You’ll quickly find out where someone’s heart lies when you talk about vesting and how to split the shares
Before I started down the start-up rabbit hole, I was a corporate lawyer. Some of my clients used to glaze over once we started talking about legal agreements — to them, they were simply the boring parts of the deal. To those clients, I often told them to think about the agreement not as a formality they needed to get over and done with, but as an acid test of values. I have often found that in discussing agreements, people quickly discover the true values of those across the table from them_._
So, want to know if you have the right co-founder? Take a day out of building your product to discuss the shareholders’ agreement and you’ll find out. Here’s a quick guide to how to get started without needing to pay a lot in lawyers’ fees.
Let’s shake on it! Or not..
People sometimes argue that there’s no point in having an agreement because (i) it’s too expensive or it takes too long to litigate; (ii) the courts in their country are corrupt/ineffectual; and (iii) there’s no way to cover all eventualities and if someone wants to act in bad faith, there’s always a way of doing so. All these are true.
There are many reasons why I think a shareholders’ agreement is useful but the most important reason is that the discussion about the shareholders’ agreement will predict your ongoing working relationship with your co-founder. It forces you to talk about the unsexy stuff in the business and brings out (before it’s too late) any key differences in values and priorities.
If you and your co-founder have different ideas about how you make day-to-day decisions, what happens when one of you leaves, or how to split the shares, you will likely have very different ideas on why you’re starting the business, where the power lies in the relationship and what your respective contributions to the business are. This isn’t a shareholders’ agreement issue. This is a fundamental disagreement about values that will impact on your day-to-day running of the business. So, find out about these differences now, before you commit to many years of building a start-up together.
In my case, I knew my co-founder was a keeper when we had the fairly uncomfortable discussion about the shareholders’ agreement, and neither of us took it personally. It’s never fun to be discussing share splits, vesting and how to break an impasse in decision making. It’s not as interesting as talking about your vision for the business, and more importantly it will feel quite personal at some stage of the discussion. But, if you have found yourself a co-founder who who can work through all the messiness with you, and come to a fair outcome for all parties involved, you know you have a co-founder for life.
$400 an hour to do what..?!
I have listed below some basic key points to discuss with your co-founder(s) before you start a start-up. Some of this stuff may seem dead boring (especially the meetings!) but trust me, I have seen enough horror stories when any of these are not properly thought through. This is what I used to advise my clients, so hopefully this will save you some money in lawyers’ fees!
1. Capital contribution and share split
How much money are you each contributing to the business? Will the share split be a reflection of that capital contribution? Or, do you decide that even if one co-founder is putting in more money, the share split should be equal because the other co-founder(s)’ non-monetary contribution entitles them to have an equal voice in the business?
Here, it’s important to note that the capital (i.e. monetary) contribution need not be the sole determining factor of the share split, so think carefully about what you and your co-founder(s) are bringing to the table, from a monetary and non-monetary perspective.
2. Board Reserved Matters vs Shareholder Reserved Matters
Here, you’ll need to discuss what matters should be decided by the board vs what matters should be decided by the shareholder. The various types of decisions you should be thinking through will include: fundraising, firing a co-founder, entering into agreements with third-parties (e.g. partnerships), coming up with an employee option plan and so on.
Also, should a decision should be made by a 51% majority, 75% majority or 100%? Obviously the higher the percentage required, the more likely that contentious decisions can’t be made which may slow down the company. So, weigh up efficiency against perceived fairness.
Later when you get external investors, this gets even more complicated and you will want to have thought about what matters the co-founders together should absolutely retain decision-making power over, and how to reserve that power for the co-founders.
3. Director appointment
Here, you’ll need to think about who gets to appoint directors to the board and how many directors you want on the board (ideally an odd number). Director appointment rights can reflect shareholdings, but can also diverge from the shareholdings. The shareholders and the directors of the company on day one are usually the same.
In addition, you may also want to have some independent non-executive directors on the board, who you trust, as they may be the tie-breakers. If you want independent non-executive directors on board, you will need to think about a fair way to appoint them, so their decisions don’t skew towards the co-founder who appointed them.
As the company gets outside investment, board appointment becomes even more strategic like a chess match. I would highly recommend reading The Facebook Effect to see how Mark Zuckerberg managed to retain control of Facebook’s board and how that helped them weather storms over the years.
4. Conduct of Board and Shareholder meetings
The process for board meetings and shareholder meetings need to be carefully thought through because otherwise, it will leave room for rogue directors or shareholder to invalidate decisions by arguing that the process wasn’t followed.
Why is this a problem? If you think about Board Reserved Matters and Shareholder Reserved Matters being the key decisions that a company needs to make, then just imagine if any of these decisions cannot be legally upheld because the process wasn’t followed. In practical terms, this may mean you can’t get a bank loan, you can’t fire certain rogue actors from a company or even change bank signatories as you aren’t able to obtain a valid resolution.
Here, you’ll need to think about things like: what is the minimum number of directors or shareholders at a meeting before it’s valid (i.e. the quorum), in the case of shareholder meetings, are you voting by one person one vote or one share one vote, what is the minimum notice period to be notified of meetings and what happens if a key member doesn’t receive notice for any reason and can you vote remotely (through video call, email, telephone). I cannot stress enough how important it is to think through this process because I’ve seen how bad it can get for a company when these things aren’t properly thought through.
5. Deadlock
This simply refers to the process of forcing a decision if the board or shareholders cannot agree. A deadlock process takes time to resolve and a start-up may not be able to afford that time, so this is really seen as a last-resort. For e.g. if a rogue director or shareholder is consistently blocking resolutions that really need to be passed (such as the decision to fire a director-employee), then you may want to go through a deadlock process to allow a third party to make the final decision.
Here, you’ll need to think about: what counts as a deadlock (e.g. if a resolution has been raised three times and not passed), how the deadlock process is triggered (you don’t want to automatically trigger the process as it can be a fairly lengthy/expensive process so a director or shareholder should be the one triggering the process), who the third party arbiter will be (ideally you’ll want someone independent who has an understanding of the matter/business — can be a third party lawyer, auditor etc), who pays for the arbiter (this can be expensive so you’ll need to decide if the company pays or if the director/shareholder who has triggered the process who pays), and what’s the maximum amount of time the arbiter has to make a decision.
6. Vesting shares
Vesting provisions state that whatever percentage shareholding you have agreed you would get in the company, it doesn’t belong to you until certain events occur. Vesting is based on the principle that a co-founder is not automatically entitled to own a big chunk of the company just by showing up, but that they actually need to earn their ownership of the company. Vesting provisions help mitigate risks around a co-founder’s actual contribution or commitment to the company.
Vesting is a strange concept to people who aren’t in the tech world. When I told some very sophisticated banker friends that my shares in Seek Sophie vest very slowly, they asked me what on earth does vesting even mean? The concept is at odds with what happens in the real world where once you own shares, you own shares. You have a share certificate, you’re on the share register and you have the right to freely transfer the shares.
In the tech world, when you have shares that come with vesting rights, you own the shares in the exact same way. So, if you have agreed on a 30% shareholding, you actually have that full 30% shareholding on day one of the company’s registration, even though the shareholders’ agreement says your full ownership vests only after 3 years. However, your ownership of the shares will be subject to the terms of the shareholders’ agreement so you’ll need to follow the vesting provisions in the shareholders’ agreement if you don’t want to be sued by the other shareholders.
In terms of vesting, co-founders need to decide what sort of contribution is deemed to be sufficiently meaningful and valuable to the company. Is vesting tied to time spent in the role (and is that 1 year, 2 years or 5 years), or to meeting some key performance indicators (e.g. sales targets, objectives) or to some other desired outcome that is uncertain from day one? When does vesting accelerate (i.e. upon an event happening, the vesting schedule is thrown out of the window and all remaining shares automatically belong the relevant co-founder) — is this on an IPO, a sale of the company or certain fundraising milestones being met? Are there any circumstances where the company is entitled to a claw-back of the shares — e.g. if the co-founder is found to be fraudulent, can the company take back shares that have already been vested?
7. Transfer of shares
There will be situations when a co-founder wants to leave the company. In these circumstances you’ll need to think about: can they sell their shares to a third party; do the co-founders have a right to buy the shares before they’re offered to a third party; if the co-founders don’t have the money to pay for the shares, can they still have a veto right over who the third party is; and what price should the shares be sold at?
The question of price can get contentious — is the price of the shares the current market price (in which case, how will that be valued and who pays for that valuation), at the price of the previous valuation (in which case, what happens if the company’s valuation has significantly declined since then), at a pre-determined price, or at a discount?
8. Non-compete
The non-compete provisions restrict shareholders from joining or starting a competitor, or hiring employees away from your company.
The key thing to note here is that companies often like to make the restrictions as broad as possible. However, the courts don’t usually enforce restrictions that are too broad as they view them as being unreasonable. So here, you’ll need to think about what sort of restrictions really make a difference in protecting your business as it stands (what specific knowledge areas, what industries, what cities/regions/countries) and narrow your restrictions to what really matters to make sure that they are enforceable.
Ok I’m convinced, where do I begin?!
If you’re convinced that you should have a shareholders’ agreement in place with your co-founders, here’s how to go about doing that without needing to pay a lot in lawyers’ fees.
Step 1: Find a template you can work off.
If I were advising a friend on their shareholders’ agreement, I would first send them my template as a starting point as to what I think is entirely fair (which in my case, means entirely equal). If you would like me to send you my template or point you towards some good ones you can use, please PM me.
Step 2: Read the template to see if it reflects how you think the relationship between you and your co-founder(s) should work.
Whatever template you use is only a starting point and will need to be amended to reflect the realities of the relationship you have with your co-founder(s).
On a practical note, when you’re going through the template, do think about your deal-breakers and the areas where you are happy to compromise on. This will come in handy when you need to trade points with your co-founder(s) when discussing the agreement, or decide whether to walk away.
Step 3: Discuss with your co-founder(s).
Put aside a day to discuss the agreement with your co-founder(s), provision by provision. If there are any disagreements, make sure you iron out specifically what those disagreements are and reach a conclusion.
Step 4: Commit the discussion to writing.
Often people have different understandings of what had been agreed. I’ve seen this so many times in practice when each party believes they’ve agreed to something very different from what another party thinks.
So, it’s important that any agreement is committed to writing and all parties agree on the version of events written down. Obviously putting it all into a proper legal agreement is best, but if there are budgetary constraints or other issues, just write it all down in one place (in a word document, on the back of a very large napkin, anywhere!) and have everyone scribble their signature on it.
Step 5: You’re all set. Start building your start-up!