Shareholder agreements can be a waste of time, energy and money
In my last few years practising law I reviewed, drafted and negotiated literally hundreds of shareholder agreements. But I have recently come to the conclusion that, for the most part, shareholder agreements are an unnecessary distraction for the shareholders and do nothing to advance the interests of the company to which they relate. Too often shareholders have fought over utterly useless but irritating clauses with the only winner being the lawyers who usually charge on a 6-minute basis while they engage in point-scoring at the expense of their respective clients.
My view was (and still is) that all of the important provisions should be incorporated into the company’s constitution. After all, constitutions are well tried and tested, having been around for over 100 years (assuming the starting point for NZ was the 1908 Companies Act). Constitutions are neutral, they do not take sides and the standard provisions apply to all the shareholders, regardless of who they are or how they became stakeholders in the first place.
Investors in start-up companies often insist on having shareholder agreements to protect their interests, even though their percentage shareholding is usually well below 50%. In other words, investors often upset the balance created by a standard constitution. Their justification is that their money, and the return on their investment, is more important than the sweat equity of the founders or the money invested by the founders’ friends and family.
However, I never came across an investor whose money was better than the ideas or efforts of the company he invested in. The investor may have been successful in a previous business but the money he made does not mean he knows more about the founder’s business than the founder himself.
With this view I have tried hard to resist unfair, biased shareholder agreements that favour the investor over the founder’s interests. I have not always succeeded, although that is usually because at the time of investment the founder is desperately in need of the investor’s money and is therefore in a very weak negotiating position. Conversely the investor is in a very strong position and is therefore able to insist on an onerous form of shareholder agreement.
One way of avoiding this problem is for the founder to seek money before he really needs it. Another way is to seek money from more than one potential investor at the same time. In fact it is usually a bad idea to seek money from just one source at a time, especially if that one source eventually says no (i.e. after doing due diligence for several weeks and then getting cold feet). By the time the company gets rejected by the investor, its financial position has usually deteriorated and the founder is forced to go to a less than satisfactory second-best option investor who, using the strength of his bargaining position, can then insist on a lower valuation and an increased stake in the now desperate company.
Unfortunately, an investment of this nature does not usually result in a fruitful or rewarding relationship between the founder and the investor (more on this later – Why Nations Fail).
Therefore, if the founder can start negotiating with potential investors at an early stage, his chances of getting a well balanced and fair deal will improve exponentially. That in turn means that he has a better chance of obtaining a good investor and a good investment instead of having to sell his soul and half his company to a rapacious investor.
This also means that it should not be necessary to have a shareholder agreement, except to the minimal extent necessary to protect the few matters that might not otherwise be effective in a constitution.
These few matters are:
- Non-competition clause: because a restraint of trade is prima facie illegal under the Illegal Contracts Act (unless it can be proven by the person trying to enforce the restraint to be reasonable), it is unlikely that a general restraint in a constitution will be enforceable against a shareholder. Therefore, to the extent that a restraint is considered necessary, it would have to go into the shareholder agreement. In that case, the starting point for negotiations should be that it applies to all shareholders, including the investors.
- Confidentiality provision: such a provision should be enforceable in a constitution, although I don’t know if it has been tested in the courts. Employees have a general fiduciary duty at law to keep company information confidential, while company directors also have a statutory duty of confidentiality.
- Shareholder loans: where more than one shareholder lends money to the company, no shareholder should have a better right than anyone else to demand repayment. So it is a good idea to provide that no shareholder can demand repayment without the consent of all other lending shareholders and even then only on the basis that all lenders are repaid on a pro rata basis at the same time.
Common provisions requested by an investor are drag and tag-along clauses. Drag-along clauses allow a major shareholder to force all other shareholders to sell their shares in the company to a third party on the same terms as the “dragging” shareholder. Tag-along clauses allow small shareholders to participate on a pro rata basis in a partial sale by a major shareholder.
While such clauses sound like a good idea, they are generally useless. Although I have seen them incorporated in shareholder agreements and constitutions over the last 15 years, I have never seen the tag-along clause used in practice, and have only seen the drag-along clause used twice.
If the relationship amongst the shareholder is harmonious, everyone will know what is happening with the company, especially if the main shareholder groups are represented on the board of directors. Full, frank and honest discussions will result in a consensus on whether anyone or everyone will sell their shares.
if despite this someone insists on having drag-along rights, those rights can more easily go into the constitution. The benefit of this is that the clauses will bind all shareholders, even though only a 75% vote is required to adopt or amend a constitution.
Standard constitutions have perfectly adequate pre-emptive rights provisions. Again these have been tried and tested and do not need to be tampered with. If someone wants to sell his shares, there is a ready-made procedure to follow and, if there is a dispute over the price to be paid for the shares on offer, the dispute can be referred to an independent valuer.
I do not believe in setting valuation procedures or formulae in advance. Just as I cannot predict the future, neither can a draftsman predict the situations in which the valuation procedures or formulae might be used. More often than not such procedures end up being used in situations that had not been anticipated by the draftsman, often with disastrous results.
Super-majority voting provisions are another bugbear of mine. These are usually found in shareholder agreements presented by an investor and are designed to give the investor veto rights on certain important issues. This goes against the general principle of company ownership, under which each share gives the holder the right to one vote. IMHO this rule should apply regardless of who the shareholders are. As mentioned above, an investor’s money is no better than the founder’s business or idea, so the investor should not be entitled to any more of a vote than anyone else. If the investor wants a better say in how the company is run, he should buy more shares and put his money where his mouth is.
The same rule should apply to board decisions. If there is a harmonious working relationship between investors and founders, all issues will be dealt with on a consensus basis. If an investor with a seat on the board doesn’t like a particular proposal, he should use reasoned arguments to convince the rest of the board not to proceed. He should not be entitled to avoid discussions and fall back on a veto right. If he loses the argument, the majority decision should prevail.
The principles behind these ideas are reflected in an excellent book I recently read, called “Why Nations Fail”, by James Robinson and Daron Acemoglu. In their book the authors argue that a nation’s economic success is predominantly determined by its political institutions. “Inclusive states” have no single centre of power but are innovative and prosperous thanks to the jostling of competing interests under the rule of law and secure property rights. Inclusive democracies with strong independent judicial systems thrive. Countries such as Great Britain and the United States became rich because their citizens overthrew the elites who controlled power and created a society with political rights more broadly distributed and the government accountable and responsive to citizens. In these countries the great mass of people could take advantage of economic opportunities. Conversely, nations dominated by self-centred elites (referred to as “extractive institutions”) fail, are extremely poor and end up in a vicious circle of plutocracy, suppression of technological innovation and economic and personal freedom.
It is not difficult to draw an analogy between nations and companies. The principles of democracy and ownership are the same and should apply in the same way to a start-up company. This means that, if an investor gets disproportionate control over the company and abuses that control, he will be no better than a dictator or oligarch in an extractive political regime.
A start-up company that has forced upon it, through governing documents imposed by an investor, provisions that override general democratic principles is less likely to succeed than one where the rule of “one vote per share and one vote per board seat” applies.