Starting and running a business is hard. On top of the factors that business owners typically focus on when running a successful business—product development, customer acquisition and retention, financial hygiene, etc.—businesses with multiple owners must address the interpersonal dynamics of going into business with others. When a business is new, there is a tendency to ignore tough conversations with co-founders because the team is aligned on the future. That initial alignment makes the time before or around formation the best time to set expectations between co-founders and to put the necessary documentation in place to protect all founders’ interests in the business.
In the corporate context, these expectations are typically documented in (1) a stockholders agreement (aka a “shareholders agreement”, depending on terminology in the state of incorporation) and (2) a buy-sell agreement. This post focuses on stockholders agreements. Stay tuned for a future post on buy-sell agreements.
Stockholders agreements take any number of forms depending on the priorities of the founders and the equity split amongst them. A stockholders agreement for a business owned 90% by one founder and 10% by another will likely look very different from a business owned 25% by each of four founders. The topics discussed below are often included in stockholders agreements, though the terms vary quite a bit depending on the specifics of the company and its founders.
Management of the Company
Stockholders agreements often allocate management and decision-making authority amongst the stockholders. Matters at both the stockholder and board of director levels are detailed. At the stockholder level, this could mean (1) requiring the approval of a certain number of outstanding shares (typically either a simple majority vote or a supermajority vote, such as two-thirds or three-fourths of outstanding shares) to approve specified matters; and (2) detailing how the board is elected and potentially giving certain stockholders specific rights to appoint one or more directors. Stockholders agreements can also specify matters requiring the approval of a supermajority of the board of directors.
Transfer Restrictions
Stockholders agreements often impose transfer restrictions on shares held by the stockholders. Transfers of shares are generally restricted except for transfers made (1) to a specified group of “Permitted Transferees” (affiliates or family members of a stockholder, legal entities wholly owned by the stockholder and/or their family members, etc.); or (2) pursuant to a “right of first refusal” process. A right of first refusal allows a stockholder to source a third-party buyer for their shares, at which point a purchase price and other material terms are agreed upon by the stockholder and the third-party buyer. Before the third-party buyer is allowed to buy the selling stockholder’s shares, the selling stockholder must allow the company and/or the other stockholders to buy those shares on the same terms offered by the third-party buyer. If the company and/or other stockholders don’t purchase all of the shares proposed to be transferred, the selling stockholder is permitted to sell the remaining shares to the third-party buyer.
I am a major proponent of right of first refusal clauses in stockholders agreements. A right of first refusal gives stockholders a chance at liquidity for their shares when they would otherwise be subject to the approval of the other stockholders in approving a transfer. A right of first refusal simultaneously protects the non-selling shareholders by ensuring that they have some control over who shares are transferred to. If the non-selling shareholders prefer not to be in business with the proposed third-party buyer, they can step in and exercise their right of first refusal to block the sale by buying those shares on the same terms offered by the third-party buyer.
Preemptive Rights
Stockholders agreements often include a preemptive right giving certain stockholders a right to purchase shares to be issued by the company. The intent of a preemptive right is to ensure that the stockholders have a right to maintain their existing ownership percentage. When exercising a preemptive right, the stockholder is required to put more capital into the company in exchange for the shares issued by the company.
Information Rights
Stockholders typically have a statutory right to receive certain information about the company upon request. This information could be financial in nature, such as monthly, quarterly, or annual financial statements, or information specific to the ownership of the company, such as specific share ownership. It is relatively common for stockholders agreements to codify information rights and/or to modify the default information rights provided by statute.
Other topics sometimes included in stockholders agreements include:
- Non-competes imposed on stockholders both during the period that a stockholder owns shares in the company and for some period of time after share ownership ends. Certain states have strict rules for imposing non-competes or outlaw them completely, so care should be taken to ensure that the non-compete is not prohibited by law.
- Confidentiality obligations imposed on stockholders, again during the period that a stockholder owns shares in the company and for some period of time after share ownership ends. Note that confidentiality obligations are often imposed in other agreements as well, such as proprietary information and invention assignment agreements (PIIAAs).
While generic stockholders agreements are readily available online, there are many different flavors of each of the above concepts that should be tailored to the facts and circumstances of each company. A stockholders agreement put in place without careful consideration as to why certain concepts are, or are not, included is just as risky as not putting the agreement in place at all. Founders must understand the terms of their stockholders agreement so they are not surprised if and when the agreement comes into play.