What is a Founder’s Agreement and 10 reasons why your business needs one

There is no legal requirement to have a Founder’s Agreement but here are 10 reasons why you need to consider it.

If you’ve decided to run your business through a company vehicle, then you have a safety net cast against your personal assets, should the worse happen. If there is more than one founder it is essential that you agree, formally, how you are going to operate the business: such as how voting rights will be allocated; what controls you have over your shares, that your intellectual property is secure; agree how you will resolve business disputes and as such agree the way forward at the onset to avoid any disputes or misunderstandings, which at a later stage could jeopardize the business. As such you will need a Shareholders Agreement which is a legal document that regulates the way business is conducted amongst its shareholders of the company and offers a platform on which to build your business.

A Company requires appropriate and properly tailored articles of association and a complementary shareholders’ agreement is also strongly advisable. Unlike the articles of association, a shareholders’ agreement does not require filing at Companies House.

Shareholders’ agreements are essential for any company that has more than one shareholder. It is particularly beneficial where different shareholders are to be treated differently, where there are different classes of shares or where the company is owner-managed or family-run or if any of your shareholders are only employees being granted shares in lieu of coding, software or other services.

There is no legal requirement to have a Shareholders Agreement but here are 10 reasons why you need to consider it:

1. It can impact how the company is run

How a company is run is usually left to the Board of Directors. Often founders are directors also, but what if you wish to recruit directors who are not shareholders or you want to step away from the daily management at a later stage. It is advisable that the shareholders ensure certain issues should require shareholder approval, such as loan agreements or bringing in investment or selling assets

2. Shareholders may not agree

Disagreements occur in all businesses and it is sensible to agree the provisions that should apply if you disagree with the other shareholders in the Company. It is much harder to do this once the disagreement has already occurred. If disagreements can be foreseen and addressed in the Shareholders Agreement this will help greatly and save costs down the line when legal action is considered. We would suggest provisions that set out who is the chairman and any casting votes required; or a delegation of areas of responsibility ; or what happens in the event of a disagreement and who determines the outcome. Those that have only 2 shareholders 50:50 need this clearly mapped as otherwise if you cannot agree then it could result in deadlock and the company being wound up, losing your valuable IP along the way.

3. It can address how to resolve disputes

Many of the disputes which typically arise between shareholders can be avoided or resolved quickly if there are documents in place which deal with the issue. If disputes do occur, there can be specific clauses for dealing with disputes. These may include at what stage there would be a referral to mediation, or who any arbitrator can be. This clause can specify that legal action must only be taken as a last resort.

4. It can protect the minority shareholders

A shareholders’ agreement can provide protection for minority shareholders by only allowing certain decisions to be made by the unanimous consent of all the shareholders. For example, the agreement can limit the ability for the company to issue further shares unless all the shareholders agree. In addition, if there is a sale of the shares of the company, the minority shareholders can insist on “tag along” provisions that enable a minority shareholder to tag on to a majority shareholder. This protects the minority shareholder where the majority may only attempt to sell their own shares instead of finding a buyer for all the shareholders. This is something in-coming investors will certainly welcome and look attractive to them if they are giving you seed or scaling up funding.

5. It can protect majority shareholders

Majority shareholders can benefit from a “Drag along” provision. This would come into play where an offer is received to buy all of the shares in a company and the majority shareholders wish to accept that offer. The rights allow the majority to force the hand of the minority shareholders on the same terms to avoid losing the deal. This is key for those that develop IP, launch and wish to sell on the product once it has been tested in the market.

6. Attractive to Investors

Having a Shareholders’ Agreement can demonstrate a professional business that has taken legal advice and planned for certain eventualities. This increases the attractiveness of the company particularly for investors as they can be reassured that disputes can be dealt with swiftly and that all parties have transparently laid out their obligations to the company

7. Control the transfer of shares

A Shareholders’ Agreement can provide a provision where if one shareholder wishes to sell their shares, other shareholders or the company have a “right of first refusal” over those shares. This is a useful mechanism as it can be used to restrict who may or may not acquire shares in the company. There would be nothing worse as founders if one decided to leave and simply sold his shares to someone unacceptable with no knowledge of the business. This can also relate in the event of death preventing beneficiaries acquiring control over your business instead the agreement would set out the provisions by which the Company would buy those shares from the estate instead if so wished.

8. Potential to link shareholdings to employment

A Shareholders’ Agreement can contain a clause whereby a shareholder’s shareholding is linked to their employment. If this is the case and the shareholder leaves, provisions can be drawn up so that they must offer their shares up for sale. This protects the Company should someone leave on bad terms . Otherwise, there is generally no requirement for them to sell their shares if they cease to be employed even if you dismissed/voted them out. How the shares are valued following a shareholder’s exit can also be addressed.

This is especially key for the technology sector as you will want to ensure all Intellectual Property created by them is correctly assigned to the Company and all data and confidential information released also. You may also need to have a warranty that any IP created is genuinely unique and will not infringe a third parties rights which would jeopardize the business. In the event that you have promised shares to someone to help you start the company, any conditions or restrictions on those shares can be dealt with in the shareholders agreement.

9. Restrictions
If a shareholder exits the company, the remaining shareholders may wish for restrictions to apply to the exiting shareholders’ ability to set up or work in a competing business or poaching clients or using your IP such as unique code or software or using confidential information. These restrictions can be more restrictive than those contained in an employment contract and can protect the interests of the company. Likewise if this is not your only business other interests could be disclosed here to prevent anyone taking action against a shareholder for conflicting interests at a later date if a dispute arises.

10. Can vary how much dividends are paid

A Shareholders’ Agreement can set out the various dividends paid to each shareholder where there are different cases of shares or cap or limit withdrawals to protect the capital and cash flow of the company.
By not having an agreement in place, shareholders may end up walking away with too much, or the company business can grind to an abrupt halt under the management of a minority shareholder veto. This means it’s important to consider options carefully and, if you decide you need one, get the right shareholders’ agreement for your circumstances. Templates do not work you need to design this around your needs and all agree to the provisions so you have a sound platform on which to build your business.

These are just a some of the reasons why a Shareholders’ Agreement is important and useful for a company to protect individual shareholders.

If you require further advice or assistance, please do not hesitate to contact me karen@acitylawfirm.com

Hey, like this post? Why not share it with a buddy?

Posted in Articles and Publications.