Or: KISS (keep it short and simple)

With frustrating regularity, I am consulted by people who have come up with a good idea, have worked hard to transform that idea into a viable business proposition and have then done a deal with venture capitalists (“dragons”) to obtain the funding they need to move the business on to the next level.

Almost invariably, in return for providing the funding, the “dragons” will have required that a new limited company be set up as the vehicle for the venture and intellectual property rights for the idea be transferred into that vehicle.  Equally frequently the original parties to the business will become the minority shareholders in the new company – often with less than 25% of total voting rights.

Again, almost invariably the dragons will have required that the original parties to the business sign up to a set of constitutional documents for the new company – Articles of Association, Shareholder Agreements/Investment Agreements etc.

These documents are frequently lengthy and complex (prepared by the dragon’s similarly “dragon-minded” solicitors).

Very often these documents will create complex structures of share-capital with different classes of share capital (A Ordinary, B Ordinary, C Ordinary etc) and complex formulae to determine the voting rights of each class.  Very rarely will the original parties to the business end up holding the same classes of shares as those held by the “dragons.”

In summary, whilst these documents may be sold to the original owners of the business as providing them with protection notwithstanding their new status as minority shareholders (and notwithstanding, no doubt, the dragons’ entitlement to appoint the majority of directors on the board of the company) very rarely is the protection given effective.  Most of the protections provided will be couched in terms of a requirement for “Investor Consent” and guess who the Investor is?  The dragon.

Going back, then, to the basic points which should be covered off in a Shareholders Agreement – and to the reasons why a Shareholders Agreement is necessary in the first place.

Fundamentally a Shareholders Agreement is necessary to protect the interests of minority shareholders – particularly if they hold less than 25% of the voting rights in the company and are, therefore, unable to block Special Resolutions (the resolutions which make changes to the fundamental constitution of the company).

An effective Shareholders Agreement should (at the very least) make the following matters subject to Shareholder Consent (ie the consent of all shareholders or a stated percentage of shareholders high enough to protect the minority shareholder):

  1. Changes to the constitution of the company;
  2. Changes to the share capital of company (in particular the issue and allotment of further shares – which may otherwise further dilute the minority shareholders holding); and
  3. Acceptance of offers to purchase the company (or its business and assets).

If what is offered instead is “Investor Consent” look very carefully at how this is defined.

In addition, a minority shareholder would be wise to ensure:

  1. That there are appropriate “tag-along” provisions – requiring any purchaser of the shares of the company to make an offer on similar terms for all of the shares of the company, rather than just the majority shareholder’s holding; and
  2. That there is provision allowing them to appoint at least one director to the board of the company

The overall motto must however be, “Keep it short and simple.”  If it takes over an hour to figure out what voting rights are associated with the shares which you hold then it is highly unlikely that those voting rights will be effective.

And if a dragon invites you to sign up to a complex set of Articles of Association, Shareholders Agreement/Investors Agreement etc  – offering you a pot of gold in exchange – always, always (always!) consult an appropriately qualified legal adviser before signing.

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