There are many reasons why a business can fail. However, one of the leading causes remains differences between shareholders. These can all be avoided with a shareholder agreement. But what can this document settle between companies?
They have disputes and different points of view, which more often than not lead to legal battles. Therefore, if you want to follow only good advice, here is all you need to know about the shareholder agreement.
What Is a Shareholder Agreement?
When you start a business with one or more partners, it’s quite easy to think that nothing will ever go wrong. Especially if your partners happen to be friends or family. However, even friends and family members fall out and, if that happens, you might end up with nothing. Therefore, as long as you have a very well drafted and discussed shareholder agreement, you are safe from any legal claim or battle.
As you might have imagined, a shareholder agreement is a type of legally binding contract between two or more of the shareholders in a company. Yes, it can only include a part of all the shareholders, if you so desire. For example, a shareholder agreement can be signed between the shareholders who own the same kind of stocks and so on.
What Does the Shareholder Agreement Cover?
Its primary purpose is to make sure the owners of a company have a fair relationship. In fact, here are the benefits of a shareholder agreement.
- It will clearly state all the shareholders’ rights as well as obligations.
- The agreement will regulate how shares will be sold in the company.
- It will describe the way in which you and your partners will run the business.
- Act as protection as far as minority shareholders are concerned.
- It will also provide protection to the company itself, not just the partners.
- The shareholder agreement will define how you and your colleagues will make the decisions in the company.
You can put a shareholder agreement in place any time you like. However, we suggest you do that right from the beginning, since the inception of the company and when you start issuing the first shares. It will put you all in the same mindset and give you all the same expectations about what’s coming in the future of your company.
Remember that, if you postpone it for a later date, by that time it might be too late. When there are more than two people involved in running a business, it’s difficult for them to think alike in the long term. Therefore, by the time you find a window to take care of the shareholder agreement, your partners’ minds might have changed so much that it’s not possible anymore.
8 Elements the Shareholder Agreement Needs to Contain
Since you now know what a shareholder agreement is and that it’s crucial for your business, without further ado, here is what you need to include in your shareholder agreement.
1. The Anti-Dilution Rights
Allow us to explain what they mean. In simple words, anti-dilution stands for the idea that the shareholder who has this right gets extra shares, sometimes. Therefore, he or she will have protection against declining shares from a percentage point of view if. This situation arises if and when the company issues new shares.
2. Pre-Money and Post-Money Valuation
It is crucial that you understand the difference between these two concepts. Pre-money valuation means your company’s value before you include funds coming from the outside. Post-money valuation is the opposite. It means the value your company reaches after you infuse it with external capital.
Once you know how to differentiate between the two, you will also understand that there is a difference in the percentage you pay toward your investors. In the long run, this difference could mean a lot of money for you and your partners.
3. Liquidation Preference
Here is one right that needs to go in your shareholder agreement but which only takes effect in case you have a liquidation event. This is the situation in which your shares become cash, as the name suggests. There are multiple reasons why it happens, as follows. You might have gone bankrupt, sold the company, or sold a huge chunk of its assets.
Cash investors are the first to get their money back, in this case. Next, come the founders, who can claim whatever is theirs from what money is still in the capital. Here is also where the shareholder agreement comes in. Depending on what you drafted in it, in the beginning, you might get back all your money or only a part of it.
For example, if it says so in your original agreement, your investors might be entitled to a positive return. This means that they will get their money back and more. Therefore, there might be not more funds left by the time it’s your turn to get back what you put in.
4. Control Rights
They refer to an investor having control over your company. Via the shareholder agreement, you can decide alongside your fellow founders and your investors in which situations and on what topics they can intervene. Intervening here means either blocking an initiative or influencing a crucial decision.
In the majority of cases, the founders themselves have control when they need to make a corporate decision. In order not to allow the investors to share in the influence, the founders must negotiate some special rights. Keep in mind that even minority investors can still have a heavy word to say at times.
5. The Drag Along and the Tag Along
The first concept, the drag along, is in place so that it can protect the majority shareholders. It basically means that they can literally force the minority shareholders to agree in case they ever want to sell all the shares. Keep in mind that you literally have to put this into the shareholder agreement and that you must specify the shareholder percentage exactly.
For example, you can say that, if a majority of 51 percent decides it’s time to sell the shares, then the remaining 49 percent must oblige.
At the other end of the spectrum is the tag along, for it aims to protect minority shareholders. The definition here is simple. If one of the shareholders wants to sell his or her shares, then the other shareholder or shareholders can, if they want, participate in the sale pro rata (proportional).
6. The Difference Between a Good Leaver and a Bad Leaver
In other words, you can use the shareholder agreement to specify the terms and conditions in which a founder can leave. And when they do,you can divide them into two categories: the good leaver and the bad leaver.
The first type refers to a founding member who still gets to keep some of the shares, simply because they did such a good job. The bad ones get nothing in return. The advice here is that you, as the founder, agree with your investors as to what a good leaver or a bad leaver really is. When the time comes that someone really wants to leave, you might not share the same perspective as to what a good leaver is.
7. Transferring the Shares
Here is one more clause which aims to protect the shareholders. It ensures that no shares can be estranged or sold to an unwanted third party. First, a buyer must be sought. Then, the shares must be offered to the other shareholders at the same price which was established for the third party.
If you believe there will be some kind of dispute over the real value of the shares, you can also include another clause in the shareholder agreement. It can come in the shape of a formula to define the fair value of the shares. Keep in mind that transferring the shares and its restrictions doesn’t apply to family members of the shareholders, nor to a trust.
As hard as it is to believe in the beginning, as time goes by, disputes appear among the founders and shareholders of a company. In fact, they can get to be so bad that there is literally no resolve for any of them. They are called ‘fundamental disputes’ and solving them should find its way into your shareholder agreement. Here are a few examples of such conflicts.
- Additional funding that the company needs
- Reducing or increasing the shares
- Paying dividends
- Whether to sell the business or not.
Therefore, you can add a fundamental dispute clause to your agreement. When the time comes, you can use it as an exit strategy. The clause can include a mechanism through which one or more shareholders can buy out the others.
As a conclusion, you should know that when it comes to business, the possibility of falling out with your founding colleagues or shareholders is immense and ever-present. Even more so when you do business with your loved ones.
You know what they say: never do business with friends and family! Still, if you absolutely must do it, consider a shareholder agreement first.
Images from depositphotos.com.