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Start-ups: Do You Need A Founders' Agreement?

Agreements are important throughout the life of a business, no more so than right at the start.

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Agreements are important throughout the life of a business, no more so than right at the start.

Guides

Start-ups: Do You Need A Founders' Agreement?

Agreements are important throughout the life of a business, no more so than right at the start.

Share this article

As a business owner it is important to be able to appreciate the legal framework in which your business relationships are to operate.

To this end, it’s well worth exploring the benefit of a suitable shareholders’ agreement (also sometimes known as a “founders’ agreement” in early stage companies), how it might evolve over time and what might happen if you don’t have an agreement.

In the beginning…

So you’re starting up a new venture – it’s very early days, and you want to keep discretionary expenditure to a minimum. Whilst in the short term choosing not to have a shareholders’ agreement may save some money, in the longer term the lack of firm foundations for your company could cost you a lot more.

Unsurprisingly, at the start of a new business relationship your focus will be on opportunities and not on potential pitfalls. You will most likely implicitly trust your business partner and will not be thinking about potential future bumps in the road.

Weighing the need for legal certainty and the costs of obtaining advice and putting in place suitable agreements is a delicate balance.

We would encourage business founders to contemplate how the business relationship between them will shape the future of the business and its success. Get it right and you will be well-placed to navigate those bumps as they arise, but get it wrong or do nothing and those bumps could prove insurmountable and/or extremely costly.

As a business grows, its founders’ roles develop too – sometimes founders grow apart through no fault of their own. Having in place a shareholders’ agreement from an early stage enables you to put structure around how you will work together, make decisions and resolve disputes.

Thinking up front about your end-game, spheres of responsibility, whether unanimity is necessary or desirable for certain decisions and what should happen if you or your business partner(s) decide to leave the business either temporarily or permanently, will hopefully mean that a consensual agreement can be reached and documented upfront.

A delicate balance is needed here, as too restrictive an agreement could have the unintended effect of burdening the business with bureaucracy, in turn impeding the dynamism an early-stage business needs.

Inevitably, trying to resolve issues after they have arisen is much more difficult as at that point things may have broken down to the extent that those involved are now focused on their own interests and not the greater good of the company.

Moving forward

Even if you’ve already established your business without any agreements, it is not too late to put consensual agreements in place (assuming you can agree terms).

As others come on board (perhaps family and friends investors) it is important to document what their rights and obligations are.

Will they receive shares? How will they be rewarded for their investment - are dividends expected or will they rely on capital growth? How will shareholders realise their investment? Can they freely transfer their shares to anyone or will there be pre-emption rights in favour of other shareholders? Can shareholders be forced (or opt) to sell alongside a majority of shareholders through “drag” or “tag” rights?

All these issues can be regulated through a shareholders’ agreement combined with suitably tailored articles of association.

In scaling-up your business, the level of investor protections and extent of constraints to be placed on existing shareholders will need to be carefully considered against what a particular external investor brings to the table.

This might be measured in cash terms (i.e. the extent of the incoming funding) or by reference to any valuable expertise, experience and/or contacts that investor can make available (the types of bargaining positions often taken on Dragon’s Den).

At present, companies looking for funding (whether as debt or equity) are not short of options. However, being spoilt for choice means carefully considering which form of funding and which funder/investor best fits your business’s needs.

On receiving new equity investment, your constitutional documents (i.e. your shareholders’ agreement and articles of association) will typically be reviewed and/or rewritten – but careful thought needs to be given to the same kinds of issues as previously.

The type of investment will likely dictate the legal agreements that will be put in place – equity investors will generally expect board representation, investor protections and will require regular prescribed financial information.

Moving towards an exit

Having suitable agreements in place can help demonstrate to potential acquirers or investors that the company is well-run. In turn, a well-run company should be less likely to reveal unexpected curveballs in due diligence. The use of suitable drag or tag rights can also make a sale easier to achieve.

Impact of not having agreements in place

Bumps in the road can take many forms – a divergence of interests, boredom, disillusionment or even finding out someone is diverting business for their own ends.

Without a shareholders’ agreement the parties must rely on the Companies Act and/or the company’s articles (which themselves might not be tailored to the circumstances).

There is no concept of a “no fault” divorce in English company law and the respective percentage shareholdings can be key, as can being a director, which can bring with it access to company information alongside potential personal liability in some instances.

Dealing with shareholder issues is often time-consuming and a distraction from management. This can be detrimental to the business and can unsettle staff. As lawyers, we often see business owners when issues arise - and helping navigate issues without detailed agreements can be significantly more difficult and hence more expensive.

Disgruntled shareholders looking to sell because of a fall-out can make for a less attractive business and a lower financial return on your hard work.

Having agreements and tailoring them to the stage of the business is therefore important. This is certainly an example of ‘prevention’ being better than ‘cure’, and agreeing a solid foundation for your business should yield significant benefits in the longer term.

This article was written by Nick Atkins, Partner, and Katie Philipson, Senior Associate, at Stevens & Bolton LLP.

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Start-ups: Do You Need A Founders' Agreement?

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