When partnering up with other entrepreneurs, it’s helpful to have a shareholder agreement, sometimes called shareholders’ agreement. These agreements are contracts among the shareholders governing corporate actions as well as rights and duties of the shareholders. Such agreements can be entered into before or after incorporation. If entered into afterward, the founders should not wait long to draft and sign an agreement.
Corporations are formed by filing Articles of Incorporation with the state. One of the things the corporation then does is approve bylaws. The bylaws set forth how often the directors and shareholders will meet, what a quorum shall consist of, how many directors can be elected, and so forth. But there are many important provisions that are customarily found in an agreement among the shareholders. Some of the more important ones are listed in this post.
Voting Requirements in Shareholder Agreements
Corporate bylaws might state that only a majority of shareholders or directors is required to pass a resolution. But a shareholder agreement can bind the shareholders to require a higher percentage to approve any or all corporate actions. For example, a shareholder agreement might require a two-thirds majority or even a unanimous vote to approve borrowing money. Even though the bylaws require only a majority, the shareholders are free to contract among themselves to require a greater majority than the bylaws.
Restrictions on Transfer
In small startups, the founders do not want to be surprised by one of the shareholders suddenly selling their stock to an outside person. If that happens, the remaining founders find themselves in business with someone they might not like or with whom they do not share a vision for the corporation. For that reason, the founders might want to include provisions such as these in the shareholder agreement:
The shareholder may transfer their stock to a spouse, child, parent, family trust or other person provided that the transferee agrees to be bound by the terms of the shareholder agreement.
If the shareholder wants to sell their shares, the shareholder agreement might require a right of first refusal to purchase those shares on the part of the remaining shareholders.
There could be an agreement that no shares may be sold to any person absent unanimous agreement of the other shareholders.
The sale of the shares could be restricted for a period of time, perhaps six months, a year or more.
Noncompetition, Nonsolicitation and Trade Secrets
Shareholder agreements also frequently contain provisions that the shareholder will not work for or invest in another corporation that does business in the same space that the startup does. Such an agreement could also restrict the ability of the shareholder who is leaving to solicit business from the startup’s customers. The agreement might also forbid the departing stockholder from sharing the company’s trade secrets with others. Each of these types of provisions are limited by time, scope and, if applicable, geographic area. Each of them is worthy of a separate blog post. They are listed here for the sake of highlighting that they are appropriate subjects to include in a shareholder agreement.
Dispute Resolution Clauses in Shareholder Agreements
Civil litigation is expensive, and the results can be wildly unpredictable. The judge might not be well-versed in corporate disputes. A jury certainly would not be familiar that subject. To avoid the expense and uncertainty, a common clause in a shareholder agreement requires the parties to mediate to try to settle their differences. Mediation is an informal process in which each side to a dispute explains their position to a neutral person who usually has expertise in the subject matter of the dispute. The mediator attempts to assist the parties to come to an agreement on their dispute by listening, shuttling between camps, assessing the strengths of the parties’ cases and making suggestions when they might prove helpful.
If mediation is not successful – in other words, if the mediator “declares an impasse” - then a dispute mediation clause in the shareholder agreement might require the parties to submit to binding arbitration, often before an arbitrator who is a member of the American Arbitration Association and perhaps under AAA rules. This procedure is slightly more formal than mediation. But once the arbitrator makes a decision, in most cases the decision is final. The parties can go to court only for assistance in enforcing the award.
Preemptive Rights in Shareholder Agreements
Preemptive rights are designed to maintain the percentage of a shareholder’s interest in a corporation. They are best explained by an example. Suppose that the corporation has three shareholders who each own 100 shares. Then the corporation decides to authorize the issuance of another 700 shares, for a total of 1,000 shares outstanding. One of the shareholders decides to buy all 700 shares. But if that shareholder buys all 700 shares, then they will become the majority shareholder, which the other two shareholders might not like.
If there is a preemptive rights clause in the shareholder agreement, then each of the other two shareholders can maintain their proportionate interest in the corporation by requiring that each shareholder may buy an equal number of the 700 new shares.
Many More Provisions for Shareholder Agreements
The shareholder agreement clauses in this post are among the more common ones. There are other, more complex provisions such as drag-along rights, tag-along rights, valuation requirements when selling shares, and more. The variety of potential clauses for shareholder agreements, and the protections they offer, should be explored by the founders of startups. Everything the founders can do to make sure they are all in agreement on what the corporation should be doing, and how it should be run, lessens the possibility of discord in the future.