Being a startup law firm, many entrepreneurs approach us, asking about the essential agreements they should sign as startup founders. Once we start explaining, the first thing they ask is what the difference between a founders’ agreement and a shareholders’ agreement is? And why execute both since they are very similar?
Yes, true. Both are very similar. However, if you execute one and forget the other, you’re making a big mistake. Wondering why? Well, in this article, I will be explaining the difference between those two agreements. And why both are so much important to execute?
Let me start with the founders’ agreement since it’s the first-ever agreement startup founders must sign. This agreement is executed during a startup’s very early stage, between its founders only as a promise to build something together. It details the relationship between them and how the management of the company will be handled by defining the roles, the responsibilities, the ownership structure, the exit options, etc. of each founder. Also, a founders’ agreement details who owns the intellectual property of the company, how to resolve disputes arising between founders, what happens if they disagreed on a certain point, how shares are transferred to someone from outside the company and what are the founder’s restrictions. Its primary purpose is protecting every founder’s interests and prevent future conflicts between them by going through any problem founders might face, any possible conflict between them, and any events changing expectations.
On the other hand, a shareholders’ agreement is a legal contract executed during a startup’s later stage, typically when investors start coming to the company. Initially, the ownership structure of the company was only divided by its founders’, but once investors start joining the company, they will be looking for their part. Here comes the role of a shareholders’ agreement. This agreement is much more detailed than a founders’ agreement. It’s executed between the people who own part of the business. Those who may or may not be founders. It includes many provisions, such as:
The different types of shares held by every founder and investor, whether common shares or preferred shares.
The voting powers of each one of every founder and investor.
The issuance of new shares process.
An anti-dilution clause that protects the size of a stakeholder in a company in case this size will be decreased due to an increase in the total number of shares.
A vesting clause defining the vesting period of each shareholder. In other words, to protect the company, shareholders will not enjoy their ownership in the company immediately, instead they will enjoy it on a gradual basis by receiving 25% every year for four consecutive years, it’s a way of keeping the shareholder committed to the company as long as possible, especially if such shareholder was hired to run and develop the company.
A tag-along clause, which is mainly to protect minority shareholders in case majority shareholders decided to sell their shares in the company, with a tag-along clause, the majority may only attempt to sell their own shares instead of finding a buyer for all the shareholders.
A drag-along clause, which is the opposite of a tag-along and basically for the benefit of majority shareholders wherein case they found a buyer to purchase all the shares of the company, under a drag-along clause they can force minority shareholders to sell.
A right of first refusal clause, which gives the existing shareholders of a company the preference to buy the company’s shares over any party from outside the company in case a shareholder decided to sell his or her shares.
A deadlock clause which specifies after how long the shareholder will be able to sell his or her stake in the company.
And finally, the traditional corporate provisions such as confidentiality, conflict of interests, non-compete, intellectual property assignment, governing law, and jurisdiction.
It’s crucial to have both agreements written and executed appropriately. Don’t underestimate any of them. Imagine if you did not complete a founders’ agreement, and a founder decided to walk away from the company. Such founder can easily take the company’s intellectual property with him or her, and you can do nothing about if you’re not legally protected. As a result, your company will end up worthless, especially a startup company where its IP is its most valuable asset. Additionally, a shareholders agreement is also as essential as a founders’ agreement, particularly when it comes to bringing investors to the company; those will not give you a dime if you don’t have a shareholders’ agreement.
How can a lawyer help?
Bear in mind that you should always have a lawyer next to you no matter what kind of agreement you’re executing. Even though you can easily find templates of a shareholders’ or founders’ agreement on the internet, but those will not be as precise as possible for your business. I strongly recommend you to have a specialist lawyer to draft this contract for you. That way, you can make sure you did not miss out on any critical point that could cost you a fortune.