7 June 2021
The shareholders’ agreement is a key legal document that regulates the affairs of the company. If you are a founder of a startup that is about to enter its first round of fundraising, you can expect that your investors will be keen to enter into a shareholders’ agreement with you that sets out the roles and obligations of the founders and investors vis-à-vis each other. In particular, for investors who are looking to invest into a startup company, the shareholders’ agreement is also indicative of business stability as it gives them an idea of what they can expect to get out of their investment. Therefore, it is important to ensure that you and your incoming investors will be signing a well-drafted shareholders’ agreement that sets out a framework for addressing all the issues that could arise in the course of running of your startup.
Below we outline five essential matters that you should address in your shareholders’ agreement:
1. Board Representation or Participation
One key issue to be addressed in the shareholders’ agreement is the management of the company. For investors, they will likely want to have some form of board representation so that they can have a say in the company’s operations. Meanwhile, founders will want to ensure that they maintain sufficient control of the board, particularly as each subsequent investment round will see the addition of new members to the company, who will likely demand for board representation as well.
Accordingly, as the founder, aside from making sure that the shareholders’ agreement directly empowers you to appoint and remove directors from the board, you should negotiate with your investors so that only investors holding only a certain percentage of shares will have the right to appoint a director. Alternatively, if you are not keen on allowing your investors to have board representation, you may offer your investors observer rights instead. Observer rights will entitle your investors to receive notice, attend and speak at board meetings, but they will not be empowered to vote on any of the resolutions.
2. Matters Requiring Unanimous Consent (also known as Reserved Matters)
When it comes to the management of the company, aside from demanding for board representation, your investors may also ask for certain decisions of the company to require the unanimous consent of all shareholders before it can be passed as a resolution. These are often referred to as “reserved matters” in the shareholders’ agreement.
Common reserved matters include the allotment of shares, the variation of the company’s capital structure and the amendment of the company’s constitution. For investors, this mechanism enables them, as minority shareholders, to have a say in major decisions of the corporation. However, from the perspective of the founders, care should be taken when determining your reserved matters list as a poorly drafted reserved matters clause could hamper your ability to make swift decisions regarding the day-to-day operations of the company, and in the worst-case scenario, give a minority shareholder a veto right that is abused as leverage in certain situations.
4. Deadlock Resolution Mechanisms
While it may be difficult to envisage that there could be a divergence in opinion between you, your co-founders and your investors, one should never overlook the risk of a deadlock occurring. If unresolved, this deadlock can cause the company’s business to come to a standstill, and in extreme cases, the winding-up of the company may be the only option if there is no mechanism in place to deal with the deadlock. As such, a well drafted shareholders’ agreement should always contain a deadlock resolution clause.
Examples of mechanisms that can be employed to resolve a deadlock situation are as follows:
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Escalation: This provision will require the deadlocked matter to be “escalated” for determination by the company’s senior management or board of directors.
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Chairman Casting Vote: This clause will specify that the Chairman of the meeting will be granted the casting vote on any deadlocked matters.
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Russian Roulette: A Russian Roulette provision will entitle one or more shareholders to buy-out the other shareholders at a specified price, and vice versa. If none of the shareholders agree to sell at the specified price, the clause can allow for further counteroffers until an agreed price is reached.
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Fairest Sealed Bid: This clause will entitle the shareholders to submit to an independent third party a price at which they are prepared to pay to purchase the other shareholders’ shares. The third party will determine which of the bids represent the “fairest price”, and the loser will have to sell his/her shares at such price.
Note that it is also possible to employ more than one of the above mechanisms together. For instance, the shareholders’ agreement can specify that the deadlocked matter will first be “escalated” to the company’s senior management or the board of directors. However, if the deadlock is still unable to be resolved by upper management, the next step would be to employ a “break-up” provision like the Russian Roulette clause which will entitle one or more shareholders to buy-out the other shareholders who are in disagreement.
5. Drag-Along Rights
Last but not least, if you are a founder with an exit strategy, it would be essential for you to incorporate a drag-along clause in your shareholders’ agreement as this ensures that when you are ready to sell your startup, you will be able to procure all of your fellow shareholders to sell their shares to your third-party buyer as well.
As the third-party buyer will often be looking to acquire complete control of your company, the drag-along clause provides you with flexibility and an easy exit route by eliminating the risk of a difficult minority shareholder from blocking the sale of your startup. The drag-along clause can also be beneficial to investors as it ensures that they will be treated on the same terms during the exit.
For further information, please contact:
Amanda Lew , Consultant, JC LEGAL
info@jcco-hk.com
