Incorporating a company and entering into a shareholders' agreement can highlight several issues, as well as provide protection and certainty in the event of disputes. While this is advised for early stage startups, it remains optional - but if the founders successfully attract outside investment, a shareholders' agreement becomes a must before any money changes hands.
In this series of articles, I’ll try to demystify some of the jargon around shareholders' agreements which founders might encounter through a startup’s lifecycle. This first article provides an overview of exactly what a shareholders’ agreement is, and why a tech company’s founders might consider adopting one.
1. What is a shareholders' agreement?
Shareholders' agreements are private contracts between the shareholders of private companies, governed and enforced by normal contract law. In the context of technology startups and companies, they are also commonly referred to as founders’ agreements where the only parties are the founders of the business. If an investor is on board, they can be referred to as investment agreements, seed investment agreements, subscription and shareholders' agreements or business angel agreements. They are all essentially the same thing - a shareholders’ agreement. When adopting a shareholders’ agreement, it is normal practice to also adopt a related set of articles of association.
2. What are the articles of association?
Every UK company has a set of articles, which are required and regulated by statute and company law (e.g. the Companies Act 2006, but also any decisions in subsequent company law cases which might affect how a statutory rule is interpreted). The default set of articles for companies incorporated after 1 October 2009 is commonly referred to as the ‘model’ articles and when a company adopts a new set of articles alongside a shareholders’ agreement, the new set will usually modify or replace the model articles significantly.
The basic purpose of the articles is to place obligations on the shareholders and how they deal with the company and each other, and how the company deals with the shareholders. The document also deals with how directors should behave and the formalities of how the company should operate.
3. Why do we need both? Why can’t everything be in the shareholders’ agreement?
While many of the common provisions contained in shareholders’ agreements and articles could be contained in either document, the difference in regulation between contract law and company law means that in practice both are still necessary. In addition, a number of matters are not suitable for inclusion in the articles, e.g. anything that needs to remain confidential (since a company’s articles are publicly available at Companies House) or any personal rights or obligations unconnected with specific company law requirements (e.g. the requirement to assign all IP to the company).
4. Should the company be party to the shareholders' agreement?
This is debatable, since the general rule is that a company cannot restrict itself from exercising any powers it is given under statute. However, it might be a good idea for the company be a party to the agreement since this will allow for the company to commit to certain obligations that would otherwise need to be contained in the articles (and therefore public knowledge). Despite this, it is not common practice in the technology industry.
5. The advantages of entering into shareholders’ agreements for tech company founders
I come across a huge number of startups comprising of two shareholders (CTO, CEO) each holding 50% of the company’s shares. If there is a dispute leading to a deadlock between the two, the position under the model articles makes this very difficult to resolve. The model articles do not contain dispute resolution procedures, nor do they include any non-compete provisions, or deal with the death or incapacity of a shareholder.
Other common setups involve minority shareholders, e.g. where a CEO holds 80% and the CTO 20%. In these situations, the CEO can pass ordinary or special resolutions without the CTO’s consent. Common ordinary and special resolutions include the ability to remove directors and adopt new articles.
A shareholders’ agreement can offer protection to minority shareholders by allowing for contractual rights to nominate a director to remain on the company’s board, introduce pre-emption rights (where if the company issues new shares, the minority shareholder is offered them pro-rata to their existing shareholding so that their shareholding percentage does not dilute), or introduce tag-along rights (where another shareholder sells their shares, the minority shareholder also has to right to have his shares purchased at the same time).
Any changes to the shareholder agreement will also usually require the consent of all parties, while the articles can be amended by special resolution which is usually a 75% majority.
The other main advantage of adopting a shareholders’ agreement is confidentiality - since as you now know, the articles are available for anyone to download while the shareholders’ agreement remains private.
6. Common provisions in shareholders’ agreements between founders
Shareholders’ agreements between founders do not need to deal with the mechanics of completing an investment, so are usually less complicated than investment agreements. Common provisions include a definition of the business the company will carry out, the obligations of each shareholder, how dividends will be paid, how shares may be transferred or issued, any restrictions on the parties (e.g. non-compete and other restrictive covenants), any minority shareholder protection provisions, requirements of confidentiality, assignment of intellectual property to the company, dispute resolution procedures and what happens in the event of termination or a shareholder leaving the company.
7. So should founders adopt a shareholders’ agreement or not?
Tech startups don’t usually have huge legal budgets, so keeping costs low is imperative. Many founders skip entering into shareholders’ agreements when they believe that they will be able to attract investment in the near future, since any shareholders’ agreement between the founders alone will eventually be replaced once investors come on board.
This is risky, since any disputes in the meantime can lead to a catastrophic failure that might otherwise have been avoided or lessened. On the other hand, since any new shareholders joining the company will not automatically be subject to the existing shareholders’ agreement, the cost of adopting a new version when investors do come on board can be significant. The question is, how much risk are founders prepared to take while waiting for the first investment?
In my next article, I explain how shareholders’ agreements might differ once an investor comes on board.