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Shareholders' Agreements for IT Companies: 9 Key Points

As business starts, the co-founders are inspired by an idea, and conflicts rarely arise. Ambition and plans for stunning success take over. But the best thing partners can do when starting or scaling a business is to be realistic and set clear rules. A Shareholders' agreement (SHA or corporate agreement) can become a tutorial for such an aim. 

The law doesn't offer a solution for every potential issue or conflict between shareholders, so it is essential to put the Shareholders' Agreement in place at the earliest opportunity. Then, if there is a dispute or uncertainty on how to proceed in a particular situation, you can look to the Shareholders' Agreement for guidance.

In this article, you can find the scripts for the cases if something does not go according to plan.

 

What is a Shareholders' agreement?

The document fixes the binding rules for running a business and solving day-to-day administrative tasks. For example, how to appoint or fire the CEO, who decides loans and how often co-founders should call a meeting. Let's draw a parallel. The sales manager works according to a script. It is hard to imagine an employee communicating with leads without a pre-thought-out scenario. The same is with the SHA. It is risky to conduct business on the principle of "figure it out as we go". The first conflict will lead to a dead-end, from which it would be difficult to find a way out.

 

Why do IT companies need the SHA?

  1. To distribute shareholders' functions, spheres of influence and responsibility. For example, one partner is responsible for attracting customers, the second for product development, and the third - for the organizational company structure.
  2. To implement an algorithm for making significant decisions in a company and overcoming impasses.
  3. To protect each shareholder's ownership: determine the share and terms for selling and purchasing shares.
  4. To protect a business from corruption, from the disclosure of confidential information and competition, to forbid partners from creating competing products, and reuse knowledge bases. Moreover, it would help if you implemented an interests conflict policy.

The SHA helps business owners to disperse on equal, balanced and fair terms if a conflict arises.

 

What is better to include in the SHA: 9 key points

Points (terms) in the SHA will change depending on such factors:

  • company's country of incorporation;
  • type of business: product, outsourcing or outstaff company;
  • company structure;
  • functions of each company (if the company has a holding structure);
  • the tax burden;
  • shareholder shares: whether the company has majority shareholders and minority shareholders.

 

For example, let's take a US outsourcing LLC with four founders. Each of them has 25% of shares. Let's say right away that this is a parent company that owns Ukrainian subsidiaries. Now we turn to the analysis of each clause of the shareholder agreement separately.

 

Shares in business

Firstl, it is worth fixing the number of shares held by shareholders. In our case, there are four shareholders. Each of them has 25 out of 100 shares, which means that each has a percentage of capital ownership of 25%.

Next, it is necessary to determine whether shareholders can transfer or pledge a share. For example, it is good to state in the SHA that parties cannot pledge shares without the prior consent of all shareholders.

 

Transfer of shares

Imagine that a partner decides to sell his share to a person with a negative business reputation. You categorically disagree with this. What to do? You need to add a priority purchase clause to the SHA in advance.

The shareholder who decides to sell the shares informs other partners about it. Set a notice period. For example, 30 days. Then the remaining shareholders decide whether to buy out the share or not. The time for reflection should also be limited. Only if all shareholders have refused to buy, the seller can transfer ownership of the share to third parties. If the remaining shareholders agree to purchase a share, then the appraiser-auditor should determine its price.

The approach seems to be fair and transparent. Those who plan to attract new participants need to be careful with it. If the founder decides to sell part of the shares to a third party to invite another partner, then the minority shareholder can block the entry and buy back the shares. Therefore, create a business development strategy before signing a corporate agreement.

 

Shareholders meetings

To draft this section of the SHA, answer the following questions:

  • How many people does it consist of? The company, from our example, has four shareholders.
  • How do shareholders make a decision? For example, unanimously, ¾ or other options. Be careful with the unanimous form if the company has 3 or more founders with different shares. If 100% of votes are needed to make a decision, then everything will "run" around the business partner with 1% of the shares, since the fate of the company depends on his vote.
  • Can the meeting be held remotely? The positive answer is obvious. It is essential not to forget to write about it in the SHA. You need to specify corporate shareholders' email addresses and also provide that the decision taken at the meeting is signed by the participants personally or with the help of services for electronic signatures, for example,  DocuSign.
  • What decisions should be made only by the shareholders' meeting? The item is developed taking into account the structure and financial indicators of each company. Here is a list of business solutions from our example.

So, the decisions that should be made only at the shareholders' meeting are the following:

  • Amendment of the charter and funds of the company;
  • Liquidation decisions;
  • New participants, investors and business angels introduction;
  • Venture capital funds attraction;
  • Appointment of the director;
  • Employment and dismissal of senior managers;
  • Salary or remuneration determination;
  • Obtaining loans in the amount of more than 50,000 US dollars;
  • Net profit distribution;
  • New offices opening;
  • Amendments to lease agreements, software licenses or software development agreements;
  • Contracts for the sum of more than 1,000,000 US dollars.

Also, add items to the SHA for the case of a partner's death. In such a situation, the shares pass to the heirs, who will become participants in the company or refuse and sell shares to other partners. Remember that the terms specified by the law will pass from the day of death until the moment of inheritance. During this time, the composition of the shareholders will be incomplete, and the ability to make decisions can be blocked. It means provisions that partners can solve without one of the members should be added to the SHA.

 

Shareholders' functions

Partners can share the positions of top management in the company: CFO, COO, CMO, and CTO. Then it is important to prescribe areas of responsibility, determine functional responsibilities and performance criteria. For example, the CEO's KPI can be tied to the margin of deals.

 

CEO: appointment, duties and dismissal

CEO`s tasks can be defined as the day-to-day management of the company. But functional responsibilities should be specified. Here is the list that can be used in the SHA:

  • responsibility for reporting to the regulatory authorities;
  • maintenance of communications with shareholders for the operational decisions provisions and strategic purposes setting;
  • shareholders’ meetings organization;
  • employment;
  • management of  different processes in the company, planning and daily work control to ensure the quality of services, and meeting deadlines;
  • communications with clients and contractors;
  • contracts with customers signing on behalf of the company, their marginality analysis;
  • development strategies for the departments, projects and teams.                            

We recommend elaborating the total price of contracts that the director signs on behalf of the company. You can determine the percentage of margin transactions. Be sure to write down who and how makes the decision to dismiss the director. For example, the decision for the CEO's dismissal can be taken by 3/4 of shareholders from the total number.

 

Stalemate resolution

A deadlock is a situation in which it is impossible to make a decision. Imagine that co-founders from our example have to vote unanimously in order to take a loan. Two of them agree and two disagree. The debate on the subject had grown stale and unproductive. The algorithm for resolving such a situation can be prescribed in the SHA.

Here are 6 scenarios for getting out of the conflict.

 

Roulette

Each co-founder can send an offer to another with a proposition to buy his shares. The second participant either agrees or sends a counteroffer to buy out the share of the first party at the exact cost. So, there are only two ways: sell or buy. The problem with the method is that it is initially more favorable for a shareholder with more outstanding financial capabilities. Knowing that the partner doesn't have money to buy the share, a shareholder can offer a low price.

The roulette game method was chosen by the online retailer Ulmart owners. The conflict has been going on since 2016. The owners of 61.5% of the shares didn't agree with the partner, who has 38.5% of the shares, about the additional investments and funds increase. Besides the deadlock, the IT company faced problems with creditors. In 2018, a London court ordered two shareholders to buy out a 38.5% stake in a third shareholder for $67.16 million. However, the deal was not closed.

 

Texas shootout

Each shareholder seals an offer to buy shares in an envelope and writes down the price. The envelopes are opened simultaneously, and a shareholder who made the highest bid is obliged to purchase the shares of the other shareholders at the declared price. The mechanism results in a higher premium on the selling price.

 

Dutch auction

The method is similar to the previous one, only with the reverse action algorithm. In this case, the one who indicated the minimum price buys.

The proposed scenarios are aimed at ensuring that the partner receives money for his share and leaves the company as a founder. Then the other business co-owners will be able to make a decision. 

But not all shareholders are ready to play roulette or arrange a shootout. There are 3 more scenarios for this.

 

Put option

One shareholder requires another to buy his shares. The appraiser determines fair market value. The method is beneficial for minority shareholders or shareholders with weaker financial capabilities. The scenario allows them to get out of a deadlock at a fair price.

 

Call option

The co-owner can force another co-owner to sell his share to him. It will benefit a shareholder with a controlling stake or greater financial strength but create a bad reputation in the eyes of new participants and investors..

There are situations where coercive mechanisms are justified. For example, partners decide to sell the company, but one of them refuses. It turns out that the deal will fail because the investor wants 100% of the company, not a part. To avoid this situation, the SHA provides a drag-along right, or the right to demand a joint sale. Suppose participants with 50% or more in the authorized capital decide to sell the business to a third party ultimately. In that case, they can oblige the minority shareholder to join such a transaction on the same terms.

 

Liquidation

If the above mentioned methods did not work, the only way is to liquidate the company.

Also, don't forget to write which body will consider the disputes about the corporate agreement violations. It can be the court of the country the company was registered. For example, your company was incorporated in the state of Delaware, USA. In that case, it is logical to foresee that the liquidation will also be carried out under the Delaware laws by a state court.

 

Confidentiality

Information is the most valuable asset of every company, for an IT company - especially. Marketing research, client and investor base, algorithms, features, know-how, methods and business plans make the company competitive. It is essential to insure the business against leaking confidential information, including through the partners. So, a ban on confidential data disclosure should be added to the SHA. The more detailed the list of confidential information objects, the deeper an understanding of permitted boundaries. In addition to the SHA, we advise developing a full-fledged non-disclosure agreement (NDA) to specify the rules for confidential information.

 

Non-poaching

Another value of the company is people: employees and customers. Therefore, limit the partner's ability to take the team with him when leaving. Moreover, it would help if you prohibited offering customers more profitable conditions than yours. The clause in the SHA can be formulated as follows: within 12 months after the termination of the corporate agreement, each shareholder doesn't have the right to convince IT specialists of the company and induce company clients to stop cooperating with the company.

 

Competitive business prohibition

Imagine that a minority shareholder gained experience in a company, sold shares and opened a similar business based on the experience and unique knowledge they obtained through participating in your company. Add a ban on establishing a  competing business to the SHA to prevent this. The restriction applies to personal advice, the purchase of shares and other types of assistance to competing companies. The only exception can be if the other partners agree to such actions.

 

Also, it is necessary to emphasize that all intellectual property (IP) rights belong to the company. It means that shareholders (and employees) can't use, copy, or create such objects in their personal commercial activities without the consent of other shareholders. If the transfer of IP rights is not defined in the SHA, the partner may leave the company and take significant developments (software, methods, features) with him. This situation creates legal risks for businesses. For example, an investor conducts due diligence before financing. The deal can fall through, or its price may be significantly reduced if the audit reveals that the company doesn't have IP rights and can't prove that it owns all the IP rights for the IP objects.

 

Agreeing on the strand - this is standard advice, which is still worth heeding. Conflicts arise when a company runs out of money or there is a lot of it. At least one of these situations will definitely happen, so it is better to be prepared for any of it by defining the rules of corporate relations in advance.

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