MyFondia VirtualLawyer
September 1, 2016

Shareholders’ agreement and the price of funding a start-up

Many young companies in the setting up or growing phase are dependent on external sources of funding, and a common way to finance the company’s activities is to rely on funding provided by an angel investor and/or a private equity investor. In business, nothing is free, and funding a start-up has its own price. From the perspective of the entrepreneur, this price is realised in the partial loss of control and potential income. This phenomenon itself is not unusual, but sometimes said price may come as a surprise to novice entrepreneurs.

In general, the above-mentioned investors invest by buying shares in the company, thus becoming minority shareholders of that company. A shareholders’ agreement is almost always made in connection with an investment, whereby the investor receives a variable number of rights through which the investor ensures their opportunity to control and maximise the return on the investment. The rights granted to the investor may be very extensive, depending on the size of the investment and negotiating positions of the parties. Thus, every entrepreneur should already at the early stage of negotiations be aware of what might be required of them. Some of the most common subjects of negotiation are described below.

Liquidation preference

Many investors demand priority in the future distribution of funds, known as a liquidation preference. In practice, this means that when the company’s funds are distributed (e.g., in connection with a sale of the company or as dividends), the investor has the right to receive a stated sum before other shareholders receive anything. This guarantees the investor a pre-determined return in the event of liquidation, which may be many times higher than the investor’s original investment.At its worst, liquidation preference can lead into a situation where the only party benefiting from the company’s success is the investor at the expense of other shareholders.

Anti-dilution protection and future funding

As the company grows, it is common to raise new rounds of funding and for new investors to join the ranks. The first investors will generally ask that provisions concerning anti-dilution and the future funding of the company are included in the shareholders’ agreement. The original investor wants to use these provisions to safeguard their ownership and say in the company in the future or at least ensure that they have the opportunity to defend their ownership in future funding rounds. The downside of the original investor retaining their ownership is that future rounds of funding will dilute the holdings of other shareholders disproportionately.

The company’s management

Investors demand almost without exception that they are given an opportunity to participate in the management of the company. This is achieved by agreeing on, for example, the distribution of board positions and decision-making in both board and general meetings. In practice, this often leads to investors being given the right to veto on important matters, which are decided on in the board and/or general meetings.

(Restrictions on) the transfer of shares

The most central terms of many shareholders’ agreements relate to the transfer of shares and the restrictions that apply to this. Investors often bring their own dimensions to these provisions. Many private equity investors are investment funds, and the rules of the fund often have clear provisions as to when the fund must exit from its investments and return the funds to its own investors. For this reason (among others), investors demand prerogatives relating to the transfer of shares and, in practice, this could lead to the sale of the entire company even if other shareholders do not support it.

Other common provisions

In addition to the above, an entrepreneur must be prepared to negotiate and agree on, among other things, the distribution of profits, employee shareholders’ working obligations, non-competition and non-solicitation clauses, reporting to investors as well as investors’ access to information on the activities of the company.

Intangible benefits of investment

Although it might be tough from the entrepreneur’s point of view to give up control in a company that they founded, it is worth taking into account the many positive aspects that the investment and investor bring. In addition to financial investment, many investors will be able to bring human capital to the company, for example, in the form of experience, new ideas as well as a wide network of contacts, and are thus capable of contributing to the company’s growth and success in many ways.