The shareholders’ agreement: a solid foundation for sustainable collaboration

Starting a business with multiple founders is often a challenging and intensive process. In the early stages, founders have a lot to deal with: choosing the right legal form (read more about this here), attracting financing and developing the product or service. There is a high level of mutual trust. It is precisely at this point that it is important to lay down agreements on mutual collaboration, but above all to make agreements on how to deal with the early departure of one or more co-founders. In order to avoid complicated negotiations or conflicts, every founder who goes into business with others would be well advised to conclude a shareholders’ agreement.

Shareholder agreements regulate who bears which responsibilities and who contributes what (labour, knowledge, network, but also money or intellectual property). Agreements must be made about how important decisions are taken and what happens if not everyone is on the same page. In addition, the shareholders’ agreement regulates when someone is a bad leaver, early leaver or good leaver and, above all, what the consequences of this should be.

By making clear agreements, the start-up is assured of a good start and its founders are prepared for future challenges. In this article, we briefly discuss the relationship between the articles of association and the shareholders’ agreement and discuss in detail what you should include in a shareholders’ agreement.

What is the relationship between the articles of association and the shareholders’ agreement?

When establishing a private limited company, it is a legal requirement to draw up articles of association. The articles of association form the legal basis of the private limited company and contain the main rules relating to the internal structure of the company. The articles of association include the purpose of the private limited company, the types of shares, the bodies of the private limited company and the powers of these bodies. The articles of association are publicly available via the trade register of the Chamber of Commerce.

Drawing up a shareholders’ agreement is not mandatory, but it is strongly recommended. In this agreement, shareholders can make additional arrangements to give their collaboration a more concrete and practical form. These include agreements on the division of tasks, decision-making and exit arrangements. This agreement only applies between the shareholders themselves and is not publicly available to third parties.

What should you include in a shareholders’ agreement?

Below, we will discuss a number of important topics that should be included in the shareholders’ agreement. This list is not exhaustive. It is advisable for every company to carefully consider which specific agreements are important to make.

01      Commitment and vesting

Shareholders may agree to commit themselves to each other and to the company for a certain period of time. This allows you to create certainty and stability for the company. For example, shareholders may agree not to sell their shares for a period of five years. This is also referred to as a lock-up period. Such a commitment is also sometimes combined with a side activities clause, which means that the founders are available to the start-up on a full-time basis and will not engage in any other business activities alongside the start-up.

In addition, you can agree on a vesting arrangement. This means that shareholders receive their full share package from day one, but that the shares they hold will “vest” over a period of, for example, four or five years (reversed vesting). The vesting arrangement may, for example, stipulate that none of the shareholding is vested at the time of incorporation, that 20% is vested after one year (also known as a cliff) and that the remaining 80% vests in monthly instalments over the following 36-48 months. At the end of the four- or five-year vesting period, all shares allocated to the shareholder will be fully vested. The vesting clauses are usually linked to a leaver arrangement, in which a distinction can be made between a good leaver, an early leaver and a bad leaver.

• A good leaver could be, for example, a shareholder who transfers their shares as a result of death, permanent incapacity for work or because of necessary informal care. The shares of a good leaver are generally valued at fair market value.
• An early leaver could be, for example, a shareholder who terminates their management or employment contract before the expiry of a certain term, for example within the lock-up period or within the vesting period. The vested shares of the leaver must be offered at market value (or at a limited discount thereto) or may be retained, while unvested shares must generally be surrendered without compensation.
• Examples of bad leavers include shareholders who act in breach of the shareholders’ agreement or the articles of association, or whose management or employment contract is terminated due to embezzlement, fraud or inappropriate behavior in the workplace. The bad leaver penalty is often substantial: both vested and unvested shares must be surrendered without the shareholder receiving any of the market value, at most the original purchase price.

Which vesting schedule is reasonable and what the consequences should be of a classification as a good, early or bad leaver is always a matter of customization and depends on all the circumstances of the specific case.

02      Decision-making

One of the most important parts of a shareholders’ agreement is to set out how decisions are made.

The most important bodies within a private limited company are the board of directors and the general meeting of shareholders. The law and the articles of association largely determine which body is authorized to take which decisions. Additional agreements regarding decision-making within the company can be laid down in a shareholders’ agreement.

Board

The board is responsible for the day-to-day management of the company. This day-to-day management also includes decisions on hiring or dismissing staff, making investments and purchasing goods or services. However, some board decisions have such an impact on the company that shareholders wish to have a say in them. These decisions can be subject to a right of approval by the general meeting in the shareholders’ agreement. In this way, shareholders without a seat on the board still have a certain degree of control over the company. It is important to realize that this agreement only works internally: a decision that is taken in contravention of the shareholders’ agreement often remains legally valid in relation to third parties. Internally, however, this may constitute a breach of contract, as a result of which the parties involved may be held liable for performance or damages.

Examples of management decisions that may be subject to approval include decisions on financial obligations and investments. These include entering into obligations exceeding €100,000; concluding commercial contracts exceeding €250,000; attracting new financing; making investments (CapEx) or providing financing to third parties. In this way, shareholders retain a certain degree of influence over the financial position of the company.

In addition, management decisions relating to the conclusion or termination of agreements with shareholders or directors of the company may also be subject to approval. This gives shareholders a say in the governance of the company.

Finally, a right of approval can be linked to strategic business decisions, such as entering into or terminating partnerships, implementing changes in business activities, and determining the business plan and budget. This gives shareholders a say in the direction and future of the company.

General meeting (of shareholders)

The general meeting is regarded as the body with the highest authority within a company. The law grants the general meeting a number of powers, including the adoption of the annual accounts; the appointment, suspension and dismissal of directors; and decisions on amendments to the articles of association, mergers/demergers or the distribution of dividends. The general meeting has far-reaching authority because its members are the ultimate owners of the company and therefore bear the economic risk.

The main rule is that the general meeting decides by majority vote. This means that a decision is adopted if 50% + 1 vote of the votes cast is in favor. In the shareholders’ agreement, you can make different arrangements, for example regarding minimum attendance at a meeting (quorum) and qualified majorities.

Qualified majority

A qualified majority means that certain decisions of the general meeting can only be taken with a larger majority of votes. Often, a qualified majority requires at least two-thirds of the votes. Unanimous decisions are also possible. However, please note that certain decisions are subject to mandatory legal provisions regarding quotas. For example, a decision to dismiss a director may require a qualified majority of votes, but that majority can never exceed two-thirds of the votes. For this reason, this ratio is often included as the standard ratio for all decisions that must be taken by qualified majority.

In addition to the standard qualified majority, an investor majority may also be agreed. This means that a decision can only be taken if a majority of investors (often holders of a specific class of shares, such as preferred shares) agree to it. This gives investors extra security, particularly in cases where they do not hold a simple majority of all shares.

Quorum requirement

A quorum means that a certain percentage of the issued capital must be present, for example 75%, in order to be able to take (all or certain) legally valid decisions at the general meeting. Please note that the law also imposes certain requirements on quorums; for example, the quorum required for the dismissal of a director may not exceed two-thirds of the authorized capital.

Deadlock

In the context of decision-making, a deadlock situation can sometimes arise: an impasse (in a 50/50 situation) in which decision-making within the general meeting or the board becomes impossible because the parties are unable to reach a joint decision. When half of the shareholders vote in favour and the other half vote against, no decision can be taken. This can be detrimental to the business operations and continuity of the company.

Therefore it is important to include a deadlock clause in the shareholders’ agreement. In such a clause, you lay down what happens if a deadlock situation arises. For example, you can assign a casting vote to a third party. You can also opt for mediation or arbitration. You can even agree that a shareholder must sell their shares or be obliged to buy the other shareholder’s shares in the event of a deadlock situation.

03      The transfer of shares

In the early stages of a partnership, the focus is often on starting up and growing the business. However, it is also a good idea to consider the possible end of a partnership at this stage. Under what conditions may a shareholder transfer his shares? And what agreements apply in that case?

If a lock-up period has been agreed, shareholders may not transfer their shares during this period. Only after this period has expired may a shareholder transfer his shares, subject to the conditions laid down in the law, the articles of association and the shareholders’ agreement.

The law stipulates an obligation to offer: a shareholder who wishes to sell his shares must first offer them to the other shareholders. This guarantees the private nature of the private limited company. The articles of association and the shareholders’ agreement may deviate from this, for example on the basis of the following two provisions:

• A shareholder who wishes to sell his shares and has received an offer from a third party must first offer the shares to the other shareholders at the same price and on the same terms. This is also known as the right of first refusal. If the co-shareholders do not exercise this right within the agreed period (e.g. 30 days), the selling shareholder may transfer the shares to the third party.
• A shareholder who wishes to sell his shares must first notify the other shareholders in writing. He must state the price and conditions under which he is prepared to transfer the shares. The other shareholders can then accept this offer within the agreed period (usually 30 days). This is also known as the right of first offer. If the other shareholders do not accept the offer, the selling shareholder may offer the shares to a third party. However, this may not be done on terms more favorable than those offered to the other shareholders.

The above rules are often accompanied by exceptions. For example, a transfer of shares for tax optimization purposes, without a change of control taking place, should be possible. Investment funds often stipulate exceptions for other affiliate transfers, so that the fund has the freedom to restructure the fund structure.

Mandatory offer

Shareholders may agree that they are obliged to transfer their shares in certain situations. For example in case of:

• Termination of the management agreement (which may also be grounds for leaving, see above);
• Long-term incapacity for work;
• Death (in which case the obligation rests with the heirs);
• Change of control (if the shareholder is a company);

Drag Along and Tag Along

Drag-along and tag-along provisions may be included in the shareholders’ agreement. A drag-along provision enables shareholders who wish to sell their shares to a third party to compel the other shareholders to participate in the transaction on the same terms. This clause may be included to enable the sale of 100% of the shares to a third party. It is a common provision whereby majority shareholders can compel minority shareholders to participate in a sale. A good drag-along provision is considered a prerequisite for achieving a good exit value without minority shareholders being able to obstruct the process, but proper arrangements to protect minority shareholders are a must.

Whereas a drag-along right is intended to strengthen the position of majority shareholders, a tag-along right is intended to protect minority shareholders. It prevents minority shareholders from finding themselves in a situation where all major shareholders sell their interests to a third party, leaving the minority shareholder with one or more new shareholders. A tag along right can be activated when, for example, 40% or more of the shares in the company are offered to a third party, with the result that the minority shareholders can participate in the transaction with the third party and sell a proportionate share of their shares on identical terms. Specific (co-)founder tag along provisions also occur.

Valuation

The shareholders’ agreement can set out guidelines for the valuation of the shares. The valuation can then be determined in advance, thereby preventing any discussion on this matter at the time of sale. You can also distinguish between good leavers and bad leavers. Make agreements about the process, timelines and costs.

Conclusion

Many conflicts between shareholders arise because agreements have not been clearly laid down in advance. A sound shareholders’ agreement guarantees the continuity of the company and prevents costly legal proceedings. The above provides an indication of the topics that need to be agreed upon in a shareholders’ agreement. It is important to tailor these agreements specifically to the company in question, its business model and the shareholders involved.

The INC. team offers comprehensive support in formalizing the partnership in a shareholders’ agreement and establishing a company. Please feel free to contact us to discuss your specific situation.