Last week’s post laid out a checklist of legal documents and concepts that are important to early stage companies, and provided a brief summary of each. This post is the first in a series that will examine those documents in greater detail. The first document to be considered: the Stockholders Agreement.
A stockholders agreement is a contract that structures the relationship among the stockholders of a corporation, and sometimes the corporation itself. If there is only one stockholder, there is no need for a stockholders agreement, but if there is more than one founder, a well-thought-out stockholders agreement will help set ground rules that can solve corporate issues that may arise in the future. Stockholders agreements allow for private ordering of a corporation’s governance structure and often achieve governance structures that could not be accomplished in a corporation’s organizational documents. Stockholders agreements also often contain provisions, such as buy-sell provisions, that do not strictly relate to the management of the corporation but allow the current stockholders to maintain control over the composition of the stockholder base itself. Stockholders agreements may also address investor and management concerns related to access to information, confidentiality and competition. Some common provisions found in stockholders agreements address issues including:
- Drag-along rights: Drag along rights are one of the most important components of a stockholders agreement in a start-up context, as they can allow a majority stockholder or stockholders to require other stockholders to join in the sale of a company whether through a merger or a stock sale. Many buyers will only complete an acquisition if they can do it without lingering stockholder claims, and drag-along rights can help get there. Since the end goal for many startups is to complete a successful M&A exit, drag along rights are attractive to, and often required by, many major investors to ensure that an otherwise successful future exit opportunity will not be complicated or blocked by minority stockholders. The drag-along generally requires stockholders to take all actions reasonably necessary to consummate the transaction, and not to exercise any statutory dissent rights or raise objections to the sale. These provisions can also provide remedies in the event a minority stockholder fails to deliver its stock. Typically, a drag-along provision will also provide that any deal in which a stockholder is “dragged” along will receive the same per share price, terms and conditions as any other stockholder with the same class of equity, and will frequently carve out special obligations such as joint liability for indemnity claims and non-compete obligations.
- Board composition and director duties. In conjunction with a company’s bylaws, a stockholders agreement can contractually bind the stockholders to vote to elect to the board directors designated by certain stockholders of groups of stockholders and to support the removal of these designated directors. The stockholders agreement can also address the mechanics of restricted nomination rights, appointment of directors to various board committees, and staggered boards. This flexibility can be especially helpful to early stage companies, as it can be used to establish designated board seats for founders and major early investors and to provide for independent or tie-breaking board members in 50/50 owned companies.
- Management. Stockholders agreements often give stockholders the right to influence the employment of key managers, typically the chief executive officer. While only the board can appoint officers, the terms of employment of key managers can be structured to require a unanimous board vote or approval by key stockholders. As discussed with respect to board composition above, this can be helpful to early stage companies with founders who logically should also occupy key officer positions.
- Approval over Key Decisions. Stockholders agreements allow a company the flexibility to require enhanced approval over what otherwise would be ordinary decisions for the board or management. These provisions can provide for anything from board supermajority voting requirements to stockholder approval for many business decisions, such as acquisitions and divestitures, debt incurrence, additional equity and the like. When drafting these types of provisions, one must be careful not to run afoul of the rules and requirements set forth in the company’s other corporate documents (e. charter and bylaws), and state statutes.
- Information Rights. A stockholders agreement that provides information rights to the stockholders can allow stockholders greater involvement and inclusion in the day-to-day business affairs of a company. Information rights can be a valuable incentive for early stage investors and can include provisions regarding receipt and timing of company financial statements; rights to review documents regarding the company’s properties, financial records, business plans and budgets; and the ability to discuss the company’s affairs, finances and accounts with management (typically with requirements that these discussions happen at a reasonable time, with advance notice and in a manner not to unreasonably interfere with business operations).
- Transfer Restrictions. One of the most useful and common provisions included in a stockholders agreement is a restriction on the transfer of shares. Typically, these provisions prohibit early stockholders from transferring their shares except in certain circumstances, known as “permitted transfers.” These restrictions provide equity stability for the company and greater control over who can hold company shares. Permitted transfers typically include transfers to immediate family or for estate planning and affiliates of institutional investors. For founders, it is very important to have a stockholders agreement that addresses unexpected events that affect share ownership, such as departure, change of marital status or death of a founder. Key factors that must be considered when drafting provisions regarding transfer restrictions include: (i) the reasonableness of the restrictions; (ii) the duration of the period during which transfer is restricted; (iii) whether transferees will be bound by further transfer restrictions; and (iv) purchase price considerations.
- Preemptive Rights. The pro rata right to participate in future equity rounds is important for founders who otherwise lack control over the company. While traditionally, preemptive rights were either available by default or installed in the company’s charter, they provide maximum flexibility when included as part of a stockholders agreement. Relevant provisions in a stockholders agreement can grant exceptions to preemptive rights (usually for board approved equity plans, acquisitions and banks), provide for preemptive rights only to certain stockholders, waive preemptive rights in certain instances, and lay out rights and remedies for stock issued in violation of preemptive rights. These provisions require significant attention during the drafting process, as they can be useful tools to maintain ownership and voting percentages for certain key investors during early stage financings.
Though the types of provisions outlined above tend to be the most common items included in a company’s stockholders agreement, there are a multitude of other features and objectives that a stockholders agreement can be designed to accomplish. Given the complex nature of many of these concepts, counsel should be retained to assist with the drafting and implementation of a stockholders agreement, as a well drafted agreement can provide tremendous flexibility for a startup company and help make the company an attractive option for key early stage investors.