When founders start a new business together, everything in the beginning is rosy and magical. The sky is the limit. At the time, it is often seen as too formal and a waste of time to formalize things like the corporate governance of the company. We don’t even have our product fully launched in the market, why do we need something like a shareholders agreement among us founders? I’m sure we’ll be able to work things out on a case-by-case basis….
Fast forward 2 or 3 years on, the company may have a solid business running. It may not be the type to be raising a lot of outside capital from venture capital investors, so there’s been no one specifically asking to put something like a shareholders agreement in place.
But when times are difficult for companies, as we saw during the economic low points of COVID-19, shareholders will often have serious conflicts over things like time commitment and individual contribution to the business, the need to put more capital in, or potential pivots in strategy in response to changes in the marketplace.
Here are some of the issues which keep coming up as we see more clients having reasons to try to get these agreements in place:
1. Corporate Governance and a Board of Directors
The company may have made decisions, even big strategic decisions, in an ad hoc manner over the years. Many founders are now considering a more formal governance structure including a proper board of directors. In many cases this involves bringing in an outside director to join the board for more arm’s length and objective insight on how the business should be managed. Many companies already have advisors who have been given equity in the company. Creating a board and giving that long-term advisor a formal seat at the decision-making table at the board can be the next step towards better governance of the company.
2. Defining Roles and Responsibilities
Some founders over the years may have moved on to other projects or otherwise be spending less time on the company while the other founders are still fully engaged. This change in time and commitment may call for an update to equity ownership of each founder shareholder, or clearly separating the role of founders as shareholders and as employees entitled to salary and bonus compensation (including new equity grants). Major founder shareholders may also want to hard wire into the company’s corporate governance specific rights to appoint someone (themselves or someone else) to specific company roles such as the legal representative, the CEO/GM, and the CFO.
In the early stages, founders may have each had their shares fully vested in the company without the business having even started. Having their sweat equity already locked in before they have even started to sweat! If one founder ends up carrying more weight than the others, this is a recipe for animosity and conflict. It may be difficult to put equity already owned back on to a vesting schedule (although this will not prevent your first outside investor from trying to), so you may again consider new grants to make adjustments that dilute the other owners who are not contributing as much.
3. New Business Directions
Many companies have had to alter their business models to accommodate customers’ changing behavior and changing spending habits since COVID-19. Founders and other major shareholders may not always be aligned on which new strategic direction to take. Deadlock can be resolved by having a board of directors decide on issues, as previously mentioned. At the same time many minority founder shareholders may feel a board of directors or simple majority shareholder vote can leave them powerless and at risk, and may want to push for having veto rights over certain big changes in the company. A proper shareholders agreement will therefore often require unanimous or super-majority voting by shareholders on fundamental changes in business scope, need to raise new capital, take on company debt, or incur major expenses and capital expenditures, etc.
4. New Capital Requirements
Many companies have historically encountered difficulties among founders when funds are needed to expand or simply to keep a business going. This can be a thorny issue for founders to resolve especially when one founder has more at stake economically and emotionally in the business than the others. A founder with majority stake will often try to incorporate capital call provisions into well-drafted shareholder agreements. Such “pay-to-play” provisions may permit the majority shareholder subscribing to the capital call to take up the allotment of any other shareholders that fail to subscribe to the capital call, thus diluting their ownership and creating an incentive for them to participate.
5. Shutting Down the Business
No one likes to see the end of a business and the temptation will always be to want to hold on to value in the business as a going concern. At the height of the economic turmoil from COVID-19, we saw many small and medium sized businesses even with solid long-term prospects hurt by cash flow problems these days. Liquidation, especially in China, can be a long and laborious process and all stakeholders need to be on board and fully engaged to see it through. Not liquidating a business and not making any ongoing tax and other regulatory filings can leave its founders open to being blacklisted for setting up a new business in the future.
6. Financial Controls and Reporting
Founders, like any major shareholders, who may have taken a less prominent day-to-day role in the company will still want to have access rights to look at company books. They may also want the day-to-day managers to produce a monthly update on financials and a more comprehensive quarterly/annual report. Although these access rights may never formally be used, it gives non-management shareholders a bit more piece of mind to have these mechanisms in place. This is especially relevant if the business and founders’ personal assets and expenses are not clearly separated or there are risks of insider transactions not priced on arm’s length terms.
7. IP Ownership and Confidentiality
The company domain name, trademarks, patents, and copyrights on product designs for work that was produced on behalf of the company should be owned by the company, not any particular founder. This can be covered at a high level in the shareholders agreement and specific IP ownership then covered on a case-by-case basis. Company trade secrets such as key business processes, client contacts, and other proprietary information should be protected by confidentiality provisions.
8. Non-compete
Founders often leave to start competing businesses. Confidentiality provisions can go a long way to protect against that founder using the company’s information to help launch that business. But some founders may want to go a step further and setup more robust non-compete provisions. At a minimum, the shareholders should agree among themselves that they will not start or work for a competing business or otherwise take customer opportunities for themselves personally while owning shares in the business.
Some founders start their business together as close friends or even family members, and these bonds help get them see eye-to-eye or get through some difficult decisions. But often the founders will face stress tests that push these bonds to the limit, or these bonds do not exist in the first place. A proper shareholders agreement may seem too formal for some, but it can go a long way towards aligning everyone’s rights and responsibilities and letting the business adjust as needed to flourish.
Please feel free to reach out to us (inquiries@chinalawsolutions.com) if you and your fellow founders are looking for assistance in structuring a shareholders agreement.