If you’re ready to sign your first term sheet with an investor, the next step is ensuring you have all the proper legal documents in place. One of these documents is the shareholders agreement (SHA).
Putting together 40 or so pages of confusing legalese isn’t founder-friendly, so we’re sharing an Open Source VC SHA template to help simplify the process.
A SHA is a private document that acts as a source of truth for the governance of your startup. Here’s what you need to know.
What is a Shareholders Agreement?
A SHA establishes the rules that govern what shareholders can and can’t do, and their rights and obligations.
Why put a Shareholders Agreement in place?
When you register your startup, you’re usually provided with a one-size-fits-all company constitution. A SHA provides more flexibility than a company constitution, enabling you to establish how you want your startup to be governed.
What does a Shareholders Agreement typically cover?
Board of directors
For early-stage startups, the line between the management of the company and the board can be blurry. But as a startup grows, it’s important to consider and define each party’s right to sit on the company's board. The SHA often includes the process for:
- Appointing or removing directors to the board
- The minimum and maximum number of directors on the board.
- Which shareholders (if any) are specifically entitled to appoint directors
- What votes are required to change the board composition
Management and decision making
The SHA will define what and how decisions are made, and who can make them.
Typically, decisions made by shareholders and decisions made by the board of directors are as follows:
- Shareholders have the right to vote on appointing and removing directors, varying the constitution and winding up the business.
- The board of directors has decision-making authority regarding executive employment, general business operations, financing and budgets, forecasting, deciding on the business plan, issuing shares, declaring dividends, and selling the business.
Generally, as part of the SHA, the shareholders will have 1 vote for each share held, and each director will also have 1 vote. However, specific shareholders or directors may be granted rights to veto or approve specific matters - you’ll need to determine these matters with your shareholders (and with the help of your lawyer).
Shareholders Agreement Resolutions
Once you’ve decided who has the right to vote on certain decisions, you need to determine how many votes are required to make the decision. For example:
- Some decisions must be made unanimously by all shareholders or the board of directors.
- Some shareholders may not have voting rights (e.g. a silent partner).
It’s also important to decide how many votes are required to pass resolutions (decisions approved by the board or shareholders). There are generally 3 types of resolutions:
- Ordinary resolution: requires a majority vote of over 50% to pass the resolution.
- Special resolution: requires 75% or more of the votes.
- Unanimous resolution: all parties to the decision must agree to pass the resolution.
If a board or shareholder decision is subject to a major disagreement between shareholders or directors, and no side has the necessary majority support (or “deadlock”), the Company requires a provision to break the deadlock. There are several options (e.g. giving the Chairman of the board the casting vote and power to decide) when it comes to the deadlock provision to overcome a potential deadlock which should be discussed with your lawyer.
Dealing with shares
Pre-emptive rights allow shareholders to purchase new or existing shares before any third parties.
Anytime a startup raises capital, it needs to issue additional shares, which means existing shareholders could end up with a smaller ownership percentage. Pre-emptive rights enable shareholders to avoid dilution of their investment when the startup issues new shares. Existing shareholders have the right to invest additional capital for additional shares, allowing them to maintain their existing shareholding percentage.
If a shareholder wishes to sell their shares they are usually required to notify other shareholders of their intention to sell under the SHA. Pre-emptive rights on a transfer of shares allow existing shareholders to purchase these shares before third parties. There are often exceptions to the pre-emptive rights for share transfers when a shareholder is transferring to its affiliates.
Pre-emptive rights are generally proportionate to a shareholder’s ownership percentage, meaning they generally cannot buy all the shares and unfairly increase their shareholding in the startup.
Drag along rights
A drag along provision allows the majority shareholder(s) – usually founders and investors – to require the minority shareholder(s) to sell their shares, typically in the event of the company being acquired or sold. Drag along rights generally require that shareholders constituting a minimum percentage ownership of the shares in the company wish to sell their shares (e.g. shareholders holding at least 60% of the shares in the company).
Drag along rights are important as they give the majority shareholder(s) certainty regarding the possibility of selling a startup. Drag along rights reduce the administrative burden on a startup when pursuing a sale and also ensure that a minority shareholder cannot derail a possible sale by refusing to sell its shares. It’s important that founders carefully consider the drag along threshold to ensure you don’t get forced to sell your startup unwillingly.
Tag along rights
Tag along rights allow minority shareholder(s) to tag along with majority shareholder(s) and sell their shares for the same price and on the same terms and conditions, if the majority shareholder(s) has first complied with the pre-emptive rights and is selling to a third party.
Founders and investors often want tag along clauses so that a majority shareholder(s) can’t sell its shares, which would effectively transfer control of the startup to an unknown third party, unless it finds a buyer willing to buy shares from all shareholders with tag along rights. This often means finding a buyer willing to buy the entire startup.
Including comprehensive dispute resolution provisions in your SHA can mitigate the risk of litigation.
A 3-step dispute resolution clause can help avoid disputes among your shareholders and startup, progressing to Court action. A common dispute resolution procedure is as follows:
- Step One: The parties of the dispute must notify each other of the details of the dispute (the facts, circumstances and how these amount to a breach of contractual obligations, together with the amount of any potential loss), and engage in good faith negotiations to attempt to resolve the dispute.
- Step Two: If the parties cannot negotiate and resolve the dispute between themselves, the SHA will generally compel them to refer the dispute to an independent mediator (or another means of alternative dispute resolution, e.g. expert determination).
- Step Three: If steps one and two fail, then the parties are entitled to commence Court action.
This article does not constitute legal advice, and the SHA document is only a template. You should always seek legal advice if you’re considering using this template.