As a startup-orientated law firm, we at Nordic Law have had several early-stage startup clients with the recurring, oldie but goldie, question – do we really need to have a shareholders agreement (SHA) as we are all good friends and we all go way back? Down the line, without exception, we always advise our startup clients that they never should start a business without an SHA, let alone grow a business without it. With a well-functioning SHA, the founders and shareholders of a startup are able to solve, even possibly severe, problems beforehand and at its best an SHA minimizes the pressure of the shareholders enabling the shareholders to focus only on developing the business operations knowing that the core rules of the startup are clear, comprehensive and predictable. In other words, the yellow brick road to success is most often paved with a well-written SHA.
The next question we also often stumble upon is why an SHA is so vital? An SHA can along with the startup’s articles of association be classified as the constitution of the startup. An SHA should in minimum govern how significant decisions in a startup are done, how the shareholder structure and the roles of each shareholder are defined, how a startup can be closed or sold in a liquidation event and how intellectual property rights essential to the startup’s business operations should be protected. Especially in the light of the fast-paced business environment of early- and growth-stage startups, an SHA should be considered a must-have.
In this first blog post, which is an introduction to a series of startup-related blog posts by Nordic Law, we will present certain key issues that should always be taken into consideration when drafting an SHA for a startup with working shareholders. The main focus will be on three separate topics:
1) The roles of the shareholders and decision-making;
2) Leaver situations and transfer of shares; and
3) Redemption of shares from working shareholders.
The Roles of the Shareholders and Decision-making
In startups with many founders, one of the key aspects is that every shareholder is aware of his or her role in the startup. For majority shareholders it is also essential that their status is reflected in the administering of the startup. A good SHA should therefore always in a clear and understandable manner define the roles and specific tasks of the shareholders so that each shareholder is at all times aware of what is expected of them. This can, for example, be achieved with the help of the classification of shareholders to founders, working shareholders and investors. Especially if certain shareholders are responsible for managing and running the daily business operations, it is essential to define the roles of the shareholders that are not that active with the daily operations in order to avoid the `oh-so´ traditional “free rider” problem among startups.
If and when the roles of the shareholders have been defined, the next question that arises is the decision-making process of the startup. In most startups we have assisted, one or two of the founders have been the majority shareholders, whereby – prior to outside investors entering the picture – it is important to ensure that the majority shareholders are in every situation able to make all the decisions that are necessary in order to further-develop the startup. In this aspect, the SHA should always be prepared carefully as it is important that the SHA enables the majority shareholders to keep control of the significant decision-making, meaning, for example the right to nominate additional members to the board. It is also common that the SHA contains lists of certain key decisions, which require a qualified majority (explicitly defined, normally as 2/3 of all votes) and/or written consent from the majority shareholders.
Another recurring question is the role of the startup itself – should it be an actual party to the SHA or not?
The opinion varies quite a lot, but in our view the startup itself should also be a part of the SHA as quite a few conditions of the SHA affect also the startup itself, whereby the startup is not per se bound to the SHA if the startup is not also an actual party to it. Another solution is that the startup is not an actual party to the SHA, but instead the startup commits in writing to abide by the conditions of the SHA that affect it.
However, if you are the founder of a Finnish startup, you should always keep in mind that even though the startup would be a party to the SHA, the startup cannot abide by the SHA if it would mean that the startup would not comply with the Finnish Limited Liability Companies Act. That is also a factor that should always be kept in mind to ensure the best outcome with the SHA.
Leaver Situations and Transfer of Shares
As in everyday life, at some point also startups experience certain hiccups, which sometimes end in shareholders leaving the startup. It is, therefore, important that the SHA contains the necessary rules that control possible leaver situations – for example, what would happen if one of the co-founders suddenly decided to leave?
As a starting point, the shareholders could take advantage of the classic “bad leaver v. good leaver” concepts. If a shareholder leaves due to inappropriate behaviour, which would entitle the startup to terminate said shareholder’s employment agreement, then said shareholder would be classified as a ‘bad leaver’. In a ‘bad leaver’ situation the startup and/or the other shareholders normally have the right to redeem the shares of the leaver for a heavily discounted price (such as the original subscription price). Then again, if a shareholder is leaving based on the mutual decision of the shareholders or the shareholder is leaving due to circumstances that have been beyond the parties’ control, then the leaving shareholder is most often classified as a ‘good leaver’. It pays out to be a ‘good leaver’ as the shares of the leaver are most often redeemed for a considerably higher price compared to the ‘bad leaver’ situation. In ‘good leaver’ situation the redeeming of the shares could, for example, be based on the market value of the shares.
However, there are also other share transfer situations besides the above mentioned good or bad leaver situations. In the SHA should thus in an explicit manner be defined what the correct conduct is when transferring shares of the startup. Common conditions regarding the transfer of shares are that shareholders may not transfer shares without the consent of the other shareholders and that other shareholders shall always have the right of first refusal meaning that the remaining shareholders shall always have the right to purchase the shares of the selling shareholder. The right of first refusal and the correct conduct should in detail be defined in the SHA in order to avoid confusion among the selling shareholder, the remaining shareholders and the third party purchaser.
To the transfer of shares is closely connected the complete exit of the shareholders. In the SHA should be defined how the complete business of the company may someday be sold. In that instance, the common clauses concern drag-along and tag-along rights. The drag-along right becomes applicable when and if the majority shareholders wish to sell their shares and they receive a serious offer. If the majority of the shareholders want to sell, the rest of the shareholders have to join and cannot object to it. The tag-along right, however, is in place to protect the minority shareholders, including often investors, and it is useful when the majority of the shareholders have decided to sell their shares. If for example, a certain minority investor has originally invested in the startup because of the original founders, the tag-along right allows the investor to sell his or her shares at the same time as the original founders are selling.
Redemption of Shares from Working Shareholders
As mentioned above, in a well-functioning SHA the roles of all shareholders should in a clear manner be defined, whereby certain key employees, who often also are minority shareholders, would normally be defined as working shareholders.
The startup and/or the other shareholders should always have a right to redeem the shares of a working shareholder when the service or employment agreement of the working shareholder has been terminated – exemplified, the employment agreement of coder, and working shareholder, Adam is terminated and thanks to a well-written SHA, the startup has got the right to redeem Adam’s shares.
However, an unconditional rule that would always require the leaving working shareholder to give up all of his or her shares could in some situations be argued as unreasonable, whereby we come to the mysterious world of vesting clauses. Simplified, with vesting is meant that each shareholder gets his or her full package of shares at once, but the startup and/or the other shareholders have the right to purchase a percentage of the shareholder’s equity in case he or she walks away before all shares have vested – in other words, been earned. In a nutshell, vesting clauses protect especially the startup as all shareholders can rest assured that everybody in the team is working towards a common goal – the building of a successful and thriving startup.
The right of redemption normally lapse upon the working shareholder’s shares becoming vested within the time frame set in the SHA. Standard vesting clauses typically last four years and have a one year ‘cliff’ meaning that if a shareholder bound to the vesting clause would leave the startup before the first year is complete, said shareholder would be obliged to sell all shares to the startup and/or the other shareholders.
However, after four years the shareholder would be able to keep all of his or her shares even though the shareholder would leave the startup.
Above has been presented certain key topics regarding a startup’s SHA that hopefully have given a bit clearer view of the dos and don’ts. One thing that should always be kept in mind is that a well-written SHA takes away a lot of unneeded stress from the shareholders, which has got a direct positive impact on the startup itself. As the modified saying goes – happy shareholder, happy life.
Finally, as you may have guessed, there are other additional topics that are also very important to notice regarding an SHA, such as the protection of intellectual property rights and conditions relating to confidentiality, non-competition and non-solicitation, which can all be characterised as essential. This and much more will therefore be the topic in the next part of this blog series, so stay tuned for more!
[The author of this blog post is a partner at Nordic Law striving to learn the startup way of writing.]