Here are 3 things that all start-ups, founders and business owners should think about in terms of shareholder agreements.
1. The board
A company must have at least one director. As businesses grow, more directors are often added to the board to help with strategic decisions and provide leadership.
There is no maximum number of directors, but often to ensure that a Board does not get too big to be slow to make decisions, or too large to be functional, a Shareholders’ Agreement (SH Agreement) can specify a maximum. A common maximum number of directors is five. Having an uneven number is also helpful to avoid a deadlock in decision-making.
The default rule is that a majority of shareholders (50.01%)must approve the appointment, and the removal, of a director. However, constitutions / SH Agreements can vary this rule. Different options for appointment rights include:
- Higher consent threshold to appoint a director. For example – 75%
- Named founder’s right to appoint a director. For example, Hudson Martin may appoint one director
- Shareholder holding a certain threshold of shares having a right to appoint. For example, each shareholder 20% or more of the shares.
- Group of shareholders having a right to appoint one director between them. For example, all shareholders (other than the Founders) will collectively have the right to appoint one director.
It is also important to consider what might happen if a company’s shareholding structure changes. For example:
- If you have a founder appointment right (see point 2 above) – what happens if the founder is diluted or no longer holds shares? Should the founder still have aright to appoint a director? This could be addressed by a founder’s appointment right being subject to a minimum shareholding percentage (for example, Hudson Martin may appoint one director provided that she holds at least 5% of the shares in the company).
- If the company has a wide shareholding basis,would it still work to have directors appointed by 75% shareholders (see the first point above)? Or would that mean you need too many smaller shareholders to agree?
A SH Agreement should be a living agreement, so it can(and should) be amended to ensure it is still relevant and workable as a company grows. Keep in mind that once rights are given, it is often difficult to get shareholders to agree to give up or limit a right that they have been granted.
If you have a maximum number of directors and grant rights to appoint a director based on a percentage of shareholding, then make sure the numbers work. For example, a maximum of three directors and a right for shareholders holding 25% or more of the shares (i.e.potentially four directors) would not work.
2. New shareholders
If a company wants to bring on a new shareholder, the default Companies Act rules are that:
- the Board decides (by majority decision) how many new shares are to be issued to the new shareholder and the price for the new shares; and
- the existing shareholders must first be offered those new shares, and the number offered must be pro-rata to the existing shareholders’ current shareholding percentages (so that the existing shareholders have a right to not be diluted). This right to be offered new shares is called a pre-emptive right.
- If shareholders decline the offer of new shares, then the Board can then offer those shares to the proposed new shareholder. The shareholders have no further say about who the new shareholder is.
If all shareholders are not also directors of the Board,then the shareholders may want to consider:
- Is having pre-emptive rights appropriate? Most shareholders like the idea of pre-emptive rights as it provides them with an anti-dilution protection (i.e.they will not be diluted unless they choose to say no to more shares). But if there are a number of smaller shareholders, then the Board may not want to have to go to all shareholders before it can raise capital for new investors.
- Is the company likely to need outside investment in order to grow? If so,should all current shareholders get a say in who can become a new shareholder? Some closely companies like the idea that the current shareholders have to all agree who can become a shareholder, others put the consent threshold at 75%, and others just leave the default position of the Board deciding (i.e. no shareholder input).
- Is the company likely to incentivise employees or contractors by offering them shares? You may want to include a carve-out to any pre-emptive rights process that allows the Board to implement an employee share purchase scheme for the company (i.e. the shareholders agree up front to the idea of an ESPS and then leave it for the Board to implement, usually within certain parameters – check out this article.
Shareholders should consider what the company’s need for capital, or to incentivise employees, is likely to be over the next six months, a year and beyond, and then ensure that it has an agreed process for implementing (and issuing new shares).
3. Existing shareholders
If a shareholder wants to exit, then it will need to find someone to buy its shares. The purchaser could be an existing shareholder(s), a third party or even the company.
When you start a company, you know who your other shareholder(s) are and (presumably) are comfortable with operating a business with them. Most people would be uncomfortable with finding out that their fellow shareholder had sold their shares to a party they did not know, and then being left to operate the company with that new person.
The Companies Act does not include pre-emptive rights on the transfer of shares. To combat this scenario, SH Agreements often include such pre-emptive rights. This means that if a shareholder wants to sell their shares, they have to first offer those shares to all the other shareholders. The number of shares that is offered is calculated based on the number of shares the non-selling shareholders hold relative to each other. For example, if there are three shareholders and Shareholder A holds 45%,Shareholder B holds 30% and Shareholder C holds 25%. If Shareholder C wants to exit then:
- Shareholder A would be offered 60% of Shareholder C’s shares (45 / (45 + 30)); and
- Shareholder B would be offered 40% of Shareholder C’s shares (30 / (45 + 30)).
Shareholders should also consider whether they want to include a mechanism for determining the price that shares are offered at. The selling shareholder would normally first offer up a price. If shareholders cannot agree a price,sometimes it is helpful to have an independent third party determine the fair market value of the shares which could then be used as the purchase price.
Pre-emptive rights on transfer provide anti-dilution protection to existing shareholders. However, if an exiting shareholder sets a share sale price too high it may undermine this protection. Consider having a fallback position of an independent third party being able to value the shares.
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Author: Sarah-Jane Lawson