Note: “Road To Exit: Start-up’s First Year” is a practical blog series addressing the most common legal questions and problems that a start-up company and its management faces during their first year of operation. The series is sponsored by Attorneys at Law Borenius Ltd.
First up, an insight to shareholders’ agreements between the founders.
If you start a company with several founders, or you expect to get more shareholders down the road, you should seriously consider executing a shareholders’ agreement simultaneously with the founding of the company. A shareholders’ agreement (or SHA) is an agreement regarding the administration of the company, ownership and transfer of shares, working obligation, non-competition and other issues governing the relationship between the shareholders and the company. There is no fixed definition or description of the shareholders’ agreement, nor is it regulated by law. Any type of agreement between the founders and the company regarding the issues referred to above can be deemed to be a shareholders’ agreement.
Here are the top 5 issues to agree between the founders.
1. Transfer of IPR´s to the Company
This one should be self-evident. Almost always some preliminary work on the business idea, service or product has been carried out prior to the establishment of the company and all such IPR´s (Intellectual Property Rights) must be transferred to the company. If the company does not own (or validly license) all the IPR´s necessary to run the show, the company will not get funded or sold. Period.
2. Working Obligation and Exceptions Thereto
This is particularly important in start-up companies. Working on the business idea can mean that there is a long period before the company actually makes revenue or is able to pay salaries to the founders. An individual founder may be tempted to take a “real job” or loses interest in the company altogether. Such situation, where some founders continue to work for the company and others bail out, can cause a lot friction between the founders. The SHA should thus include a description of the roles and the obligations of each of the founders and respective working obligation provisions. In case of breach of the working obligation, the other founders should be able to redeem (partially or entirely) the shares of the breaching “leaver” founders.
3. Qualified Majority Mechanism to Avoid Deadlocks
There are no fixed five year plans for start-up’s, as they need to re-evaluate their business model continuously. Therefore, although the SHA should include a framework on how the company and its founders/shareholders work together to achieve the agreed goals, the agreement should also be flexible to allow changes of direction when needed. This means that you should be able to amend virtually all the issues in the SHA with the approval of a certain amount of founders/shareholders (jointly called the “qualified majority”). Respectively, everyone should agree to accept and comply with qualified majority decisions. Without the qualified majority provisions, it may be difficult to find consensus on necessary issues.
4. Non-competition, Particularly after One Is no Longer a Shareholder
Again, one of the key issues in SHAs. No one should be allowed to have side operations that potentially conflict or compete with the core business of the company. The tricky part is to agree on the scope of non-competition, which scope reasonably protects the interests of the company, but is also fair and reasonable to the individuals who are under the non-compete obligation. Too broad a definition of the protected business may mean that the leaving founders find their options very limited. Non-competition should continue for as long as an individual is a shareholder in the company and also for some time thereafter (in Finland 3 years is generally considered as maximum). Various exceptions to the non-compete undertakings are regularly agreed upon.
5. Transfer Restrictions for Shares and Mechanism for Redemption of Shares if the Agreement Is Breached
The main rule in start-up´s should be that all issues of new shares and transfers of existing shares should take place in a coordinated manner. No wild sales should be allowed. With founders, the simplest thing to do could be to agree that all issues/transfers may only be made with a qualified majority decision (see point 3 above). Provisions concerning controlled and/or forced exits (drag along, tag along and so forth) are crucial elements of VC (Venture Capital) SHAs, but less important in the very beginning.
SHAs are essentially temporary arrangements and they are terminated or replaced in subsequent financing rounds and in exits (terms which are looked into in subsequent blog posts). However, it is fair to say that a well executed founders’ SHA creates a good roadmap for the development of the company.
About the Author
Antti advises on venture capital, M&A, capital markets and general corporate law related questions. He has wide-ranging experience in advising small and medium-sized companies on numerous M&A and financing arrangements, representing both companies and finance providers. Antti has also worked on numerous capital markets transactions.
Attorneys at law Borenius Ltd is one of the leading law firms in Finland offering a full spectrum of commercial law services. Attorneys at law Borenius’ mission is to be the most hands-on, client-centred business solution provider. The firm’s approach to business challenges is team-oriented, combining its strong and diverse expertise with a thorough business understanding.
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