So, you’ve been offered an investment opportunity in an ‘early stage’ company which has some interesting new business ideas? You’ve assessed their business plan and (while it’s a bit optimistic) you think it makes sense; you think their potential market is exciting, and you’re thinking about investing.
Obviously there are significant financial risks (e.g. the company may fail completely and all of your money may be lost), but you think that the potential return makes these worthwhile. You’ve talked with your accountant about the financial and tax issues. So, what should you look for when you receive a proposed ‘shareholders’ agreement’ or ‘subscription agreement’?
Here are some common features of shareholders’ agreements (also known by various other names) which should get your attention, when you see them:
1. Drag Along rights
Often, the major shareholder intends to build up the business to the point where they can exit through selling their shares to a larger industry participant, or to a larger financial investor. The major shareholder will probably want to be able to deliver complete control to that potential buyer, because they (logically) think that is likely to maximise their exit price. So, it is common for an existing major shareholder to want ‘drag along rights’ which allow them to strike a deal for the sale of their shares, and then to ‘drag along’ minor shareholders so that the minor shareholders have to sell at the same price.
There are a number of risks (as well as potential benefits) for minor shareholders in drag along rights. For example – the major shareholder may have to make significant promises (often called ‘warranties’) to their buyer to obtain the maximum price for their shares, and they may have to accept a price which varies based on the future performance of the company (often called an ‘earn-out’ arrangement). As a minor shareholder, who is less active than the major shareholder, you are likely to know less about the company and are likely to have less influence over its performance. So, if you are ‘dragged along’, are you willing to provide the same warranties, or be subject to the same earn-out? Probably not.
If times are tough, then the major shareholder may be forced to sell at an inferior price to obtain liquidity (for example, to service their other private debts). If that happens, is it fair that you are ‘dragged along’ as a minor shareholder at the same inferior price?
If ‘drag along rights’ are properly and thoughtfully drafted, then those issues can be addressed for minor shareholders.
2. Dispute resolution / deadlock breaking clauses
It is common to find ‘dispute resolution’ or ‘deadlock breaking’ clauses in shareholders’ agreements. It is also quite common for those clauses to be complicated and illogical, or even for them to make no sense at all.
There seems to be an unreasonable fear of ‘dispute’ or ‘deadlock’ amongst potential investors in companies. While dispute and even deadlock are not to be taken lightly – they are not necessarily disastrous either. Disputes and disagreements are a normal part of business, and it can be a huge mistake to agree on inappropriate or artificial methods of resolving disputes and disagreements, because this can lead to uncommercial behaviour from shareholders who find themselves in dispute. Rather than trying to resolve their dispute commercially, some shareholders may be tempted to try to ‘game the system’ by using ‘deadlock breaking’ clauses to get an advantage for themselves over other shareholders.
There is no appropriate ‘one size fits all’ approach to dispute resolution and deadlock breaking in shareholders agreements – figuring out what is appropriate relies on a thoughtful assessment of the actual situation of the investor.
It can be dangerous to assume that a shareholders’ agreement (whatever name it goes by) will protect your interests as an investor. Usually there are inherent risks in this sort of investment – but a poorly written or inappropriate shareholders’ agreement can exacerbate those risks for you as an investor. This article mentions a couple of issues which investors should consider when looking at a shareholders’ agreement. Part 2 of this article will deal with more of those issues, including the issue of “Who really controls the company’s intellectual property?”, and is coming soon. If you would like assistance with advice on shareholder’s agreements or any related documents, or would like to discuss any issue, then please give Stephen Robertson a call on (07) 3226 3944.
Stephen is a commercial lawyer with extensive experience in advising businesses in areas of acquisitions and divestments, commercial agreements, structuring, legal risk and revenue issues. He also advises on property law, with a focus on commercial and industrial property. Follow @SJR_Nicholsons