Three things for a founder to watch out for with shareholder agreements

When companies get seed investment from a crowdfunding raise or individual investors, it is often the case that a shareholder agreement (SHA) will be put in place that restricts some of the things that founders can do.

We have been working with a number of businesses recently that have just completed either a private or crowdfunding round. Most of these shareholder agreement restrictions have applied in some form or another to each of them.

We thought it would be useful to highlight some of the constraints typically involved, and why founders should look out for, understand, and potentially push back on some of them.

1. Making it difficult to pass resolutions

Under company law, there are ‘ordinary shareholder resolutions’ that require the support of 50% of shareholders to pass, and ‘special shareholder resolutions’ that require 75% of shareholders to pass.

Ordinary resolutions are used for things like appointing directors, issuing shares and agreeing dividends. Special resolutions are required if you want to change the company’s name, change the Articles of Association, re-structure the business or waive pre-emption rights on a share issuance.

Founders typically control over 75% of the business after their first fundraising round. For that reason, it is not uncommon that in the SHA associated with the round, the shareholder support required for specific actions is increased to 90% or 100%.

This is to prevent the founders from unilaterally taking actions that could alter the equity structure of the business. This will typically include issuing new shares or options or otherwise restructuring the equity in the business.

While it is understandable why some investors insist on this, it is important that founders consider the potential restrictions that this could put on the business, specifically in terms of issuing new shares and giving options to the team.

2. Restricting the issuance of options to your team, and the exercise price they will pay

A similar but slightly different control is for an incoming investor to explicitly limit the number of share options that can be issued by the company following the investment round.

In addition to limiting the number that can be issued, it is also common to limit the minimum price at which they can be issued/exercised. Typically this will be set in the SHA to be the post-investment value of the company.

The reasoning behind this is to protect those investors that have just injected capital, as it stops any new options from being exercised for less value per share than they have just committed to. This may be an issue for those who wish to give their team shares at a lower price.

3. Restricting the issuance of further shares, and the price of them

Just as for share options, it is quite common for the further issuance of shares to be explicitly restricted. This could be in terms of what price they can be issued at, whether pre-emption rights automatically apply, and whether pre-approval is required from the other SHA parties. This is again about protecting that round of investors but may lead to a lack of flexibility in the future.

It should be stressed that all the limitations above are understandable in the context of protecting the interests of those investing in the company.

What is important is that the business owners, at the time of signing up to any shareholder agreements, fully appreciate and understand any restrictions that they are placing on their business.

When negotiating the terms of the SHA, it is best to ensure that any future flexibility you may need going forwards is enshrined in the document, if at all possible.

Questions about share schemes? Start with our Complete Guide to Setting Up a Company Share Scheme.