If you haven't set up a company before, you may not have thought about share types or legal documents. As a founder, you'll need them both. Having sat on both sides of the table, as a founder and investor, here are some basics that I feel every new entrepreneur should be familiar with.
Legal documents for startups
When investing in or setting up a company, it's important to ensure there are four types of legal agreement in place:
Articles of association. Every company needs this by law. It's a legal document that determines what the company does, how its ownership is structured (i.e. different classes of shares) and how it runs. Because they are mandatory, articles of association often come as a fairly simple template, while the important stuff is decided in the...
Shareholders Agreement. Unlike articles, shareholders agreements (often abbreviated to SHA) are not a statutory requirement. They are a legal contract between the shareholders of a business, which govern the relationships between the different shareholders, as well as between the shareholders and the company itself. This document is where you'll define the rules around important issues like the makeup of the board, issuance of shares, mergers and acquisitions, the ownership of IP, and future financings.
Share Subscription Agreement. If and when you sell shares in your company, you'll need an agreement between the buyer (the investor) and seller (the company). Subscription agreements, sometimes called share purchase agreements, define the terms of the deal, i.e. how it is priced and what exactly is being bought. While shareholder agreements govern the way shareholders behave, subscription agreements define the way investors become shareholders.
Employment Contract. Every founder wears two hats. As a founder and director, you will be acting as the company's representative. As its chief executive officer, you are also an employee of the company. Investors will typically expect a founder to sign a binding employment agreement, by which the founder will be held accountable, just like any other employee.
There are, of course, many more legal documents a founder may need while operating a company - customer and supplier contracts, non-disclosure agreements, loan agreements, SAFEs, and convertible notes are some of the more common ones. To ensure you are performing your fiduciary duty as the company's representative and CEO, you should always get proper legal advice.
There are really only two types of share to think about: "ordinary shares" (sometimes called "common shares") and "preferred shares". In most companies, especially those that never raise funding, you will only find one class of shares - the ordinary shares. Preferred shares tend to come into play at the request of investors (see below).
When incorporating a company, most founders create a single class of ordinary (or common) share. Often they will issue 1 or perhaps 10 shares to themselves. This is fine if you never expect to take on additional shareholders or investors. If you think this is a possibility, however, it's a much better idea to issue a larger number of shares on day one, say 100m (one hundred million). The quantity makes little difference, except that it may save you admin and cost in the future.
As your company grows, it's likely that you will take on investors. Hopefully the value of your company's shares will grow. The more shares you have the easier it will be to maintain a reasonable price-per-share, and the easier it will be to take on investment. The idea here is to make it easy for investors to purchase a number of whole shares without having to make adjustments to their target investment amount, and without requiring a "share split".
While it is possible to own a fraction of a share, most accounting firms would recommend a stock split as part of a funding round, so that all shareholders can continue to own a number of whole shares, as illustrated below. To avoid messing around at a later date, just issue a large number of shares when you start.
|Cost per share
If you raise money for your startup, sooner or later you'll come across an investor who wants preference shares and/or specific clauses written into your shareholder agreements. Such requests are common, especially in later rounds, so you will need to know what the implications are. Quite simply, the holder of preference shares, in certain circumstances, receives preferential treatment over ordinary shareholders, including both founders and other investors. What that preferential treatment is exactly can vary. You will need to define this in your legal agreements. The main goal of preference shares is to provide investors with a "liquidity preference", which gives them a better chance of recovering their funds should things go south. We'll come back to this below.
Some founders like to create a separate class of shares, with superior voting powers, just for themselves. Such stock behaves the same as ordinary shares in every way, except when it comes to a shareholder vote. The idea here is for founders to maintain control of the company, even if their ownership stake dips below 50%. (I've done this myself. A former business partner and I created shares with ten times the voting power of ordinary shares. Looking back, it isn't something I would do again or recommend. It's an obvious obstacle to getting a funding round closed and it's not unreasonable for investors to want some influence over the companies they're funding, especially when it comes to serious decision-making.)
Founder preferred shares
According to Maynard Webb, it's possible for founders to create yet another class of stock when they start their company, known as "founder preferred shares". These shares enable founders to convert up to 20% of their ordinary shares into any series of preferred stock that the company subsequently creates and sells to investors. The purpose of these shares is to enable founders to get liquidity during later funding rounds, allowing them to take some money off the table. This would be harder to achieve if the founder only owns ordinary shares because the shares sold by the company in Series A and beyond are likely to be preference shares. It's likely these would have a liquidity preference, and perhaps other advantages over ordinary shares, making the founder's shares unappealing by comparison. If this is something you want to explore, be aware that there may be tax implications, unless you issue them on day one.
As always, it's best to seek professional advice on all of these issues. The purpose of this explanation is simply to give you a basic idea of how this all fits together.
It's no secret that most startups struggle with cashflow. This makes it hard for founders to hire good people. Salaries are often the largest cost to a business, and startups usually don't have much money to throw at them. To overcome this obstacle, many early-stage founders pay their employees with a combination of salary and stock. This enables them to offer a lower basic wage, but still to tempt high-quality personnel through a generous options allowance.
As a founder, it's wise to create a share options pool as early as possible. The earlier you create the options pool, the less likely it is that you'll create conflict with shareholders. Although most investors understand the logic behind options, most don't like it when their shareholding gets diluted by 10%! To avoid arguments, always create an options pool either before or as part of an investment round, never immediately afterwards.
I've seen all of these scenarios, and the first is always the cleanest. Trying to create an options pool after closing funding usually results in the founder losing out. Either they forget the options pool completely or they give up 10%-worth of their own shares to make it happen. You can see the implications of these different options below:
Scenario 1: options pool created prior to/during the round
Scenario 2: options pool created after the round
Note: this is the version that might cause investor dissent!
Scenario 3: options pool created after the round from founder shares
How do different share classes affect founders?
The simplest share structure, from a founder's perspective, is for all shareholders to own the same class of ordinary stock. In such a scenario the same rules apply to everyone. The strength of each shareholder's vote will be equivalent to the number of shares they own, and in a liquidity event all shareholders get paid out pro-rata to their stake.
Preference shares make things slightly more complicated, but only when the company underperforms. If the company is sold for a higher price-per-share than that paid by all preference shareholders, the spoils are divided just as with ordinary shareholders - everyone participates pro-rata to their stake.
The difference comes if the company falls in value.
Although preference shares can come with other benefits, the main one tends to be a liquidity preference. In simple terms, preference shareholders get paid what's due to them before the ordinary shareholders receive anything. And what's due to preference shareholders will depend on the type of liquidity preference they have (see table below).
Preference shares can be either "participating" or "non-participating", and can carry a liquidity preference of 1x, 2x, or even 3x. The most common type of preference share, and the friendliest to founders and existing investors, is 1x non-participating.
In the example below, the company has sold for $10m. For simplicity's sake, we'll say that this is lower than the share price at which all of the investors bought in, and that each shareholder's preference takes priority over the previous investor's. The different distribution amounts shows how the difference types of preference can affect the shareholder's outcome, in the event of a relatively low exit price.
In this example, the two shareholders with a 3x liquidity preference could potentially convert their preference share into ordinary shares. In that scenario, each would sell 20% of the company for $2m . However, the alternative option is to make the most of their 3x liquidity preference. That would pay them back three times their initial investment, i.e. $3m each. It's a no-brainer.
But what about the remaining investors? Well, now that those with 3x liquidity have walked away with $6m, the 2x investor has little choice. If they were to convert to ordinary shares, they'd receive 20% of the remaining $4m (i.e. $400K). So instead, they also take advantage of their liquidity preference and receive $2m (2x their $1m investment).
This leaves just $2m for the founder and the first investor. The first investor has a 1x liquidity preference, which gives them the right to take back their initial investment. Seeing as this is much greater than 20% of the remaining $2m, the last investor takes the $1m. So, having built a company that sells for $10m, of which they still own 20%, the founder is left with proceeds of only $1m. Or are they...?
Even then, however, the founder doesn't get to walk away. The last investor, unlike the other investors, as well as having a 3x liquidity preference, has the right to participate. Seeing as they own 20% of the company, they are also entitled to 20% of the remaining proceeds. So they take another $200K of the last $1m, leaving the founder with $800K.
To many people $800K may not sound too bad, but let's imagine the company sold for $5m instead of $10m. In that case, the founder gets nothing.
How to avoid preference shares
Your ability to rebut requests for preferential treatment will depend on how attractive your investment opportunity is, what share structure already exists, how many investors are competing to get into the deal, and how badly you need the money.
Having a solid shareholder agreement and fair share structure already in place when you raise money is important. It will show that you're organised and careful, and is probably the best way to avoid issuing new classes of preferential stock (it's usually easier for investors to sign your existing documents than to insist on a complete reorganisation). For that reason, it can pay to make sure your existing shareholder agreement is in good shape. It may even make sense to give all investors, from day one, a 1x non-participating preference share. Many would argue that this is the fairest way to manage your cap table, and it makes sense that your earliest investors (i.e. those who took the biggest risk in backing you at the start) receive equal protection to those who joined you later.
Giving your investors preferential treatment isn't necessarily a bad thing. Preference shares are designed to limit the investor's risk, give them "downside protection", and maximise their chances of making a return. In many ways, it's how it should work: the people that give you money get paid back first, and sit higher in the queue of creditors. If things go well, you'll barely notice them. If things go less well, the investors will get paid out ahead of the founders.
Whatever your opinion, it pays to understand the implications of different preference shares. If you're raising money, think hard before accepting a more punitive preference share in order to justify a higher valuation for your startup.
Other common investor requests
When you're raising money, a liquidity preference by way of preferential stock is not the only thing your investors may ask for. Other common requests include:
- The right to participate in key management decisions by way of a board seat.
- A veto over certain board decisions, particularly any that relate to the ownership and structure of the company.
- Assurances and warranties from the company's directors as to the accuracy of the information provided during the investment process.
- Anti-dilution measures, meaning that the investor's stake does not reduce should the company raise money at a lower valuation in the future.
Note: the last of these can be quite destructive, so please always take legal advice on such matters.
An investor's shareholder agreement checklist
If you take the above seriously, and you don't already have one, you'll want to put in place a robust shareholder's agreement. When doing so, you'll need to consider all of the issues that investors typically want comfort around. Here's a list of the main points that most investors want covered in your SHA:
- Management and structure. What is the structure of the management team, and who is responsible for what?
- Governance. Who are the directors, what are their planning and budgeting responsibilities, and how often will board meetings occur?
- Hiring and firing. How are directors appointed and removed, including founders?
- Decisions and voting rights. Who decides what? Big decisions should require approval from the board, the investor majority, or perhaps everyone. Who gets a casting vote if there is deadlock?
- Board representation. Do you have a right to appoint a director to the board, or to be a board observer?
- Information rights. What information is provided to shareholders and when?
- Intellectual property. What protections are in place for confidential information, or to prevent leavers from setting up in competition?
- Shares. What approvals and steps are required to issue, buy back, split or convert shares?
- Purchases, mergers, and acquisitions. What is the approval process for making large purchases or acquisitions?
- Sale. What is the approval process for selling all or some of the existing shares? Is there an agreed minimum price or valuation method?
- Capital. What is the approval process for raising money via equity or debt, and for how should it be repaid? Is there any obligation on existing shareholders?
- Dividends. How much profit must be retained by the company before it can issue a dividend? Who receives a dividend and who decides its amount?
- Right of first refusal. Do existing shareholders have the option to purchase an exiting investor's shares, ahead of an unknown third party?
- Drag-along. Can the shareholder majority force the minority to sell their shares in the event of a sale (preventing small investors from blocking a sale)?
- Tag-along. Do minority shareholders have the right to prevent the shareholder majority from selling their shares unless the minority's shares are bought on the same terms?
- Good / bad leavers. What happens if a shareholder leaves or is forced to leave the company?
- Exits: What happens when wants to retire, passes away, or exit the agreement?
- Employees and ESOP. What agreements are in place, is there an existing share options pool, and what are employees' vesting and leaver provisions?
- Disputes and arbitration. How do you resolve disputes between shareholders?
Want to keep this for future reference? Download this infographic:
Downloadable Shareholders Agreement Template
Please note: I am not a lawyer and this is in no way to be construed as legal advice. What's more, these are documents I'm sharing myself. They are not endorsed by DQventures, nor associated to our business in any way. I am merely sharing documents I have used as an individual.
To that end, these agreements have been signed by hundreds of investors, including both angels and VCs, and have accounted for many millions of dollars of investment. That being said, you should always ask a lawyer to review your legal documents, and these cannot be relied upon in any way. They also state that Singapore is the appropriate jurisdiction, but this will obviously not be the case for businesses incorporated elsewhere, so please ensure you review the documents thoroughly before using them.
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