A startup capital raising exercise is fairly special as compared to your convential capital raising and business setup process as the ecosystem would engage with other founders, angel investors, private equity firms and institutional investors.
In this scenario a startup founder would need to consider, prepare and plan before hand of raising any money into the business or even when giving out the shares.
In this article we would like to share some notes on the clauses that appears specifically in shareholders agreement catering to startup businesses and founders.
1. Sweat Equity
Because start-up companies don't have a lot of money to pay salaries, they often give shares to co-founders and key staff in exchange for "sweat equity" instead of capital.
When done right, giving out shares can be a strong incentive for people to stick with the business and help it grow. If the business is sold or listed on a stock exchange in the future, these shares can make the company's founders and early employees very rich.
Also, giving out shares early usually has big tax benefits because any increase in the shares' value is taxed at a lower rate or sometimes not at all.
Even though there are benefits to giving founders and employees stock in the company, problems can arise if relationships with shareholders break down and people are fired.
Without a valid legal agreement in place to deal with this situation, these "bad leavers" will keep their shares, and the remaining shareholders will be stuck with minority shareholders who are now "free riding" on the efforts of the actively involved shareholders.
There are some legal "tricks" that majority shareholders can use to solve this problem, such as issuing more shares to dilute shareholders' stakes or selling the business assets to a new entity , but these can be grounds for a lawsuit, and in the end, the company may have trouble raising more money and giving the remaining founders and staff a reason to stay with the company.
2. Share Vesting
Using "vesting" clauses, which are usually part of a shareholder agreement, is a smart way to solve the problem above. Under these clauses, a shareholder doesn't get the benefits of his or her shares until certain conditions are met, like staying with the business for a certain amount of time or reaching a certain goal (e.g. obtaining a certain revenue target or number of users).
After these conditions are met, the shareholder will "vest" in the shares or a certain percentage of the shares that was set up front. If not, the company may have the right to buy back the shares on its own.
For example, a "vesting schedule" might say that shares will become "vested" once a month over the course of 4 years.
Usually, there is an initial "cliff" that says a shareholder must stay with the company for at least a certain amount of time (say, one year) or they will lose all of their rights to the shares. So, if the standard vesting period is 4 years, 25% of the shares will automatically vest after the first year. The rest of the shares will vest over the next 3 years in monthly chunks of 1/46 of the total shares.
Another problem is if the company is bought out or the people in charge change before all the shares have become fully paid. In that case, a "trigger" clause could be added to speed up the time when the shares become fully paid up. So that the shareholder has an incentive to stay with the business after the acquisition, a "double trigger" clause may say that the shares will only become fully owned if they are fired.
3. Good and Bad Leavers
The "Good Leaver" and "Bad Leaver" clauses deal with what to do when shareholders leave the company for different reasons, some of which are less to blame than others.
For example, Bad Leaver clauses say that if a shareholder is fired for breaking their contract in a big way, acting badly, or not reaching a key milestone, they have to give their shares back to the company at either the price they paid for them or the market value (whichever is lower). Good Leaver clauses, on the other hand, may say that if a shareholder is fired or leaves the company through no fault of their own and/or after reaching certain milestones, they must sell their shares to the company or the other shareholders at market value, or they can keep the shares.
4. Pre-emptive rights and Anti-dilution
As was said above, one way to get rid of the power of shareholders you don't want is to give everyone else more shares. Pre-emptive rights clauses make these methods less effective because they require the company to offer any newly issued shares to existing shareholders first, in proportion to how many shares they already own.
This will make sure that existing shareholders have a chance to buy new shares without having their stakes get smaller. This can also be a good way for the company to raise money, because it gives shareholders a reason to put more money into the business so that they don't lose their shares.
Anti-dilution clauses are like pre-emptive rights, but they let a shareholder get new shares without having to pay for them. If shares are then sold at a much lower price, this can cause the founders to lose control of their company. Anti-dilution rights are powerful, so investors might only get them when a company or its founders are in a less strong position to negotiate.
5. Limits on how shares can be sold
Restrictions on the sale of shares are another clause that protects shareholders. This makes sure that shares can't be sold to a third party that the company doesn't want without first letting the company find a buyer or giving them to the other shareholders at the same price that the third party paid.
If there is a disagreement about the price of the shares, an independent valuation or a formula can be used to figure out what the fair price is. If the price is lower than what was offered, the shareholder can take back their notice to transfer the shares. Notably, restrictions on who can buy or sell shares usually don't apply when shares are given to family members or a trust.
6. Drag-Along and Tag-Along Rights
When one group of shareholders wants to sell the business and the other group does not, this can often lead to a fight between the two groups.
Drag-Along clauses and Tag-Along clauses can help solve this problem and make sure a deal can go forward.
First, Drag-Along clauses make sure that if a certain number of shareholders (say, 75% or more) want to sell their shares to a third party, they can force the remaining minority shareholders to sell under the same terms so that the third party can get all of the shares. Tag-Along rights, on the other hand, require a shareholder who wants to sell their shares to include other minority shareholders under the same terms. This keeps these shareholders from being "cut out of the deal."
7. The right to choose directors and limit what they can do
Most of the time, a majority of shareholders (i.e. 51% or more) is needed to appoint or remove directors from the board, which gives the company effective control. But this means that a minority shareholder, even if they own up to 49% of the shares, won't be able to have a voice on the board.
In that case, a minority shareholder might be able to choose a director if they own at least a certain number of shares, like 25%. A "restricted activities" clause in a shareholder agreement may also require a "super-majority" of shareholders (such as 75% or more) to make certain decisions, such as entering into a major transaction, hiring key staff, paying dividends, or issuing more shares.
This can help make sure that minority shareholders still have a say in how the company is run.
8. Liquidation Preferences
One of the most well-known tricks that venture capitalists use is called a "liquidation preference." Investors are often given shares with the promise that, if the company is sold or shut down, they will get their money back before the other shareholders.
In some situations, though, investors may be able to negotiate a 2x or 3x liquidation preference. This means that the investor will get back twice or three times the amount they invested before the rest of the assets are given out.
This can mean that the other shareholders get a much smaller amount when the company goes out of business. Liquidation preferences for investors are fine, but if they are more than 1x, this should be a red flag unless the founders want to risk getting nothing when the business is sold.
9. Capital from loans and shares
Instead of getting shares of the company, a founder or investor may give the company a loan that could be turned into shares at a later time. This is called a "convertible note." A loan must be paid back before other shareholders (including any interest) and can give the person who took out the loan the power to take over the company in order to pay back the loan and maybe even sell the company's assets to a related company.
This is different from equity capital, which is when cash is given in exchange for shares.
Many companies have a mix of debt and equity capital, and sometimes it's better for the founders to make sure that any money they give is in the form of a loan instead of equity capital so they can keep more control and get more leverage with other investors and creditors.
10. Fundamental Disputes
Sometimes, disagreements between shareholders get so bad that they can't be solved and could hurt the business as a whole. This could be a disagreement about more money for the business, an increase or decrease in shares, the payment of dividends, or the sale of the business.
In this case, a "fundamental dispute" clause can be used to provide a way out by letting one or more shareholders buy out the other shareholders. As we talked about above with restrictions on the transfer of shares, there could be an independent valuation or a set formula. If you can't come to an agreement, a "shotgun" clause is an interesting (but somewhat risky) way to figure out how much the shares are worth.
If one shareholder makes an offer to buy the shares at a certain price, the other shareholder can either sell their shares or buy the offeror's shares at that price.
This makes sure that the person making the offer doesn't offer less than what they think the shares are worth on the market, unless they want to risk losing their own shares at less than market value.
Even though a fundamental disputes clause is a last resort, it is better than a deadlock, which could cause the company to lose all the value it has built up over many years.
Want to read more about shareholders agreement but for a typical business have a read of our common clauses in a shareholders agreement article by clicking here.