Shareholder agreements – preliminary questions for founders

May 2023

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This is the third to be released of a series of Guides about shareholder arrangements.

My first Guide explained the default position where you don’t have a shareholders agreement or tailored Articles of Association for your company.

The second Guide was a short introductory one as to why you might need a shareholders agreement in different shareholder scenarios which can arise during the course of a company’s lifecycle.

This third Guide sets out some questions founders should consider before they even think of divvying up the shares or asking someone to draft a shareholders agreement for them.

My next Guide will set out in some depth some key issues to address in any shareholders agreement between founders.

Future Guides explore in more detail the kinds of issues which need to be considered in different shareholder scenarios (such as ‘deadlock’ companies; and various investor scenarios).

Managing expectations

There is no ‘standard’ shareholders agreement, as it all depends on the dynamics between founder shareholders in each case. There are different types of founder. There are key founders (owners or drivers) and lesser founders. Some key founders are more key than other key founders. Some lesser founders are less lesser than other lesser founders. The venture may be one founder’s ‘baby’. What do other founders bring to the table?

Here are some things to think about which can affect how you structure your company and what you might look to address in any shareholders agreement and tailored Articles of Association:

• Why are you going into business together?
• Are there any power dynamics you need to cater for? Who has real ‘ownership’ of the venture (whose ‘baby’ is it? Who is the main driver?). Who has most money?! Having more money to start with tends to bring more power! And the more financially or career secure you are the more options and negotiating strength you have.
• Different founders will have different ages and personal lives, different interests and different life and business objectives. Can you manage all founders’ expectations, such as those relating to job security, earning ability, retirement plans or timing of future exits?
• What are each of your aspirations and objectives? What are you each expected to put into the venture and what are you each expecting out of it?
• Do you all share the same understandings and expectations as to each founder’s ongoing and future roles, commitment and contributions, and respective importance to the business? Who is bringing what to the table? Different founders might be expected to make different types of contributions such as cash; valuable contacts; contribution of IPR or other resources; or time, effort and skills. How important does this make them? When are these contributions to be made? Before, on or well after the business has started up?
• How well do the founders get on? Do some get on better than others?
• What might happen in the future? How might things change?

Even if you end up never having a shareholders agreement, it is important to address these questions. Only then can you meaningfully drill down into more detailed issues. And the more you all understand each other on these bigger questions, the better you will be able to deal with change. It is impossible to cater in advance for all possible eventualities. People change. Businesses change. Economies change! Things happen.

And for this reason I also strongly advise people going into business together to diarise regular breakaway sessions, perhaps every three months, where everyone can take a step back and look at the big picture and address the same questions again.

Ownership

Who should be entitled to shares, and how many should they be allocated? Should there be different classes of shares, and what rights should attach to each of them? The decisions might depend on what each stakeholder is contributing, or is expected to contribute, towards the success of the joint venture; and on what they are expecting to get out of the joint venture. For example:

The key founder

With a new business, there is often one main founder/driving force behind it (perhaps working with other ‘founders’ of significant importance to the new business) who has to make these decisions. Starting from owning 100% of ‘nothing’, he needs to strike a balance between seeking to retain control and as much of a stake as possible, and seeking to ensure that the business is given the best chance of building value. It is better to own a small share of something valuable than a large share of something worthless.

The working founders

How should founders who put in time, effort and expertise be rewarded?  It begs some very important questions:

• How hard is each person involved expected to work on the business?
• What exactly are they expected to do?
• How long do they have to work this hard?
• How is this effort to be valued?
• How much effort and input have they already provided?
• Are they taking a risk that their effort might never be rewarded, and if so how should they be rewarded for taking this risk? How many shares should they be entitled to as ‘sweat equity’, both for past input and for input expected in future?
• How much can be paid on a straightforward employment/remuneration basis?
• Should they have employment or consultancy contracts?
• Should they be given an immediate share in the long-term future of the business by being given shares in the company?
• Could they be given options to acquire shares at different times in the future depending on whether they are still contributing as expected?
• If they give up or get a bit slack, what can the others do about it?
  • Should they have to leave?
  • What should their pay-off be?
  • Should they have to transfer any shares to other shareholders?
  • How should these shares be valued? Should there be a discount to reflect the fact they have left early or haven’t done as much as expected?
• Have they contributed anything else fundamental to the birth of the business or its chances of success? For example any involvement in developing the original ideas? Any money? To the extent their contribution is not just time, effort and skill, how should it be rewarded? Should it be looked at separately from their contribution of time, effort and skill?

Other contributors

Shares can be issued to contributors of money or other ‘valuable’ assets, whether intangible such as IPR or contacts/goodwill (or ‘owning’ the target customer base), or tangible such as equipment, technical resources, premises, or any other assets or facilities. But there are several other ways in which cash or other assets could be put into the business, such as:

• Loans. Loans are a safer ‘investment’ in that they can be repaid more quickly, and in priority to shareholders’ share capital, and can be secured over the company’s assets.
• Leasing or licensing assets to the business?
• IPR: Should ownership of IPR be assigned to the company, or retained by the contributing shareholder and licensed to the company? Or should key IPR perhaps be transferred to a separate joint venture company, which can then licence it out to the trading joint venture company? This can provide an efficient (and tax-efficient) revenue stream. And if the trading company fails, the IPR can still be safe. And it can be a useful way of setting up a franchise structure or other more localised joint ventures relating to different trading companies in different areas.

Future funding requirements: Do you need to agree now as to when any future funding will be needed, and if so as to how it should be dealt with? Should some or all shareholders be required to contribute? Who? And how much? Is there agreement as to how much third party finance such as bank loans might be needed? Should shareholders be required to give guarantees of third party loans in some circumstances? What if they don’t? Should there be an adjustment to their shareholdings or share rights? Should they be required to sell out?

 

These are just some of the questions you might want to ask before starting your new company. There will be others depending on your particular circumstances.

My next Guide will set out in some depth some key issues to address in any shareholders agreement between founders.

What next? Contact me for a complimentary Shareholder Arrangements’ consultation:

If you are thinking of entering into any shareholder arrangements with business partners or investors or are having any issues or difficulties with existing arrangements please feel free to email me at andrew.james@onhandcounsel.co.uk to arrange a complimentary ‘Shareholder arrangements’ consultation where I can help you to identify what might be involved and how I can help. This will help you to avoid some of the pitfalls to which you might otherwise be exposed, and give you the peace of mind of knowing that you have an approachable competent corporate lawyer ONHAND who can provide you with experienced, effective and cost-effective advice and assistance.
If you are a director or shareholder of a company and want more information on how to deal with shareholders and director relationships so you can protect the value of your business and your role in it, together with your business and exit objectives, then please contact me.

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