Startup ESSENTIALS

What to do with shares and shareholders’ agreements?

Getting your agreements down on paper: it sounds simple, but once you actually have to work with them your inbox fills up with a ton of documents. What are you supposed to do with all that paper? All you want is to sign and get on with things. But you have to remember: tag and drag, good leaver, caps, governance, shareholders’ meetings and God knows what else.

What should you do with all this? Everything: you have to know what you are doing. Know what is in that pile of paper. It is about your business. And while you are working up a sweat to make sure fulfilment and marketing are done just right, you also have to see to it that control and ownership are properly arranged. That everything there is pointing in the right direction too.

The most important premise is that if those men in suits (a.k.a. lawyers and accountants) cannot state clearly what is in the documents, that is their problem. Not yours. If what is written in the documents is unclear. Or even incomprehensible. That has to do with the documents. Not you. After all, all those documents contain agreements. Agreements you have to keep to. So you need to understand them. Everything else is nonsense.

That is your manual for dealing with paperwork, right there. I will name four things you have to watch out for. For each one I will point to the provisions in the documents, so you know where to look first. The choice is based on more than 15 years of practical experience. A small disclaimer: this does not mean you will have no bother at all with the points not discussed here. But the chance is a lot smaller, in my experience at least.

I will stick to the essentials. As an entrepreneur, there are many things you do not have to worry about (that is to say: if you get legal help for the details). You should not spend your time on issues that are not important. Your lawyer can handle those.

But beware: there are four points that really always affect you. They determine how you will do business. If you check these four points, you will find your way through the paperwork.

The four points

1. Ownership. Who gets how much of the company and at what price?

2. Control. Who has what say when it comes to decision-making?

3. Commitment. Who may do what on the side?

4. Departure. What happens on departure or takeover?

As a rule, a number of documents go with the agreements: a shareholders’ agreement, an investment agreement and the articles of association of your startup. Those three documents contain the most important arrangements. The investment agreement is often combined with the shareholders’ agreement.

There are usually more documents. There will often be a management agreement and a deed of issue or sale. And sometimes there are depositary receipts and a STAK, the Dutch foundation that holds the shares and issues those receipts. If everything is in order, you will already find the principles of the other documents in the shareholders’ or investment agreement and the articles of association. So limit yourself to those three documents and read the rest only if your lawyer says you must.

Who gets how much of the company and at what price?

What

If you are talking about owning the company, you are talking about shares. So the issue here is how many shares each person will receive and what they will pay for them. That price per share is also called the share price. So: who gets what shares at what price? If the company is later sold, that means the sale of those same shares.

Holding shares, owning part of the company, means having profit rights and control rights. Those control rights are addressed below. Having profit rights means having a right to the profit of the company that the company pays out to you. It also gives you a right to the gain you realise if you sell your shares for more than you bought them for. So how much profit you get depends on how many shares you have. If you have 10% of the shares, you have a right to 10% of the profits the company makes and 10% of the sale price on a sale.

Preference shares

There are shares that do not receive a part of the profits but a fixed amount instead (if there is any profit). These are preference shares. In a year when there is profit, for example, such a share gives you a right to €1,000 in profit. If there is no profit, you get nothing. If the profit rights are, as it were, saved up until a year when there is indeed profit, this is called cumulative preference shares. If such a share gives you a right to €1,000, for example, and there is no profit for two years but there is profit in year three, you get €3,000 in the fourth year.

The price is the price per share. The price determines the value of the company. Or, conversely, the value of the company determines the price. If you pay €10,000 for 10%, your company is worth €100,000. And if the company is worth €100,000, you pay €10,000 for 10%. When determining the value, every company is worth today what it has today plus what it will earn tomorrow.

Future profit is called goodwill. Startups have almost nothing today. No buildings and no machinery (except for a few laptops). Often just a bit of intellectual property (inventions and copyright in computer code). So startups are almost always worth their future profit. The startup business model always shows profit exploding in years three to five. The hockey stick. But whether it will come is still up in the air. Nobody knows for sure. Whether a startup is given any value by people who want to invest in it is therefore mainly determined by how likely they think that hockey stick is. The greater the chance they estimate, the higher the value. That estimate turns on the technology (how unique is it, and how hard is it for competitors to move in?), on whether the business model is scalable (will that hockey stick come without 1,000 people having to work on it?), and on whether there is a market for it and how big that market is. Has the product already proven itself with customers? It is also often said that investors look not so much at the product as at the management: do they have confidence in the people doing it?

Determining the value of a startup is hardly different from gambling in a casino, but if an outsider, an investor, values the startup at a tidy sum, that value is unbelievably important. There is then at least someone who will put hard cash in on the basis of it. How the value is determined is rarely important in a legal sense.

Convertible

Sometimes investors agree that they will not receive shares right away, but will lend money and that loan can later be used to pay for the shares. That might be two or five years later. It is whatever you agree. Such a loan is called a convertible loan. But converting is not really the right word. It looks as if the loan is converted into shares, but that is not what happens. The loan is used to pay for the shares. Instead of the loan being repaid, it is set off against the payment for the shares and the investor receives shares.

How many shares the investor receives on conversion depends on the share price. Sometimes a price is already fixed when the convertible loan is agreed. Sometimes the price is set when the next big investor arrives. Often the price is capped. The investor then never pays more than a certain amount for the shares, and anything the shares are worth above that cap at conversion is straight profit for the investor.

Where

The arrangements on the value of shares are in the investment agreement. And if that is part of a combined shareholders’ and investment agreement, they are in that. The final distribution of shares is almost always set out at the beginning of the shareholders’ agreement. A convertible is in the shareholders’ or investment agreement too. Or sometimes in a separate document, but if everything is as it should be it is defined in the shareholders’ or investment agreement.

The articles of association state what types of preference shares there are. If there are no preference shares, you do not have to read the articles of association on this topic.

You can have your lawyer check whether all the documents are properly aligned.

Who decides what?

What

The management performs all the company’s legal acts: it is the board that binds the company. At a startup as well. What products will be developed and at what prices, who the company will work with, who will be recruited, where the startup will have its office, what kind of pension plan there will be, and so on. The management (also called the board) is appointed, and dismissed, by the shareholders. So the shareholders are ultimately the most important people in the startup. They can also tell the management in general terms what to do. And if a director goes in a direction the shareholders do not like, that director can be removed. There can also be directors who are not appointed by the shareholders. These are directors in title only. They may only do what the appointed directors authorise them to do.

The management may consist of one or more persons. In the latter case, they must work together. Each member of the management is in principle responsible for the functioning of the entire board. The management can also be a B.V. (private limited company). Then the management of the B.V. takes the resolutions.

The shareholders are the most important not individually but together. This involves the shareholders who jointly take resolutions in a meeting. That meeting is called the general meeting of shareholders, often abbreviated to GMS. If all shareholders agree, incidentally, they can also take resolutions outside a meeting. But then, again, it comes down to all the shareholders and not to individual ones. How many votes each shareholder may cast depends on the number of shares they have.

If nothing else is agreed, the management can do virtually anything once appointed. Only for resolutions that directly affect the raison d’être of the startup must the management first request approval from the shareholders. An example is the sale of all the startup’s activities.

Arrangements are nearly always made about what the management can and cannot do without the approval of the shareholders. A list of major resolutions is drawn up, and the shareholders and the startup agree that the important resolutions can only be taken with the approval of the GMS. There are many such lists in circulation. In general there is little relevant difference between them. Typically they cover resolutions such as concluding a contract worth more than a set amount, buying or selling property, guaranteeing the debts of another, concluding contracts with the board (or their partners), entering into financing, selling business units or buying other companies. That is how the shareholders keep control of the management.

But we are not there yet. Some resolutions of the shareholders (or the management) can work out badly for shareholders who hold few shares. Suppose two shareholders together own 60% of the shares and are also both directors. They can grant themselves a handsome salary. Their management resolution to do so must be approved by the GMS. That is no obstacle either: the two directors have a comfortable majority at the GMS. To prevent this, you can require that such resolutions need the agreement of more than half the shareholders. For example 80%, or even the agreement of all of them. Be alert to this. You do not want a minority shareholder to get too much control over the startup either. Sometimes it is stipulated that a particular minority shareholder must agree. Look closely at whether you find that acceptable for the resolutions concerned: for some resolutions it is less bad than for others. You do not want it to be possible, for example, for the adoption of the budget to be blocked.

Then there is the distribution of influence within the GMS itself, the highest body. There too there are ordinary and important resolutions. For certain resolutions that matter a great deal to the shareholder, dilution (issuing shares) for instance, a larger majority is then agreed. For example 80% of the votes. Conversely, influence is also taken away from some shareholders: by giving them not ordinary shares but non-voting shares or depositary receipts, for example.

Be aware, too, that a blocking vote can lead to deadlock. In such a case the shareholders have to reach agreement. It can happen with a 50-50 split of the votes, with an 80-20 split, or with a blocking vote. It can then be useful to agree in advance that if this happens you will appoint someone to break the deadlock.

Supervision other than by the shareholders

There are other ways to regulate supervision of the management as well. It can be done by appointing non-executive directors. Or by a supervisory board. And recently I saw a situation in which a shareholder may place an ‘observer’ on the board. Observers are not allowed to vote, and have only the right to attend and to speak.

At startups these structures serve above all to bring the knowledge and the network of people who have already earned their stripes closer to the management. That is a very good reason. The flip side is that running the company becomes steadily more complicated and more formal. More hassle. So I would rather see a loosely organised network of mentors, friends and advisers around the management than this kind of formalised advice and supervision.

Where

The handling of resolutions that must be submitted to the GMS is set out in the shareholders’ agreement (for management resolutions) and in the articles of association. Sometimes these are the same lists and sometimes they differ. I would read them both carefully. The rules on voting rights are in the articles of association, and where there are depositary receipts also in the terms on which those receipts were issued. The other rules are in the articles of association and/or in the shareholders’ or investors’ agreement.

So you must check two things: whether the set-up is workable, and whether there are resolutions you would want to be able to block but cannot. This concerns resolutions that directly affect your interests. Deals with shareholders or directors, for instance, and issuing additional shares at an attractive price without your being able to take part in the issue.

Keep in mind that shares may be issued later. That may lead to a situation where today, with 20%, you can block a resolution, but tomorrow, with 15%, you cannot.

Who may do what (on the side)?

You want everyone to be entirely dedicated to your startup. And, preferably, to do nothing else. And certainly not to walk away after a few years to set up a competing company, strolling off with all your human capital. You yourself, after all, are entirely dedicated to your startup. This means you are forbidden to work anywhere else, or that after your contract you are prohibited from working for a competitor. Or that you cannot leave before a certain date.

This commitment is imposed by the shareholders and the investor. You will find it in two types of clause: non-competition clauses and leaver provisions.

Non-competition clauses mean that as long as you work at the startup you may not work for a competitor, and are also forbidden to do so for a period afterwards (one to two years). That makes sense. But note: this type of provision can really put you in a bind if you want to leave anyway. And many people do want to leave. It is all in the game. The trick is to find a balance between the interests of your company and your own interests. So that you will not compete with the company but can still earn a living. That calls for realism on both sides.

So make sure you are not too quick to accept non-competition clauses. They are the most annoying conditions when it comes to leaving. And certainly if those staying behind have no reason to be on your side, they can be a real problem. You are also not an employee, protected by law, but in this case a shareholder. That means that, except in extreme circumstances, even quite one-sided (read: disadvantageous) provisions can simply be upheld.

Leaver provisions govern what happens when you leave. If a director or shareholder leaves, it is normal that they surrender their shares. If they do not, those staying behind are also working for the person who left. That is bad for morale.

If you leave earlier than agreed, you accept a penalty discount on the sale price of your shares. That is what keeps you there longer. If you leave early nonetheless, you are a so-called bad leaver. You must then sell your shares at a lower price than the price paid if you stay and see out your agreed term (and are thus a ‘good leaver’). You are also a good leaver, for what it is worth, if you die, retire or fall ill. And you are a bad leaver if you mess things up, toss your CTO out of the window or compete after all.

Intellectual property

What you and your colleagues may do on the side is also determined by what you can do on the side. That is why arrangements about intellectual property rights are dealt with here. Normally, everything made in the way of software, content or inventions belongs to the startup. Otherwise you or one of the others could use those intellectual property rights to compete with it.

Experience shows that this is often poorly arranged. And that, at the moment your software, content or invention is booming, can be quite a problem.

Concluding a shareholders’ or investment agreement is a good moment to make sure that all the intellectual property rights the startup needs actually end up with the startup. Tip: note who owns the domain names, too.

One more point: a great deal of technology is not a patent but know-how. Know-how often cannot be protected. So it is often a good idea to agree that the know-how will be kept confidential as far as possible. Not to make it all too easy for the competition.

Where

The non-competition and leaver provisions are in the shareholders’ or investment agreement. Sometimes there are also non-competition clauses in the management agreement. These may be more stringent than those in the shareholders’ agreement, so I would certainly have someone check whether the two are consistent.

The rules on intellectual property and confidentiality are part of the shareholders’ or investment agreement. Watch out here that the arrangements cover not only your holding companies but also the owners of those holding companies, that is, you personally. The owners, meaning yourselves, often hold the rights rather than the holding companies.

What happens on departure or takeover?

If a manager or shareholder leaves there are good leaver / bad leaver provisions (or good leaver / early leaver / bad leaver provisions). I discussed these above, because they also play a role in keeping managers involved in the startup.

And then there are the drag along and tag along provisions, also called drag and tag. A drag means that if a majority of the shareholders want to sell their shares, the minority have to go along. They are pulled along, hence the word drag. Without such a provision a minority shareholder could in effect block an acquisition or a participation by refusing to sell. Without a drag, they simply do not have to sell. These provisions are often drafted in a complicated way. What matters for you is checking that they are there at all. Your lawyer can go through them. You also need to decide what majority of the shareholders has to be willing to sell before the drag is set in motion. If you are a majority shareholder, you want to be able to sell easily; if you are one of the minority shareholders, you want to avoid being forced to sell against your will too easily.

A tag is the mirror image of the drag. A tag means that if the other shareholders want to sell their shares, you can sell yours along with them. So that you are not left behind like a lonely fool with a small interest in a company that has turned hostile, while your former friends drive around in big cars.

Selling shares outside the situations described here is often difficult. The articles of association always include a so-called blocking clause (the name speaks for itself). In practice another party can only buy its way in without those obstacles if at least a majority of the other shareholders agree; it is no fun being a shareholder if the rest of them do not want you.

At an IPO (initial public offering), finally, shares are issued. They are not sold. The issued shares are offered to the public and then traded on the exchange. A resolution to issue is a shareholders’ resolution. Usually it is possible to get a majority for it. Sometimes you see provisions that take an IPO into account, with a convertible for instance. Your lawyer can tell you whether these are relevant.

Investors’ exit

An investor often wants to see efforts made to bring about an exit. But usually that goes no further than a non-binding intention. If something more binding is written there, you will have to get your lawyer to try to soften it. A binding commitment with a horizon of a few years or more is not reasonable.

An investor may demand that if they want to sell, everyone has to go along with them. That they can, as it were, set a drag in motion on their own. Try not to sign that. If it is unavoidable: too bad. In practice things often still work out, because a buyer wants the other shareholders, often also the managers, to be enthusiastic about the deal.

Where

The relevant exit provisions are in the shareholders’ or investment agreement.

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