase the likelihood that your clause would be seen as reasonable by limiting restrictions on competing in terms of time, role, geographical area and type of business.

For example, it is probably less reasonable to prevent a shareholder of a UK-based gaming app design company from being involved in a business in the European software industry for 10 years, but is more reasonable that he should wait six months before becoming involved in a gaming company that sells software in the UK. A reasonable scope of restrictions obviously depends on the type of business, but it should look to protect the business, not punish the shareholder. It should be as specific as possible.
You should also bear in mind whether other terms control when a shareholder can compete. If a shareholder is blocked from selling his shares in some way, he is effectively blocked from starting a new competing venture. A short time limitation that on the face of it looks reasonable may never be able to start, and therefore might actually be a potentially unreasonable limitation and an unfair restraint of trade.

Some shareholders try to make any restriction “more reasonable” by including an express acknowledgement by all that the clause is reasonable. Certainly a court will take this into account in a judgment, but it won’t prevent a court from ruling that the term is not enforceable.

Another consideration is that if you bring professional investors into the business (such as business angels or a venture capital firm), one of the factors for making an investment in your company might be prior investment experience in your industry. You should, therefore, not expect these types of investors to want to include clauses that prohibit their current or future investment in similar businesses. Instead, you should look to protect your IP in different ways.

One way of doing this is to limit (using the shareholders agreement) what types of information certain shareholders are told about. You can do this using terms that set out “information rights”. Another way is to set out clearly what types of matters shareholders vote on, as opposed to what types of matter executive directors vote on. Professional investors typically do not take executive board positions, so might be better insulated from the detail of certain operational matters.

Should you include one a non-compete clause in your shareholders’ agreement? We would recommend that you do (a good template should address competition), but that you seek to make it reasonable. It should offer the business some protection against one of the founders leaving to set up in direct competition. But the inclusion of one of these clauses shouldn’t be seen as the only type of IP protection needed, nor completely enforceable.

Liquidation Preferences

A liquidation preference clause is usually incorporated into a shareholders agreement by a professional investor (such as a business angel or venture capital firm) as a risk reduction tool in case the business fails but still has value in it, or to give particular shareholders a superior return over others on a profitable sale. For the investor, it is usually one of the most important terms to negotiate because it largely defines the outcome of investment.

The preference term sets out how the remaining value of the company is shared between the equity owners when a liquidation event occurs. That could be a negative event such as bankruptcy, but it could also be any other time where shareholders receive money for giving up equity, such as on acquisition by another company. Some shareholder agreements also define a liquidity event as the sale of “substantially all the assets”.

The preference clause should cover two pieces of information: who receives the right to a greater return, and what that return is.

Professional investors usually buy a particular issue of equity, such as “Preferred Series A” because doing so allows rights to be tied neatly to that stock. As a result, “who” receives the right to a preference is commonly defined by reference to share classes. However, there is no specific need to do this – you could refer to a specific investor by name.

The return might be a straightforward multiple of the share price paid (such as one and a half times the price) before the other shareholders are paid, or it may be on a pro-rata basis with other share class owners until a cap has been reached. The first is known as full participation, and the latter is known as capped participation. Non-participating describes those shareholders who do not hold the right at all. Capped participation favours the founders more than full participation because as “other shareholders”, the founders benefit at the same time as the investor, and not just once the investor has had his return goals met.

There can be added complications if there are multiple institutional investors and multiple financing rounds. Preference can be stacked on top of each other, so that later investors have rights to be repaid before earlier ones. How this is done is largely a matter of negotiation between investors.

If the liquidation event is a conversion of one type of share class to another, then investors might have secondary or tertiary “dips” at returns. They might have the right to receive a multiple of price paid at the first conversion, and a secondary right to receive another multiple when the new shares they acquire are later sold or converted.

Liquidation preference clauses are usually only used by professional investors. So as a founder looking to put in place a shareholders agreement with other founders, this isn’t a clause that we would say that you need to have. However, it is useful to understand how one works.

Observer Rights

In a young business, the founders are likely to be both the owners and the managers of the business – the shareholders and the directors.

How decisions are made differs between the board meeting and the members’ meeting.

The directors of most start-ups vote on board level decisions on a show of hands. That means each director has an equal vote regardless of whether he or she owns equity, or how much.

By contrast, most shareholder motions are carried based on the approval of the shareholders who between them carry the majority of the equity. That rule can be varied by mutual agreement between them all, but in general, it is the larger shareholders who sway the decisions.

This difference means that any large shareholder, such as an angel or venture capital investor, is likely to want at least one seat on the board in order to keep some control of the company between shareholder meetings. The founders might not want to give more control of the company to the investor (who already has significant power as a shareholder). The question then becomes: how should the investor participate in board decisions?

One way of doing that is for the investor to have the right to appoint at least one non-executive director. That person wouldn’t be a management-level employee of the company, but rather simply someone who can express the opinion of, and vote in the interests of the investor.

Founders (or indeed other investors) might not agree that the investor should have board level voting power. A compromise is often that the investor can appoint an observer to the board instead. The observer has the right to attend meetings, to speak (express his or her opinion) and to listen, but doesn’t have the right to vote.

Observers seem to be a harmless compromise. But there are many reasons why founders should be wary of giving observer rights to an investor.

An argument for appointing an observer is that he or she can bring additional knowledge to the debate. That might be the case. If the observer also has sat as an executive director on the boards of other companies, he or she is likely to have a great deal business experience and a network of contacts. But it might also not be the case. Because it is the investor’s decision as to who to appoint, founders may find themselves with someone with little operational experience who wants to be seen to be talking for the “most important” shareholder. That person may be difficult to get along with, may distract the directors from day to day business, and may not understand what the founders intended the business to do. Although the observer might have invaluable knowledge, but just because he was appointed by a professional investor, doesn’t guarantee that.

A second argument is that investors should have a right to know what is happening in the business. That is a valid point, but not one solved by having an observer on the board. The solution is to give “information rights” – the right to have a face to face meeting with certain executive directors every quarter where any matter can be discussed. If an investor has information rights, then having an observer shouldn’t be necessary.

An effective board of any company should consist of members who vote independently. That doesn’t necessarily mean that directors should listen to the opinions of other members of the board, but rather that they shouldn’t follow the leader.

In practice, founders tend to look to an experienced investor for advice. They also tend to be in agreement on many issues, so opinion is unanimous and voting is not required to make a decision.

That means that even as an observer, an investor who can speak at a board meeting can have a disproportionate influence on the board (almost the same power as a non-executive director). It is hard to disagree with someone who is funding your dream, especially if they have been there before. To be cynical, if you are looking to make sure you always meet your fiduciary duty to the company and the shareholders, then voting in the way the largest of the shareholders wants is not likely to land you with problems.

An observer could be asked just to observe, and not to speak. Often venture capital companies bring in a less experienced employee of the firm, to be trained up to a position where he can himself sit on the boards of investments. The directors may have no issue with this, but there shouldn’t be a need to have a right to do this. The VC firm should simply be able to ask the directors whether they mind.

Lastly, there is a practical argument why you should not have observers to board meetings. It isn’t a particularly strong one, but could be valid. It is that many voices in a meeting take time to hear and can side-track the meeting. With a strong chairman and an agenda, this shouldn’t happen, but it could be a risk.

Should you grant other shareholders observer rights?

Good advice is never to let anyone attend board meetings that you wouldn’t value as a board member. Don’t let someone sit in an empty seat. Make sure you know who is taking that seat and what value he or she brings to the discussion.

If you are undergoing a financing round, observer rights might be something you have to concede to bring in investment. It might be better to concede an observer position than a non-executive directorship. But make sure you agree on certain terms.

What should be in your agreement?

Observer rights might be granted as terms in the shareholders agreement, or in a separate investor agreement.

Parties to the agreement, and the name of the observer

The company and the investor are the main parties to the agreement. But even if the observer is a representative of the investor, he or she should be specifically named (perhaps in a secondary agreement so as not to have to amend the primary agreement if the identity of the observer changes).

If the investor wishes to change who the observer is, then all observer rights should be temporarily suspended until the new observer is named or otherwise brought into an agreement.

Notification of meetings

Board observers have no statutory rights to be notified of meetings, unlike directors. So that right needs to be given contractually instead.

Restrictions and process

There may be restrictions on which types of meeting an observer may attend, or for he or she will be given notice. There may also be a process that must be followed for the observer to be allowed to attend, for example, the observer must give notice that he or she will attend within a certain timeframe.

Information rights

An investor may also want the right to receive all notices, reports, documents and minutes relating to a meeting. If so, this should be specifically agreed. However, also in place should be confidentiality clauses to protect sensitive information.

Deadlock Provisions

What are these clauses?

Deadlocks provisions are terms that are incorporated into shareholder agreements in order to provide methods for resolution of issues over which owners cannot agree.

Because we are dealing with shareholder agreements, typically these issues relate to the management, control, direction or strategy of the company. They are important enough to all owners such that no individual is willing to move from his position and compromise.

These decisions should also be so important that the business becomes paralysed without a decision having been made. The principle behind them is that the ability of a company to trade (and therefore its value) should not be allowed to deteriorate because of indecision.

When are they used?

A shareholder agreement might limit the circumstances in which certain deadlock provisions can be used, for example, only on issues relating to the sale of shares to a third party, or they might be able to be called upon for any matter. Sometimes, the provisions are so severe to one side that the threat of being used is sufficient to change the stance of one owner and for the issue to be resolved.

Deadlock can usually only be announced after a number of votes have been taken, and the outcome of those votes is indecisive. For example, a key matter might have to be raised (and voted on) in three consecutive meetings before deadlock clauses can be brought into play.

Just as in any dispute, before a severe solution is forced, alternative methods of resolution should be encouraged. Mediation – a process where an independent third party leads discussions between the parties with the aim of finding a solution – is often a requirement before deadlock provisions can be invoked.

Different types of deadlock provision

Deadlock clauses usually require one shareholder to sell his or her shares to the others so that he or she no longer has control over the company, allowing the remaining owners to vote through a decision.

These are types of conditional termination provisions, and there are as many different variations for different situations as lawyers can invent. However, there are some common ones:

Russian Roulette is where one owner names an all-cash price at which he values his share of the company. The other shareholder (or shareholders) must then either buy the first owner out at that price, or sell his own shares.

A Texas shootout is effectively an auction, where the owners send sealed bids to an adjudicator. The sealed bids are opened at the same time, and the shareholder who has stated the highest price (i.e. the one who values the shares most highly) must buy the other out.

A Mexican shootout is a dutch auction. The shareholders make sealed bids stating the minimum price for which they would sell their shares. The owner who values the shares most highly must buy the shares of the other, but at the price set by the loser.

Multiple choice procedures are those where the shareholder agreement gives the shareholders many options for resolving disputes, and allows them to agree on the use of one for the particular situation. The idea is that agreement might be found in choice of method, and with the severity of the means of resolution in the minds of the shareholders, compromise on the issue at deadlock might be found. Multiple choice procedures get owners back to a position of agreement (at least on one issue).

Should you include deadlock provisions into your shareholder agreement?

Deadlock provisions are effective in so far as they break deadlock.

However, resolving a deadlock by using one of these provisions is rarely valuable for a company, and this is especially so for a small or young company.

The shareholders are likely also to be directors of the company on a day to day basis. Founders who are directors are likely to have key skills that the business needs to grow. Take one away through forced buyout, and the company could suffer more than if a decision on some matter hadn’t been made.

If there is such severe disagreement, founders are likely to seek other ways out of the business without having to resolve to using draconian deadlock clauses. In other words, if the going is so bad, so early on, it is unlikely that founders will want to remain shareholders.

These sorts of terms are often designed to “punish” one side over the other in order to be deterrence. That isn’t always fair, especially when both sides think that their position is principled. Shareholders will take a stand on an issue because it is important to their vision of what the company should be doing. Because the idea of using deadlock clauses is to prevent a deterioration in value – to keep the business running – shareholders, and especially founders aren’t going to put their company in a dangerous position unless the alternative was perceived to be worse.

Lastly, a shareholder may not have the money to buy the other out. It is all very well to fix a price on the company at which you will be willing to sell your shares, but if the other side doesn’t have or cannot raise the capital to purchase there isn’t a lot that can be done.

So what should you do instead?

A better way to resolve dispute, rather than include deadlock provisions, is to make sure that deadlock cannot occur. The ways of doing that include:

• making sure that one or more owners always have more shares and therefore more voting rights than others (for example, splitting the ownership of the company in a ratio of 51:49 rather than 50:50)
• making sure that the basis on which certain decisions are made is not based on shareholdings (for example, in a company where two founders own the equity 50:50, a shareholder who has invested debt as well as equity might have 2 votes on any issue relating to capital purchases over a certain amount, whereas the other shareholder would have 1 vote)
• appointing a third party to have a casting vote (such as a director trusted by both shareholders, who herself is not a shareholder)

Share ownership cannot be controlled through a shareholder agreement, but these other solutions can.

The short is that while deadlock provisions have intriguing names that suggest a sophisticated agreement (great If you are a lawyer working on behalf of a client you want to impress), you don’t need these clauses to resolve disagreement. There are other, simpler ways of avoiding deadlock that are probably more beneficial for the owners and the business.

Why Founders Should Insist On Tag Along Rights

Should you include a tag along clause in your shareholder agreement?

More and more founders are insisting on including tag along clauses in their shareholder agreements. The following is a quick explanation of what one is, and why you might use one.

What are tag along rights?

A tag along provision gives a shareholder the right to force a buyer to buy his or her shares on the same terms and in addition to any other shares.

The inclusion of this clause gives a shareholder comfort that if any other owners decide to sell, he or she can also exit from the company at the same time.

The reason why this might be advantageous is usually because any new owner is likely to want to change the direction of the company in some way. The existing owner, especially if he is a founder, might not agree with the new objectives, but might not otherwise be in a position to veto those changes. A tag along provision gives the existing owner a way of getting out of the business while the going is good (in his or her eyes).

When is a tag along provision used?

Most founders don’t include a tag along clause at the outset of their relationship. It is usually only inserted into a shareholder agreement when an institutional investor such as a business angel or venture capital firm invests.

Professional investors usually want to build a company and sell it on within a short time frame. That strategy might suit the founders well. But the next buyer might want to do something else with the business. Since any professional investor is likely to buy a majority stake, the founders might not have much say over who the second buyer is, or which direction the business takes after the second sale.

So the founders might agree with the institutional investor to include a tag along provision in their shareholder agreement. The clause does not affect their relationship in any way – it just gives the founders a means of exit next time round.

Are there any disadvantages to including one?

A tag along clause is beneficial for founders – especially for those with minority interests. Professional investors are likely to have much wider sales networks and thus should be able to find an attractive price for the shares. Plus, those investors will sell reasonably soon. The clause benefits minority owners by allowing them to piggy-back on the deal the professional makes (importantly, if they want to). That means they can continue with running the business rather than finding buyers or negotiating terms.

A professional investor also benefits. Not only will the next buyer be more likely to want to buy the whole business (and not have to worry about minority shareholders disrupting their plans for change), but a tag along clause gives minorities a sense that they are being treated fairly, and thus less resistant to changes in business direction or sale. Including such a term can align the interests of the founders and the professional investor towards rapid growth followed by near term sale.

Right Of First Offer Term

What is a right of first offer clause and why include it within a shareholder agreement?

Such a clause confers a right to existing shareholders to subscribe for a new issue of shares before outsiders can do so.

Simply put, it allows an existing shareholder to maintain the proportion of the company that he or she owns and thus the amount of control he or she can exert over decision making.

New share issues and percentage dilution

New shares are usually issued in order to bring in outside investment into a company. Existing owners may agree to increase the number of shares in the company, which are then sold by the company to new shareholders at a premium to the value of the business. The sale proceeds collected by the company are used for further investment.

Dilution of ownership can occurs at any new share issue. If a company has 100 shares and issues a further 20, then a shareholder who held 40% of the shares previously would find that he held only 33% of them after the issue. The new issue has the effect of reducing how much say he has in the running of the expanded company.

Right of first offer allows him to buy some of the new shares (usually up to the proportion he held before) in preference to anyone else so that he can maintain his relative power compared to other shareholders.

The dilution referred to above is known as “percentage dilution”.

Shareholders can also suffer from “economic dilution”. This happens when new shares are issued that have a lower face value than old shares in the same class. For example, a company might have issued 100 £1 shares and have a share capital of £100. If it issues a further 100 shares at £0.50 and the new subscription is taken up, then the share capital of the company becomes £150 with 200 shares in circulation. The average price of a share for a shareholder who held shares before the new issue drops from £1 to £0.75.

Why a right of first refusal clause might be important to include in a shareholder agreement?

The issue of new share capital affects the value of the investment of every shareholder. Yet the decision to issue is not one that all shareholders might make, or be able to control. Sometimes, it may not be the shareholders who make the decision at all, but rather the directors.

A majority shareholder might be able to control shareholder decisions; but he might not be able to prevent the board of directors authorising the issue of new capital and reducing his voting power as a shareholder on matters important to him. (He might have limited power on the board because he might not be a director or he might only control one or few of many board seats).

A minority shareholder might be powerless to control whether a share issue happens. The effect might be to further reduce his relative holding below the limits at which the law gives him automatic rights to do certain things. He may find himself edged out of the company without being able to prevent it.

In either case, the inclusion of a right of first refusal would allow the shareholder to maintain his power.

Mechanics of the clause

Usually, a limit is put on the number of new shares that can be bought so that a shareholder can maintain his ownership percentage, but not strengthen his position unless another shareholder decides not to (or cannot) exercise his right.

The company could make it easier for shareholders to take up their right by allowing them to buy the shares at a discount to the price external buyers would pay.

Should you include this clause within your agreement?

A right of first offer clause is not common in shareholder agreements where the company is small (and/or new). That is usually because shareholders are also directors, and all owners have similar sized stakes.

You might consider the inclusion of the clause if you think that your company will be seeking external equity investment in the future, but it is likely that any new investor, particularly an institutional one, will insist on creating a new shareholder agreement.