What is a Shareholders’ Agreement?
The shareholders' agreement is a private document that outlines the rights and obligations of all shareholders at the time it was signed. It includes several clauses, the cap table, and it needs to be signed by all shareholders.
Having a good shareholders' agreement helps the company’s governance, protecting the company and the shareholder rights in most circumstances and structures how decisions should be made.
Main Clauses of a Shareholders' Agreement
Shareholders’ agreements are quite simple and straightforward, but new clauses and provisions are added when professional investors are involved. Find the most typical clauses which are covered by such agreements below:
- Roles, dedication and compensation: when a company is just getting started, it is very important to define what role each founder is going to take, their partial or full dedication and their compensation. Those 3 topics usually end up defining the company’s cap table and what percentage of the company each partner is going to hold, which is also part of the agreement.
- Non-compete and non-solicitation: very common clause in all stages, founders agree not to start any other company in the same industry for a period of time after they depart the company, usually 2 years, and to not poach any talent.
- Vesting: it is a widespread practice for all founders to have reverse vesting, so they will only get to keep their equity stakes if they stay at the company throughout the vesting schedule. Common clauses include the definition of good and bad leaver, which highlight in which cases the departing founder gets to keep her vested shares. The benchmark for founder vesting is 3-5 years on linear vesting, so if it’s a 4-year schedule and one founder departs as a good leaver after the 3rd anniversary, she will keep 75% of her initial stake (25% per year).
- Restrictions on transfer of shares: to protect the shareholders’ interest, most agreements include a right of first refusal before allowing a third party to become a shareholder. In practice, that means the party interested in selling has to notify the other shareholders with the agreed timelines and prices, and any existing holder will have priority on the transaction.
- Drag along / Tag along: these two clauses are essential to a shareholders’ agreement as it covers what happens when there is the option to sell part or the whole company to a third party. Drag along ensures that if a minimum percentage of shareholders (usually around 80%) agree to sell their shares to a third party, they can force the remaining shareholders to sell under the same terms. It is common to set a minimum sale price and the right of first refusal for existing shareholders. Tag along allows all shareholders to be included in a partial sale, under the same terms, protecting the rights of small shareowners.
- Equity plans: companies may decide to use part of their shares to be given to key employees or executives in the form of stock options, ESOP or phantom shares plans. The option pool and main lines of the program need to be approved and signed by all shareholders before granting any option. Equity plans are also a good tool to keep founders aligned with the rest of shareholder’ interests when they have been severely diluted.
- Anti dilution: these provisions allow certain investors the option to keep their ownership percentages when new shares are issued, usually due to a new funding round. It’s usually linked to a preferred shared class, which may have additional rights like liquidation preference.
- Liquidation preference: sets the payout order when the company is being sold for less than the investment amount received. The preferred shareholders get their money back before lower ranked shareowners, stockholders or debtholders. Typically the liquidation preference is a multiple of the investment committed, being 1x (getting paid back first the amount invested) the most common one. There are 3 types of liquidation preference, which define how the remaining proceeds are distributed:
- Non-participating: the shareholder of liquidation preference does not participate in the distribution after receiving its liquidation multiple.
- Full participating: the investor receives the liquidation preference and also participates in the distribution of the remaining proceeds on a pro-rata basis (following the fully-diluted cap table).
- Capped participating: the shareholder receives the amount of their investment first and then participates in the pro-rata distribution of the remaining proceeds until a cap is reached, which is usually 2-3x of the amount invested.
- Right of information: investors and small shareholders that are not operating the business keep the right to receive information on how the business is performing. The clause usually specifies what is the minimum information that needs to be shared and its cadence. Providing investor updates with the information becomes a legal requirement.
- Lock-up: for late-stage companies thinking about going public, it is common to not allow any shareholder to sell shares for a certain period upon IPOing, usually for 6 or 12 months. That clause also applies to employees holding stock options, ESOP or phantom shares.
When Should You Have a Shareholders' Agreement?
Updating or signing a new shareholders’ agreements is common when the company is at any of these two stages:
- When the company is incorporated and the founding team wants to outline the main obligation and responsibilities. Even if at that stage it may not seem necessary, we highly recommend having one from the get go, as it will touch on critical topics like founder dedication and exclusivity, vesting schedule, salaries…
- When a new shareholder joins the company or a financing round is about to happen: new investors negotiate new rights and obligations, and their newly issued shares may have different rights than the ones owned until then, like liquidation preference, voting rights, etc.
All signers of the existing agreement in place must sign the new version.
Shareholders’ Agreement Template
The complexity of the agreement grows together with the company, so if you have not incorporated your company yet, your first contract will be fairly simple. There are several templates online but we highly recommend working with a lawyer to customize it to your specific case. You can use this template as a first step.