When a company is promoted, a company secretary, and soon after, an auditor is at the point of incorporation, all the necessary statutory documents are prepared and filed. One such document is the Memorandum and Article of Association (M&A). The M&A is akin to an agreement between the company and its shareholders and all shareholders are bound to adhere to its terms and conditions. However, the M&A does not take into account the relationship of the shareholder as between themselves and many of them prepare their own document or none at all.
The most common reason given by founders is because their co-founders or partners are friends. Some founders are even apprehensive to approach this topic as they believe that such documentation indicates a lack of trust in their co-founders. This is especially true at the start of the business when relationships between all the parties are rosy and camaraderie is at an all-time high.
It is interesting to note that usually, when relationships are rosy and the business is fresh, it is the best time to create and crystallise all the necessary internal legal documentation as negotiations move smoothly. However, failing to plan ahead and being reluctant to address this issue can result in a number of significant problems which we shall explore shortly.
Internal legal documentation
Internal legal documentation mainly refers to documents, agreements and contracts entered into between the shareholders of the company running the business. It is internal documentation used to regulate, govern and manage the relationship between the parties to ensure the smooth running of the company. These documents are primarily solutions for potential problems which may arise from the general running of the company. A lawyer would assist to explore the potential problems or challenges which may arise and through negotiations between all parties, a solution is created. Therefore, if a dispute or contention arises, the parties can refer to the agreement to seek a solution.
The most common internal documents are Shareholders’ Agreements, Vesting Agreements, Memorandum of Agreements, Call Option Agreements, Put Option Agreements, Option Agreement and Trust Agreements. This list is obviously non-exhaustive and lawyers would be able to properly advise you on your needs based on the circumstances as the content and need of each agreement are very much a case to case basis.
One of the easiest methods to appreciate the importance of having such internal legal documentation is to look at real world examples. Somewhere in August 2016, a story blew up and became viral in the start-up community where a chief technical officer was allegedly brought for a ride, in essence, he unknowingly signed up for a bad deal. The key point, taken from a legal perspective, noted by the CTO was his hesitation to discuss his equity entitlements as the company had a bad experience with their previous CTO. He believed that it would be better to show results before discussing this difficult topic. This ultimately results in a disconnect with the founders and the CTO leaving the company with the technology he had created.
This case study serves to show the importance of ensuring that proper legal documentation is created and validly executed to protect a shareholder’s interest. Cases such as this turn up on the doorsteps of lawyers more often than it should. From the authors opinion, had the CTO opened the can of worms at the start, the parties would have agreed on the terms and the legal paperwork would have been drawn up to protect both the CTO and the company.
A vesting agreement or a memorandum of agreement detailing the relationship of the parties would have outlined the equity entitlements of the CTO in the company and the ownership of the technology created to vest in the company or if the parties could not have agreed, everyone would have gone their own way. The author recognises that hindsight is 20/20 and sympathises with all affected parties in this saga with the hope that in the future, people in and out of the start-up community would take heed from this. Let’s proceed and take a look at other general circumstances that regularly arise.
In some cases, the parties would not be able divide the shares equally between all the founders as some would have contributed more than another. This would result in one founder having a greater say than the other especially if one founder is not a director but merely a shareholder.
This is more prevalent in circumstances whereby there are 3 or more founders and one founder is marginalised. Of course, this would not happen immediately, but the chances of it taking place increases over time. Apart from the normal protection provided by the Companies Act 1965, the parties may even include certain protections to the minority shareholder in a Shareholders’ Agreement. The parties may determine what falls under a reserve matter which would require the full consensus of all parties involved. An example of a financial protection would be for the parties to agree that the company shall declare a certain percentage of the company profits as dividends every year or all remunerations paid to directors must be unanimously agreed by all shareholders. This would avoid scenarios whereby the majority shareholders arbitrarily decide to provide a significant remuneration scheme or salary for themselves in the capacity as director which ultimately results in a minimal amount of profits left for the company to declare as dividends.
Another major problem a minority shareholder would face is being divested of their equity in the company due to dilution of their shares. This can be done by increasing the share capital of the company and the new shares are purchased entirely by the majority shareholder. One key implication of this scenario is the management control and financial losses. The minority shareholder would receive a smaller cut of the dividend than he would have previously. Issues such as these can be pre-empted by having a non-dilution clause in a shareholders’ agreement.
Exploring investment potential, sale of shares or vesting
Most rapidly growing companies may want to explore the realm of obtaining third party investors or selling off the entire business, lock, stock and barrel. Most major investors, especially venture capitalist investors would elect to subscribe to the equity of the company. This raises the question, which shareholder would have to sacrifice their equity percentage to allow the new investor to join the company? Would it be the case where all shareholders equally dilute its equity or only the majority shareholder? What if one shareholder refuses?
The easiest method to solve it would be to have these detailed in a shareholders’ agreement which is executed at the start of the business. What about a case whereby a major company, say Google or Facebook intends to acquire the whole company and five out of six founders have agreed to the acquisition? The remaining founder may cause a dent which may, in a worst-case scenario ultimately result in the abortion of the whole deal. Had the parties pre-empted this and signed an agreement with a drag along and tag along clause, the other shareholders would have been able to compel the last shareholder to sell his or her shares.
The issues raised here are merely the tip of the iceberg of potential problems which may arise. It is important to realise that internal legal documents are not a burden or a bump but rather, it’s an important complement to the relationship between the parties. Having such documents in place does not show lack of trust between the parties but merely as a prudent measure. Convey your intentions, concerns, worries and expectations with your co-founders and partners. Once a consensus is reached, detail it down in a legal document to bind the parties, it might help you sleep better at night when a problem arises.