This is Part 2 of Leapfunders’ blog on 5 Things to Look at in a Shareholders’ Agreement. Take a look at Part 1 of the series here. In Part 2, we will discuss liquidation preferences, control rights, drag along and tag along clauses, and entrepreneurs’ positioning as good leavers or bad leavers, among other topics and advice.
What to look at in a Shareholders’ Agreement: Part 2
2. Liquidation preference
A liquidation preference is a right that has an effect during a liquidation event. A liquidation event is basically an event in which shares turn into cash: it can be a large sale of assets, the sale of the entire business or even bankruptcy. A liquidation preference ensures that an investor has a certain favourable claim on the cash proceeds from the liquidation event. Usually the cash investor gets their money back first, and afterwards, the founders will be able to claim on what money is still left. Depending on what it says in the shareholders’ agreement the investors might get more than just their money back: they could claim a positive return before the founders start to benefit.
Of course, an important question is what happens after the investors have received their money back, perhaps with a return. What happens with the remaining money, if any? Let’s take a look at an example: An investor puts in 2.5 million for 10% post-money, meaning the value of the company is 25 million. In return, the investor gets preferred shares with a liquidation preference of 1X. Let’s say the company has not performed well and lost value. It is now being sold for 10 million, which is the liquidation event. Then the investor gets back 1X (meaning 2.5 million) and then 10% of the remaining value (10 million – 2.5 million= 7.5 million) which is 750.000. So the investor gets back his original money and a return of 750,000 or 30%.
So what is left for the founders? They receive 10 million – 3.25 million = 6.75 million. So they went from owning 90% of 25 million = 22.5 million in shares to owning 6.75 million in cash. That’s still a lot of cash. But important to note that the investor went up 30% while the founders are down 70%. That’s because the investor got 32.5% of the proceeds, despite owning only 10% of the shares.
Like anti-dilution, there are also different types of liquidation preferences. The example above is called preferred participating. With this particular liquidation preference, the investor gets his initial invested-amount back (X something) and then receives a % of the remaining dividends. Other variations can be the non-participating preferred or a capped preferred. Non-participating means that the investor gets % of the total value at liquidation preference and capped means that the liquidation preference has a maximal value attached to it.
Let’s look at another example where we compare non-participating vs participating preference shares. Let’s say that the company of our first example has performed well and is sold for 50 million. For non-participating preference shares bought for 2.5 million earlier, the return would be 10% over the total amount at liquidation event. This would be 10% of 50 million, meaning 5 million. If the shareholder would have participating preference shares, this would be equal to the initial amount back, 2.5 million, and then 10% of the proceeds, meaning 10% of 47.5 million = 4.75 million. The total amount would be 2.5million + 4.75 million = 7.25 million. As you can see, there is a large difference in outcome between participating and non-participating. Like anti-dilution, there are many different types of liquidation preferences. Check the language of your contract very carefully: this can really matter when the exit comes.
3. Control rights
Control rights basically mean that an investor can exercise some sort of control over the company. The founders agree with the investors on which topics, and in which situations, an investor can block a proposal or influence a key decision. In many cases, founders have the majority of shares at the outset, and hence the majority of the voting rights. Theoretically, that means they have control over every corporate decision. To prevent investors from not having any influence, they will negotiate exclusive rights. Even investors that have a minority stake can still have control sometimes.
Below I give some examples of control rights that investors might want:
- The right to block the company from selling a large part of the assets or selling particular key assets (i.e. intellectual property)
- The right to block certain types of funding or change the current cap table. For example, changing the terms of the stock, creating more stock, buying back stock, issuing debt, etc.
- The right to appoint the management or at least certain members of the management
- The right to block a fundamental shift in the substance or direction of the business
- Whatever else seems important to them
Founders should carefully consider how much power they give the investor. Of course, a lot depends on the kind of relationship you have with them: do you know them well? What are they interested in? Are you working towards the same goals?
4. Drag-Along / Tag-Along
The drag-along was created for the purpose of protecting majority shareholders.
With a drag along, majority investors have the possibility to force the minority investors to cooperate with a sale of all the shares. After all: if the minority resists a sale, this can still prevent the company from being sold entirely. A drag-along in a shareholders’ agreement will state that if a certain minimum % of shareholders want to sell the company, then they can force the remaining shareholders to sell their shares under the same conditions.
For example: in a shareholder’s agreement, it is agreed that 51% of shareholders can drag along the remainder. That means that if there is a bid for the 51% of the shares, and 51% of shareholders want to sell, then that 51% can force the remaining 49% to sell also under the same conditions.
The tag-along tends to protect minority shareholders. A tag-along is an agreement that if one shareholder has negotiated a sale of their shares, then the other shareholder can participate pro rata in the sale.
For example: if 60% of the shareholders want to sell their shares for a certain price, then 40% will also have the right to participate in the sale. The startup has the following cap table:
- 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%
Now co-founder 1 wants to sell all his shares and finds a buyer willing to buy them. If there is a tag-along in the shareholders’ agreement, then co-founder 2, investor 1 and investor 2 can all participate in the sale pro-rata. This also means that co-founder 1 cannot sell all his shares. If all shareholders decide to tag along the new cap table will look like this:
- 27 shares, co-founder 1 = 24.0%
- 27 shares, co-founder 2 = 24.0%
- 6.7 shares, investor 1 = 6.0%
- 6.7 shares, investor 2 = 6.0%
- 45 shares, new investor = 40%
This clause has prevented one co-founder from getting a good cash exit, while all the others still hold shares. The effect of the tag along is that everyone benefits equally if there is this kind of liquidity event.
5. Good leaver/bad leaver
The good leaver/bad leaver describes what happens with founder shares in a situation where a founder leaves the organisation. When they leave, they can be classified as either good leaver or a bad leaver. Generally ‘good leaver’ means they get to keep some of their shares for a job well done, and ‘bad leaver’ basically means they don’t. The good leaver/bad leaver clause makes sure that the founder’s incentive stays aligned with the incentive of the investors.
What could happen is that the founders of the startup agree that when a founder leaves within 1 year, they have to return all their shares. This period of a year is sometimes called a cliff. After this year, they get to keep a portion of their shares depending on how many quarters they stay, until, for example, four years have passed. After four years, the founder gets to keep everything if he leaves. This is sometimes called the vesting period.
A bad leaver may be someone who doesn’t reach their milestones, has conducted mismanagement, has committed fraud or when there is an attributable breach in contract. A founder can be considered a good leaver when the founder has the approval to leave from the majority of the shareholders, when the founder becomes incapable of working due to serious sickness, or when the founder leaves when a certain milestone has been reached.
Make sure you agree a good/bad leaver while the relationship is still good. By the time someone is actually leaving, it is often too late to come to a good agreement. That kind of separation can often be emotional. Get it in contract early on and make sure the language in the shareholder’s agreement is as clear as possible.
The purpose of this blog is to quickly highlight how a shareholders’ agreement can work. This is just the tip of the iceberg. The 5 topics mentioned might well be the most important, but out in the real world, you will still have to be careful. Some other topics you may come across in a shareholders’ agreement are dividend payout, conversion rights, redemption rights, rights of first refusal, information rights, confidentiality, voting rights, claw back, piggyback rights, Lockup, the right of pledge etc. etc. etc. If you do encounter these, please make sure you educate yourself before you start negotiation with your counterpart. Go online, ask a lawyer, and use your professional judgement. If you have doubts about what are best practices, go to other successful startup founders and ask them how they have structured the terms and conditions in their shareholders’ agreement. There is no need to reinvent the wheel on this one.
Oh, and the last tip: keep your shareholders’ agreement readable. Ask your lawyer to use simple language and keep the number of pages to a minimum so that mere mortals can also understand what is written.
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