A Founders Agreement and a Shareholders Agreement are both essential legal documents for your start-up. They govern the relationships and obligations among the founders and shareholders of a company. People often confuse the two, but there are some key differences. They serve different purposes and are typically created at various stages of your company’s life. There are other parties involved, and the focus of the two documents is different.
Contents
- What is a Founders Agreement
- What is a Shareholders Agreement
- Differences between the two documents
- What should you include in a Founders Agreement?
- What should you include in a Shareholders Agreement?
- Conclusion
What is Founders Agreement
A Founders Agreement is a legal contract that governs the business relationships between the founding team. The founders sign it. A Founders Agreement should provide a framework for the relationship between the company’s founders, outlining their respective rights, obligations, responsibilities, and liabilities. It also provides a roadmap for decision-making and conflict resolution. A Founders Agreement aligns the founding team and ensures they understand their role in the venture.
What is a Shareholders Agreement
A Shareholders Agreement is a legal document that outlines the rights, responsibilities, and obligations of the shareholders of a company. It is usually longer and more complex than a Founders Agreement and is put in place typically at the time a start-up issues shares to external investors. A Shareholders Agreement provides a framework for the relationship between the company’s shareholders, as well as investor rights. It also provides for decision-making and conflict resolution.
Differences between the two documents
- Timing
A Founders Agreement is typically agreed upon at the beginning of the start-up’s formation. A Shareholders Agreement is usually created when the company brings on external investors.
- The focus
A Founders Agreement focuses on the roles and responsibilities of the founders. It also sets out the equity allocation and who can decide what. It typically also addresses vesting and leaver arrangements for the founders. A Shareholders Agreement focuses on the relationship between the shareholders, including investors. It includes voting rights, restrictions on share transfers, and other governance matters.
- Content
Typically, a Founders Agreement may cover topics such as the company’s vision and mission, the roles and responsibilities of the founders, the division of equity and ownership, vesting schedules for shares, and intellectual property ownership. A Shareholders Agreement may cover voting rights, share transfer restrictions, shareholder obligations, dividend policies, dispute resolution procedures, etc.
The key elements of both Founders Agreements and Shareholders Agreements may vary depending on the specific circumstances and needs of the company. There might be overlaps between the two documents, but the difference can be found in the main elements of each.
What should you include in a Founders Agreement?
Details of the founders and the equity ownership of each.
- Business information – What will the business of the start-up be?
- Intellectual property – A clear description of the IP; who owns it?
- Transfer of ownership provisions – Is there a lock-up provision, or can founders transfer shares immediately? Is there a right of first refusal? How will the Foundersexits be governed?
- Contributions – Who is contributing what? Are contributions in cash or kind?
- Roles and responsibilities – A detailed summary of who is responsible for what and what happens if the person is not performing.
- Decision-making and dispute resolution – Who has the authority to make what decisions? Who has a vote? Is there a veto right? What happens in a deadlock? What happens at board level? How will disputes be resolved? Arbitration, mediation? Who carries the cost?
- Vesting – How and when each co-founder gets their shares or equity over time rather than immediately, and what happens if they leave or are removed before the end of the vesting period?
- Confidentiality clauses, non-disclosures and non-competes to ensure business ideas and concepts remain confidential. Are founders restricted from joining or setting up a competitor’s business?
- Dissolution and Termination clauses – Which events may lead to the venture’s dissolution? What is the winding-up process and distributions in case of termination?
- Governing law and dispute resolution – The jurisdiction where disputes will be heard and the method of resolution (e.g., English law and courts, ICC arbitration held in London, etc.)
For more information on Founders Agreements, see our Guide to Founders Agreements.
What should you include in a Shareholders Agreement?
When external investors come on board, addressing issues beyond the arrangements between the founders becomes essential. Other than details of the business and the shareholders, a Shareholders agreement will typically contain the following provisions.
- Share ownership – The agreement should outline the number and type of shares each shareholder holds. It should also address the rights and privileges of each class of shares, for example, common or preferred shares.
- Management and control/board appointments – The role of the board of directors, who can appoint or remove board members. How will major business decisions be made? Shareholders rights can include the right to appoint a board member.
- Dividend policy/rights – The timing and frequency of dividend payments. Investors may have a right to receive a specific preferred dividend.
- Shareholder obligations – The obligation to maintain confidentiality, the obligation to provide financial information, or the obligation to attend shareholder meetings.
- Shareholders rights – Depending on the class of shares issued to them. Most of the time, shareholders will receive preferred shares. Preferred shares come with special rights and protections. Investors often want these rights to protect their investments.
Rights and protection clauses typically included in a Shareholders Agreement
- Share transfer restrictions
Share transfer restrictions limit a shareholder’s ability to transfer their shares. The purpose of share transfer restrictions is for the company to control who owns its shares, protect investors from founder departures, and allow existing investors priority on purchasing shares. Sometimes some of these restrictions are exclusively in favour of preferred shareholders. Alternatively, they may be exempted from these restrictions.
Restrictions include rights of first refusal, drag-along and tag-along rights.
- A Right of first refusal gives the holder a priority right to buy or refuse to buy any existing shares from another shareholder before that shareholder can sell to a third party. It is closely related to a Right of First Offer, meaning the shares must first be offered to the holder of the right of first offer before it can be offered to anyone else. Significant investors are often exempted from the obligation to offer their shares to other shareholders first.
- Drag-along rights allow majority shareholders to force minority shareholders to sell their shares to the same buyer on the same terms as agreed to by the majority shareholders. Drag-along can be an important right to ensure that a minority shareholder does not block the sale of the company.
- Tag-along rights give minority shareholders the right to “tag along” when shareholders want to sell their shares. So, when shareholders propose to sell their shares to a third party, the investor with a tag-along right may also sell a portion of their shares to the same buyer at the same price. Major investors might want to avoid being subjected to other investors’ tag-along rights.
- Anti-dilution rights
Anti-dilution rights are an example of an investor protection clause. It protects investors from excessive dilution of their shareholding in follow-up fundraising rounds when you raise funds at a lower valuation and issue new shares at a lower price than the investor paid. It allows investors to maintain their ownership percentage when new shares are issued. Anti-dilution rights can grant the investor additional shares for free or allow the allocation of proceeds to be adjusted upon an exit.
- Liquidation preference
Liquidation preference is probably the most significant financial right investors have. It sets out what happens during a liquidity event, i.e., when the investment is converted to cash. When it comes to liquidation, the preferred shareholder will get “preferred” treatment over ordinary shares. Preferred shareholders will receive a certain amount of money before any other shareholder when the company has cash to distribute to shareholders. The preference applies to the liquidation, winding up, or dissolution of the company. It also includes liquidity events such as the company going public or being acquired.
- Rights relating to reserved matters
Reserved matters refer to certain important decisions reserved for approval by investors (Either at shareholder or board level or both). Essentially, it means that investors can veto decisions in these matters.
Reserved matters could include decisions related to significant business transactions, senior appointments, litigation, changes to the company’s capital structure, issuing new shares, etc.
This right can be expressed as some decisions requiring that a certain percentage of preferred shareholders must vote to approve any action relating to these matters. At board level, one or more board members appointed by the investors must approve the action.
- Voting rights
Other than reserved matters, the agreement should specify the Shareholders voting rights, including any special voting rights for certain classes of shares.
- Founder restrictions
Investors could insist on the right to restrict founders from doing certain things. For example, they could insist on a lock-up restriction prohibiting the founder from selling their shares for a specific period.
- Dispute resolution
The agreement should set out provisions for resolving disputes among shareholders, such as mediation, arbitration, or litigation and the specific jurisdiction for dispute resolution.
- Exit strategies
The agreement must stipulate options for shareholders who want out, such as selling their shares or initiating a buy-out.
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Conclusion
Both documents are essential for the continued success of your venture. Although there are overlaps, each serves its vital purpose of establishing the relationship between founders and shareholders.
Founders Agreements cover the company from formation to your first equity funding round and reduces risks inherent to the business relationship between the co-founders.
Shareholders Agreements come into effect from the first equity funding round when you have external investors as shareholders and replace the Founders Agreement at that point.
Founders Agreements are replaced by more comprehensive Shareholders Agreements when the time is right to take on external investors.
