5 Things to Look at in a Shareholders’ Agreement: Part 1

5 Things to Look at in a Shareholders’ Agreement- Part 1

Looking at a Shareholders’ Agreement

As a startup founder, you want to work on your business. Only your business, just your business, predominantly your business. Everything else is basically a hassle, annoyance, and a distraction.

You have to find the right co-founders, employees you can work with and trust, you need funding, you need to keep your investors engaged, you need to find an office, you need to deal with your administration, and of course there are your customers which you need to service the best you can. So actually you need to be a business strategist, lawyer, developer, marketer, customer service specialist, designer, and HR manager all at once.

For most startup founders, this is somehow manageable, but there is one topic startup founders find it very difficult to motivate themselves to devote even the slightest attention on. This is the shareholders’ agreement. While your shareholders’ agreement is one of the most important documents, you will ever sign in your startup life.

The shareholders’ agreement is a contract between all shareholders. It defines additional agreements which lie outside of the articles of your legal entity. Your business very well may have been started in good faith and based on trust, but the shareholders’ agreement is there to ensure common understanding amongst founders and investors. The shareholders’ agreement sets the rules of the working relationship. It functions as a corporate marriage, so you can avoid potential conflict in the later stages of your startup’s life. Trust is good, a signature on a good agreement is better.

For example, in the shareholders’ agreement, you can formalize agreements between the founders about what will happen if one of them leaves the company. You can also give additional rights to some of the cash investors: this will give them the ‘preferred rights’ that differentiate their ‘preferred shares’ from the ordinary shares that the founders usually have. Preference shares are usually granted to important financiers, which will want extra ‘rewards’ for the risks they endure by investing in a startup.

As an early-stage startup, you can choose to hire a lawyer to do the work for you.  Still, it’s incredibly important to understand what the specific clauses in the agreement mean. If you don’t, you run the risk that the lawyer will decide for you what is important. The lawyer can spend a lot of time negotiating insignificant topics in the shareholders’ agreement, which can take a ton of hours, which in turn will increase the bill significantly. Basically, you have to stay in the driver’s seat, but you can only stay in the lead if you know the rules of the road. The shareholders’ agreement is important for you, and not something which can be outsourced completely.

So I hope I’ve laid out the importance of the shareholders’ agreement. Now without further ado, below you will find 5 topics that are important to think about when you draft your SHA. Now let the fun begin!

5 Things to Look at in a Shareholders’ Agreement- Part 1

Important topics to think about when drafting your Shareholders’ Agreement

1. Anti-dilution

When a shareholder has a so-called anti-dilution right, this means that, in some circumstances, they get extra shares. In particular, they are protected against a declining % of the shares when new shares are issued. New shares are normally created during later funding rounds. Let’s explain this with an example:

There is a startup which has 100 shares. There are 2 co-founders each having 45% of the company and 1 early investor which has 10%. The cap table – the overview of who are the shareholders of a company – looks like this:

  • 45 shares co-founder 1 = 45.0%
  • 45 shares co-founder 2 = 45.0%
  • 10 shares investor 1 = 10.0%

At some point, a new funding round is needed. The shareholders decide that 10 extra shares will be awarded to a new investor for a certain amount of cash. So 10% more shares are issued. How would the cap table look if all shareholders have common stock? It would look like this:

  • 45 shares, co-founder 1 = 40.9%
  • 45 shares, co-founder 2 = 40.9%
  • 10 shares investor 1 = 9.1%
  • 10 shares investor 2 = 9.1%

All shareholders will dilute by the same amount: as the number of shares increases (now 110 shares) the total % of shares all shareholders drop. The calculation after the investment round for the investors is 10/ 100+10 = 9.1%. The reason is that the 10% was based on the number of shares ‘pre-money’, so before the investment round. The difference between pre-money and post-money valuation will be discussed later on.

So what would happen if investor 1 has preferred shares with anti-dilution rights, and the founders have common shares? Anti-dilution means that the investor with the anti-dilution rights gets some sort of compensation to prevent their % share dropping. Traditionally investors only get an anti-dilution compensation if there is a ‘down round’. That means that at the next funding round, a new investor comes in at a lower share price (down) compared to the previous investor. With an anti-dilution, the first investor will be compensated.

Let’s use our example again. If investor 1 were given the strongest form of anti-dilution, it would mean that its % share will not drop, no matter what. Now if investor 1 has that right, then investor 2 would likely also want that compensation. That means that in this example, they each get 1.2 shares extra. The cap table will look like this:

  • 45 shares, co-founder 1 = 40.0%
  • 45 shares, co-founder 2 = 40.0%
  • 11.2 shares, investor 1 = 10.0%
  • 11.2 shares, investor 2 = 10.0%

The result is that the % for the founders has dropped. The anti-dilution for investors basically means that you, as a co-founder, are losing your % in your company faster. There is often a next funding round, and with an anti-dilution for investors, this means that at every funding round, you will lose more % shares. So before you know it, you will lose a lot. Always be careful at the beginning of your startup life, because if you give away too much too soon, then, later on, you will potentially get into trouble. You can only sell a share once: good to make sure the terms are right.

There are several types of anti-dilution clauses that are used. One of the most common ones’ is called a ‘full-ratchet’. It basically means that if there is a ‘down round’ the early investors will be fully compensated as if they had also invested at the lower valuation. Other types of anti-dilution include so-called ‘Broad-Based Weighted Average’ anti-dilution or its sibling ‘Narrow-Based Weighted Average’ anti-dilution. These both amount to essentially the same: if there is a decline in share price with respect to the level at which investors got in, then they get compensation to prevent their % dropping as much. The difference between the two is how you include the different types of shares. This is too much to go into right now, but please remember there are several forms of anti-dilution.

5 Things to Look at in a Shareholders’ Agreement- Part 1

Pre-money vs post-money valuation

It is important to know the difference between pre-money valuation and post-money valuation. Basically, pre-money valuation is the value of the startup before the external funding is included. Post-money valuation is the value of the startup after external funding is received. Let’s look at an example: If a startup is worth 1 million and external funding of 250K is received then in the case of pre-money valuation the investor will get 20% of the shares. The value of the startup, 1 million, is used, and the value of the external funding is added, so 250K / (1.mio + 250K) = 20%.

With post-money valuation, the external funding is already included in the 1 million. So the investor will receive 250K divided by 1 million, meaning 25%. So you see that there is a difference of 5% which can be a lot in the long run.

We will be wrapping up Part 2 of this blog next week. Sign up for Leapfunder or keep an eye on our blog to learn more about what to include in your shareholders’ agreements – including control rights, liquidation preferences, and drag along with clauses.

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