Transforming a great idea into a functional and thriving business equipped to seamlessly evolve with ever-changing market conditions and consumer demands depends largely upon establishing a stable business foundation. During the early stages, a startup faces several obstacles that, if not managed properly, may shut down the business itself. Strategic planning, implementation of sound business practices and the creation of tailor-made legal protections are cornerstones for the establishment of a successful and sustainable business. As such, founders of these “great ideas” should mindfully and actively participate in establishing the framework of their businesses.
An important part of establishing a stable foundation for any startup is ensuring that the key introductory documents are in place. The shareholders’ agreement is one of these critical documents. Also known as a “founders’ agreement,” this is a private contract among the initial founders that defines their rights and responsibilities as it relates to their interests and roles in the business. This document ensures that expectations are clearly established among all the founders and lays out a game plan for dealing with issues before they arise.
Due to budgeting constraints, some founders pay little attention to this document. Others view it as unnecessary since the agreement will be changed by future investors. More resourceful and risk adverse founders use templates available online. Should a dispute arise, founders using any of these methods expose themselves, their partners and their businesses to substantial risks.
Risks of “Googling It”
One critical mistake often made by startups is using a shareholders’ agreement found online or creating their own by combining two or more web templates. Although search engines have revolutionized our access to information, we should not rely on them to serve as business and legal advisors.
Before giving a search engine control over your business, consider the following:
- Search engines do not discriminate between a good document, a bad document and the right document.
- The agreement(s) you find may not adequately protect your interests or the needs of your business.
- A signed agreement is enforceable even if you don’t understand what the document says.
Signing a document without understanding how it impacts your rights or your business is a critical mistake. You may find yourself bound by terms that are not in your best interest and do not protect your business. The fact that you do not understand the impact of what you have signed does not shield you from the consequences.
Delay in Dealing with Disagreement or Disappointment
One of the most notable characteristics of the startup community is the resilient and positive outlook that these emerging businesses possess. It is this positive energy that spurs innovation and attracts investors and end-users alike. However, the Achilles heel of this positivity is that planning for the worst is often avoided. By failing to establish a game plan, emerging issues can destabilize a startup.
The Issue of Unanimous Consent. A critical issue often found in shareholders’ agreements is the requirement that all business decisions require the approval of all founders. This presents no issue until there is disagreement among the business owners. Without the proper dispute resolution process in place, these disputes will lead to dead lock each time a disagreement occurs. This not only creates tension and frustration among the founders, but may also stunt the growth and development of the business since the business owners are unable to effectively address important issues and make decisions.
The Failure to Plan Ahead: No Buyout Provision for Selling Your Business. Securing investors is often the ultimate goal of many startups. Now, imagine finding the ideal investor and, at the same time, being powerless to sell all or part your business simply because the founder holding a minority interest is blocking the sale. This is precisely what happens when there are no rules in place when the majority of founders want to move forward with a deal. With a “drag-along” right, a majority of the founders can sell their shares of the business, and those holding a minority interest are required to sell their interest on the same terms and conditions, allowing the sale to move forward.
The Failure to Plan Ahead: No Restrictions on Transferring Interests for the Death, Disability or Departure of a Founder. The failure to include restrictions regarding the transferability of a founder’s interest is another critical flaw often found in shareholders’ agreements. Each founder brings a specialized skillset and unique contribution to the business that is often difficult to replace, and the other business owners should be cautious about who they allow to obtain ownership in the business. Without the proper restrictions in place, the remaining founders may find themselves dealing with undesirable and uncooperative third parties.
A well drafted shareholders’ agreement should include:
- The automatic purchase of the interest of a disabled or deceased founder by the remaining founders; and
- The ability of the remaining founders to block the sale or transfer of a departing founder’s interest to a third party by purchasing that interest first.
When it comes to establishing the framework of your business, taking a “one size fits all” approach can be very harmful. The only thing worse that not having an agreement in place when you need it is having an agreement that is ill-suited to deal with issues that your business is experiencing.