When founding a startup, establishing a solid foundation with clear agreements among shareholders is crucial. A well-crafted shareholder agreement protects your rights and sets expectations with early-stage investors. Here are the top 10 shareholder agreement terms every startup founder should understand and include, especially at the pre-seed stage:
- Equity Ownership and Share Classes
Definition: Clearly delineate the percentage of ownership each shareholder holds and specify the different classes of shares (e.g., common shares, preferred shares).
Importance: This ensures clarity on the ownership structure and helps in managing voting rights, dividends, and liquidation preferences.
Explanation: Different classes of shares may carry different rights. Common shares typically have voting rights but are last in line for dividends and liquidation proceeds. Preferred shares often have priority for dividends and liquidation proceeds but might not have voting rights.
Example: If your startup has 1,000,000 shares, you might allocate 700,000 common shares to founders and employees, and 300,000 preferred shares to investors. This setup ensures investors have priority in receiving dividends and liquidation proceeds.
- Voting Rights
Definition: Outline the voting rights associated with each class of shares, including who has the right to vote on specific matters.
Importance: Voting rights determine how decisions are made within the company, protecting minority shareholders and ensuring major decisions are collectively agreed upon.
Explanation: Shareholders typically vote on critical issues like electing board members, approving mergers or acquisitions, and significant changes to the company’s structure. Establishing clear voting rights ensures that all shareholders have a say in important decisions, balancing power within the company.
Example: In your startup, common shareholders might have one vote per share on all company matters, while preferred shareholders might have limited voting rights, voting only on specific issues such as mergers or changes to share classes.
- Pre-Emptive Rights
Definition: The right of existing shareholders to purchase new shares before the company offers them to external investors.
Importance: Protects existing shareholders from dilution of their ownership percentage when new shares are issued.
Explanation: If a company issues new shares, pre-emptive rights allow existing shareholders to buy a proportionate amount to maintain their ownership percentage. This protection is vital for early investors who might otherwise see their influence and value diluted as new investors come on board.
Example: If your company issues 100,000 new shares, existing shareholders with pre-emptive rights can choose to buy a proportionate share of these new shares to maintain their current ownership percentage.
- Tag-Along and Drag-Along Rights
Tag-Along Rights: Allow minority shareholders to join in the sale if a majority shareholder sells their stake.
Drag-Along Rights: Force minority shareholders to sell their shares if a majority shareholder decides to sell their stake.
Importance: Ensures fair treatment of all shareholders during a sale and facilitates smoother transaction processes.
Explanation: Tag-along rights protect minority shareholders by ensuring they get the same deal terms as majority shareholders in a sale. Drag-along rights simplify selling the company by obligating minority shareholders to sell their shares under the same terms agreed upon by the majority, preventing small holdouts from blocking a potentially lucrative sale.
Example: If a majority shareholder receives an offer to sell their shares, tag-along rights allow minority shareholders to sell their shares under the same terms. Conversely, drag-along rights might compel minority shareholders to sell their shares if 75% of shareholders agree to the sale.
- Board Composition and Control
Definition: Specifies the structure of the board of directors, including the number of seats and the process for appointing or removing directors.
Importance: Defines the governance of the company and ensures a balanced representation of all shareholders in decision-making.
Explanation: The board of directors makes strategic decisions and oversees the company’s management. Clearly defining how board members are chosen and replaced ensures that all significant stakeholders have appropriate representation and that the board acts in the company’s best interest.
Example: Your agreement might specify that the board will have five seats, with three appointed by common shareholders and two by preferred shareholders, ensuring both founders and investors have a voice in strategic decisions.
- Dividends and Profit Distribution
Definition: Details the policy for distributing profits to shareholders, including dividend payments.
Importance: Provides transparency on how and when shareholders can expect to receive returns on their investments.
Explanation: While many startups reinvest profits to fuel growth, having a clear dividend policy can set expectations about when and how profits will be shared. This clarity helps manage shareholder expectations and can attract investors who are looking for regular returns.
Example: Your shareholder agreement might state that dividends will be declared annually if the company achieves a certain profit threshold, specifying that preferred shareholders receive dividends before common shareholders.
- Transfer Restrictions
Definition: Rules governing the transfer of shares, including any restrictions on selling or transferring shares to third parties.
Importance: Maintains control over who can become a shareholder, protecting the company’s integrity and the founders’ vision.
Explanation: Transfer restrictions prevent unwanted parties from gaining ownership and influence over the company. These rules can include rights of first refusal, which require shareholders to offer their shares to existing shareholders before selling to outsiders, helping maintain the desired ownership structure.
Example: If a founder wants to sell their shares, transfer restrictions might require them to first offer these shares to other founders or investors, ensuring the company retains control over its shareholder base.
- Founder Vesting and Clawback Provisions
Vesting: Determines how and when founders earn their shares over time.
Clawback: Allows the company to reclaim shares if a founder leaves or is terminated within a certain period.
Importance: Encourages long-term commitment from founders and protects the company if a founder departs prematurely.
Explanation: Vesting schedules typically span four years with a one-year cliff, meaning founders earn 25% of their shares after one year and the remaining shares monthly over the next three years. Clawback provisions ensure that if a founder leaves early, they forfeit unvested shares, which can then be reallocated to new team members or investors.
Example: If a founder leaves the company after two years, they will have vested 50% of their shares. The remaining 50% unvested shares will be returned to the company for redistribution.
- Anti-Dilution Provisions
Definition: Mechanisms to protect investors from dilution in the value of their shares during future fundraising rounds.
Importance: Ensures early investors maintain their value and proportionate ownership despite new equity issuances.
Explanation: Anti-dilution provisions adjust the conversion price of preferred shares to ensure that investors are protected from significant value dilution. There are two main types: full ratchet and weighted average. Full ratchet adjusts the conversion price to the new lower price for all shares, while weighted average takes into account the number of shares and the price paid, offering a more balanced approach.
Example:
- Suppose an investor bought 100,000 preferred shares at $1 per share in the first round.
- In a subsequent round, new investors buy shares at $0.50 per share.
- Full Ratchet Anti-Dilution: The original investor’s shares are repriced at $0.50 per share. So, they now have 200,000 shares instead of 100,000 to maintain their investment’s value.
- Weighted Average Anti-Dilution: If the new investment round raises $500,000 by selling 1,000,000 shares at $0.50 each, the weighted average method considers both the number of new shares and the price. The conversion price for the original investor might be adjusted to $0.75 instead of $0.50, meaning they receive fewer additional shares than under full ratchet but still see some protection from dilution.
- Exit Strategies and Liquidation Preferences
Exit Strategies: Defines the terms for an eventual exit, such as a sale, merger, or IPO.
Liquidation Preferences: Specifies the order in which shareholders are paid in the event of a liquidation.
Importance: Provides clarity on how proceeds will be distributed during an exit, protecting investors’ returns.
Explanation: Liquidation preferences determine the payout order, often giving preferred shareholders their investment back (plus any agreed return) before common shareholders receive any proceeds. This provision is crucial for attracting investors, as it provides a safety net for their investment in scenarios like the sale or dissolution of the company.
Example: If your company is sold for $10 million, liquidation preferences might ensure that preferred shareholders receive their original investment plus a 1x return before any remaining proceeds are distributed to common shareholders. If an investor had invested $500,000, they would get $1,000,000 (1x return) before any remaining funds are shared among other shareholders.
Conclusion
A comprehensive shareholder agreement is essential for aligning interests, protecting rights, and ensuring the smooth operation and growth of your startup. By including these key terms, founders can establish a strong foundation for their company, fostering trust and clarity with early-stage investors. This proactive approach not only mitigates potential conflicts but also paves the way for successful future fundraising and company scaling. At Appomate, we support app founders in navigating these complexities, ensuring they have the legal frameworks necessary for success.