Why You Need a Shareholders Agreement (Part I)

If you are forming a corporation with a partner, regardless of whether it is with your best friend that you have known since birth or a new business relationship, executing a well-crafted Shareholders Agreement is essential.  Too often, partners mistakenly believe that the corporate By Laws answer all the questions and will adequately set the parameters for the relationship between shareholders.  While the By-laws address day-to-day operations of the corporation, the Shareholder Agreement is where a number of specific rights and obligations of the shareholders are set forth.  Common provisions of a Shareholders Agreement will address such issues as voting rights, restrictions on voluntary and involuntary transfers of stock, buy-out clause, non-competition obligations, death, incapacity or divorce of a shareholder, and limitations on Board of Directors powers.  The next several posts will address the importance of the Shareholders Agreement, some of the common provisions, as well as several issues that are often overlooked in drafting the Agreement.

1.  Do Not Confuse the Articles, By-laws and Shareholders Agreement.

Entrepreneurs forming a corporation for the first time may find that they are unclear as to the differences between the Certificate of Incorporation (or Articles of Incorporation), By-laws and the Shareholders Agreement:

    A. Certificate of Incorporation:  This document (which often have a different name outside of New York, such as Articles of Incorporation), is the only document that must be filed in New York to form a corporation.  As with many states, New York provides a simple form requiring only limited information to be included in the Certificate (name of the entity, purpose, county where located, number of authorized shares, and name of registered agent).  While you may draft your own form, the simple New York form is all that is required to incorporate.  There are siutations where you might draft your own Certificate of Incorporation, as where there are different classes stock, and the Certificate of Incorporation will be more complex.  However, the basic Certificate of Incorporation is a bare-bones document that does not address any issues relating to corporate governance, authority of the Board of Directors, or the rights and obligations of the shareholders.

  B.  By-laws of a Corporation.  The By-laws serve the purpose of setting forth important terms relating to the governance of the corporation.  Thus, the By-laws establish important aspects for day-to-day operation of the corporation:

            (i) Board of Directors:  the number of members of the Board of Directors, meetings of the Board, voting, removal, vacancies, and powers of the Board of Directors;
 
            (ii) Shareholders:  Annual and Special Meetings of Shareholders, including notice, voting, and general procedures;

           (iii)  Officers:   election/appointment and removal procedures and authority of officers;

           (iv)  Indemnification:  indemnification of Directors, officers, employees of the corporation; and
   
          (v)   Miscellaneous:  Stock, Maintaining Books and Records, Seal of the Corporation, Amendments to the By Laws.        

    C.  The Shareholders Agreement.  The Shareholders Agreement  is the document among the Shareholders and the Corporation where a number of specific rights and obligations of the shareholders and the corporation are detailed.  The Shareholder Agreement is a contract, and can include essentially any terms that do not violate the New York Business Corporation Law (or any other applicable law).  Typical provisions can include voting agreements or rights among the shareholders, restrictions on voluntary transfers of stock (i.e., selling stock to a third-party) and involuntary transfers (death, bankruptcy or divorce of a shareholder), a buy-out clause, non-competition obligations, information rights of shareholders, and limitations on authority of the Board of Directors and dispute mechanisms.

2.  Why the Shareholder Agreement is Essential.

The Shareholder Agreement is essential as it clarifies the rights and obligations of the Shareholders between each other as well as certain obligations of the corporation to the shareholders that are not otherwise included in the By-laws.  Too often entrepreneurs, to their peril, are willing to rely on the relationship with their friend (now business partner) or believe they lack the negotiating position to ask for certain rights as a condition of an investment or becoming a minority partner in a business.  A well-drafted Shareholders Agreement not only helps delineate the rights of the business partners, but it will in most cases resolve any disputes before they arise because the issue will have been addressed in the Agreement.

Below are some typical disputes that will be alleviated with a Shareholders Agreement:

• Deadlock in a 50/50 corporation
• The sale of shares by your business partner to his undesirable friend
• The transfer of shares to the free-loading son of your deceased business partner
• The transfer of shares to your business partner's spouse in a divorce
• A decision by the Board to hire an employee at a ridiculously high salary         

If the business partners have a Shareholders Agreement, all of the above can be dealt with before they become issues.
 
3.  What are some of the Key Provisions to Include in a Shareholders Agreement?

Important provisions in a Shareholder Agreement will, at a minimum, include:

    A.  Restrictions on voluntary and involuntary transfers of a shareholder's stock;

            (i) Right of First Refusal
            (ii) Co-Sale (Tag Along) Rights
                                               
    B.   Resolution mechanism/buy-out clause in case of a deadlock;
   
    C.   Voting rights and obligations among shareholders;
   
    D.   Limitations on Board of Directors powers; and
   
    E.   Several Miscellaneous Rights

           (i) Restrictive Covenants
           (ii) Drag-Along Obligations in the event of sale of the company
           (iii) Information Rights

The next several posts will discuss the above typical clauses of a Shareholders Agreement, including important drafting tips.



Disclaimer:  The discussions in this Blog do not constitute legal advice nor create an attorney-client relationship.  You are urged to seek the advise of an experienced lawyer who can provide counsel with respect to your corporate/business law matters.

Venture Capital Terms: A Primer

Before you get involved with venture capital financing, whether as a company looking to raise financing, or as a potential investor, make sure you understand important terms and concepts that you will invariably be confronted with in a venture capital transaction.  Even if your business is not at the juncture of raising financing, understanding the key terms in now as they relate to a private equity transaction will help you start to position company for an eventual financing round down the road.  Accordingly, this discussion provides an overview of some of the important terms in a venture deal.

1.  Venture Capital:  You have heard the term thrown about, but what does it mean?  Simply put, venture capital is a broad term used to describe financing provided to startups and early stage businesses as well as turn around situations.  However, the manner in which the financing is provided to a company is where the many variations on potential deal structures arise.  The financing can be raised through debt (i.e., a loan), equity (i.e., shares) or a combination of the two (such as a convertible loan or a loan with stock options).

2. Private Equity:  Equity securities of a company that are not listed on a public market are referred to as private equity.  However, the term is also liberally used to refer to any venture capital deal where the financing does not involve any purchase of shares listed, or any listing of any shares, on a public exchange (i.e., stock market).

3. Valuation:  The value of the company.  A simple statement, but that is the only thing simple about it.  Valuation is usually one of the most important issues in any venture deal, with the company arguing for a high valuation and the investor looking to push valuation as low as possible.  As an investor, you may receive a term sheet with a stated valuation for the company, however, any valuation decision should be based on your independent assessment.  Further, the valuation should adjust based on information you may learn in the due diligence process.

                 a.  Post-Money Valuation:  The valuation of a company immediately after the most recent round of financing. If an investor provides $1 million in a company valued at $3 million "pre-money" (before the investment was made), the post-money valuation of the company is $4 million.

                 b. Pre-Money Valuation:  The valuation of a company prior to the investment. This amount is determined by using various possible formulas (book value, discounted cash flow, multiple of future earnings etc.). 

                 c.  Fully Diluted Basis:  All securities, including preferred stock, options and warrants, that result in additional common shares on a converted basis, are counted in calculating the total amount of shares outstanding for determining ownership or valuation.4. Common Stock:  A security (stock) that evidences proportionate ownership in the company and gives the owner voting rights and proportionate right in the assets and income of the company (after all obligations of the company).

5. Preferred Stock:  Like common stock, preferred stock represents proportionate ownership in the company, but stands a higher position (preferred) to common stock with respect the claims on the asserts and earnings.  Preferred shares may or may not have voting rights depending on what the parties negotiate.  Preferred shares generally will have a number of additional rights that common stockholders do not have, including a dividend preference and liquidation preference.  There are different types of preferred stock, including:

               a.  Participating Preferred:  giving the owner the right to additional dividends if a certain predetermined financial event occurs

               b.  Convertible Preferred:  which convert into common stock either at the option or can occur upon an event requiring mandatory conversion to common stock

               c. Cumulative Preferred/Dividend Preference:  Preferred shares have a dividend preference giving the holder the right to dividends before common stock holders.  Cumulative Preferred Stock gives the holder a right to dividends at a fixed rate of return, and that dividend accumulates each year until paid (before common dividends, if any).  Non-cumulative preferred means if no dividends declared, then the dividend is lost (rather than accumulates until declared).  

6.  Liquidation Preference:  Preferred shareholders will have a right to receive a payment upon a triggering event, such as the winding down of the company or a merger or acquisition.  The question is what is the nature of the preference:  (a) how much is paid, (b) what is the priority among different classes (common vs. preferred) and series (like Series A vs. Series B, and (c) the right, if any, of the preferred to share in any remaining amounts (i.e., along side the common shareholders).

7. Series A, etc.:   Stock of a company can be divided into different series, which will occur when there is more than one round of financing.  For example, if preferred (Series A) shares were already issued, and the company does another round it can call the new preferreds Series B.  The other important aspect is that each Series can have different dividend, liquidation, voting and other rights.

8. Convertible Stock:  Most people are aware of convertible stock or convertible rights which gives the holder of preferred shares to convert them into common stock upon a triggering event.  However, the real issue is negotiating the conversion ratio/formula, for example will it be 1:1 meaning one common for one preferred or another formula where the preferred gets more than one share of common for each preferred share. 

9. Anti-Dilution Protection:  One of the biggest concerns of any investor in a company is that it will be diluted if the company subsequently issues more shares at a lower price.   As a result, investors often demand an antidilution right, and then the question is what is the nature of that right:

                  a.  Full Ratchet gives the shareholder the right to always retain its percentage of ownership in the company.  Therefore, the shareholder is given a right to a number of shares necessary to maintain its ownership percentage in the company.  While this term is very favorable for the investor, it has the effect of substantially diluting other shareholders without the right and thus the full-ratchet provision is less common.

                  b.  Broad-Based Weighted Average results in dilution of the holder of the right, the percentage decline is tempered so as to not result in the full dilution that other shareholders will experience.  The issuance of new shares at a lower price will result in a re-weighting of the average share price, and the investor with the anti-dilution protection will have a right to additional shares to lessen the effect of the new round (however, the investor will still see a reduction in its ownership percentage).

10. Tag Along/Co-Sale:  The Tag Along right gives a minority shareholder the right to sell its shares upon the sale by a majority shareholder on a percentage basis.  If you are a minority shareholder, this is an important right because you do not want the founders or majority to be able to exit the company without giving you a right to exit in part as well.

11. Drag Along:  Means that if a set percentage of shareholders wish to sell the company's share to a third party, the other shareholders must agree and are dragged along into accepting the deal and the negotiated terms.

12. Right of First Refusal/Preemptive Right:  This right can work to the benefit of the shareholder, giving it a right to buy shares on the same terms offered to a third party.  It also can benefit the company, providing the company a right to purchase its shares rather than allowing a third party to buy them from an existing shareholder.

13. Right of Redemption:  A right of redemption gives the holder the right to demand that the company repurchase its shares at a specified price upon the occurrence of a triggering event.

14. Registration Right:  Investors with registration rights are given the right to require the company to register its restricted shares either on demand (subject to certain terms) or a piggyback right (when the company files a registration statement).  For a company, allowing the demand right is not generally favored
because registration is expensive, complex and the timing may not be right for a registration.

15. Board Seats:  A company seeking to raise funds should be aware that an investor may seek one or more seats on the company's board of directors.

16. Restrictive Covenants:  It is common place for loans to include restrictive covenants limiting certain the company from taking certain actions while the loan is outstanding, but an investor may also ask for such rights, including limitations on spending, sale of important assets, issuing additional shares, increases in salaries and other major business decisions.

17. Non-Compete Clause:  A company may want to require an investor to sign a non-compete, especially a large investor.  The investor will likely push back arguing as a passive investor it is not necessary.
  
Above are some of the more important terms you will need to address in a venture financing transaction.  Of course, the investor will take a markedly different position regarding some of the rights as the company.  Therefore, as your company is moving toward the financing stage, begin considering how you will address the important rights that the investor will likely demand.

Disclaimer:  The discussions in this blog do not constitute legal advise nor create any attorney-client relationship.  You are urged to seek the advice of an experienced lawyer who can provide counsel with respect to your corporate/business law matters.