Start-up Contracts Explained

This is you, this is your startup, these are your investors, and this is your Shareholders Agreement. The SHA is a document that is signed by all shareholders and effectively manages how the control of the company is split among them.

Usually, the bigger the company, the longer the SHA and the harder to understand for mere mortals without a Ph. D. in law. Anything that’s written in the SHA is subject to negotiation.

Therefore, be careful to consider these five things before you sign.

1.Dilution

When a company raises cash from new investors, existing shareholders get diluted, meaning their percentage hold of the company is diminished, as the new investor receives newly issued shares.

If you’ve read Part 1 you might remember how I said that every shareholder gets diluted proportionally to their share in the company. So in our case, with a new investor coming in at 25 percent, if you own 40 percent you lose 10, if you own 20 percent you lose 5.

Well, I lied.

Dilution is NOT Always Proportional. The SHA might include an anti-dilution clause, which exempts a certain shareholder from dilution completely by simply granting him new shares when a capital race takes place.

And if a man isn’t diluted, because of the way percentages work, then others must be diluted even further in his stead. In one famous example, the SHA included a clause which granted anti-dilution to all shareholders, with only one certain shareholder taking the hit.

To prevent this from happening to you, always watch out for dilution in your SHA.

2. Board of Directors

The Board of Directors is to a company much like a Parliament is to some democracies. It elects the CEO much like the German Parliament elects the Chancellor. And they can influence and/or veto decisions made by the CEO. Note that the board is not involved with day-to-day operations and not to be confused with the Management or Executives of a company, even though some of them will usually also be board members.

But in general, who gets to determine the board members? Much like voters determine who’s in Parliament, shareholders determine who’s in the board.

And in the case of startups and private companies, these are usually the founders, investors, and others such as employees, friends, and family.

But not every vote bears equal weight, once again, much like in certain democracies. The number of board seats a shareholder can determine is usually vaguely correlated to the number of shares they hold, but also to their standing inside the company and their negotiation skills.

For example,

In a young private company with five board seats, the co-founder and CEO might determine two of them while only holding a 20 percent stake, because he’s so charismatic and likable and important to the business, while another founder who also owns the same 20 percent gets to determine none.

A big investor who holds 30 percent determines another two, while one early investor with only a 10 percent stake determines another one. Others, even though adding up to a total of 20 percent, don’t speak with one voice and is out of the loop.

Once it’s agreed who can determine, how many board members, then that’s what’s written into the SHA. And once it’s signed, the deal is sealed. So you better pay good attention to the Board of Director’s section.

3. Tag-Along

Say you invested some money into a friend’s startup at an early stage, and now you hold a small stake in it.

The lead investor is some famous guy who went all-in on your friend’s idea and holds a majority stake in the company, including a majority of board seats. Things have been going well, and one of the big guys shows some interest in the startup, so much so that they want to buy control of the business.

Good news for the big guy!

The only one they have to talk to Mr. Majority over here. He can now exit his controlling stake for a sweet profit over his initial investment. And you and the other minority shareholders can go f*** yourselves, right?

Not so!

The Tag-Along clause puts a big asterisk on that deal. It gives the minority stake the right to sell the same portion of their stake at the same price and conditions. And if the big guy just wants to buy control, but not the whole company, then they’re buying from everyone equally.

So if you’re a minority shareholder in a company, be especially sure to have your Tag-Along rights included before you sign.

4. Drag-Along

Now maybe you’re one of the big investors and your exit candidate wants to buy, not just control, but the entire company.

You think it’s a great deal, but those naggy small investors don’t agree and tell you “We won’t sell our shares!” And you tell them, “Yes, you will!” And they say, “Make us!”

Turns out, you can, thanks to the Drag-Along clause.