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Every Founder should know! Why is shareholder’s agreement important?

Starting a business can be a dream come true for many. Founders tend to do the unconventional by taking chances and betting on their ideas and belief. Undoubtedly, building a large venture takes a lot of efforts and it is natural for the Founders to be emotionally attached to their businesses. However, at times, when businesses get big and lot of investors come on board, Founders may tend to loose their attachment from their brainchild. While the reason can be many folds, usually, like any relationship, difference of views and inability to drive our own vision tends to separate Founders from their ventures.

A study shows that most Founders surrender management control long before their companies go public. By the time the venture reaches 3 years old, 50% of the Founders do not remain the CEO. This number further went down to 25% by the time the company goes public. Study further shows that 4 out of 5 entrepreneurs are forced to step down from CEO’s post.1

While investors always tend to increase their value of investment, Founders may not at all times be inclined towards increasing value. On the other hand, Founders usually prefer to retain more control. This, however, may not be favorable at all times as it would impact the venture’s ability to raise higher sums from investors. This constant tug of war between investors and Founders tends to create difference of opinion.

This dilemma can be seen as far as in 1917, when Henry Royce was pushed to merge Rolls-Royce with Vickers, a large armaments manufacturer, in order to form a stronger British company. In a chapter in Creating Modern Capitalism, Peter Botticelli records Royce’s reaction: “From a personal point of view, I prefer to be absolute boss over my own department (even if it was extremely small) rather than to be associated with a much larger technical department over which I had only joint control.” .  This clearly indicates that Royce wanted to retain control and not money.

Money vs. power, is quite a difficult choice to make and Founders from the early stage would have to make this choice, depending on the nature of business as well as their vision.

Here are some hard realities of Startups – 9 out of 10 startups fail. Research suggests that 21.5% of startups fail in the first year, 30% in the second year, 50% in the fifth year, and 70% in their 10th year2.

While this may sound discouraging for Founders, for investors they simply just loose their money. Statistics suggests that 75% of the venture-backed startups never return cash to their investors. Since, investors have to bear a monetary loss, it becomes valid for them to exercise control or at times provide direction to the venture which Founders may not like.

Keeping in mind the overall success rates of startups and the premature exit of Founders, one of the key documents which governs the entire relationship between investors and Founder is the shareholder’s agreement.

In our report, we have compiled and explained the various terminology and clauses of a typical shareholders agreement, what do these clauses mean and how should a Founder negotiate such terms while raising money from Founders.

Our report, amongst others, focuses on the following aspects of a shareholders agreement:

  • Board management rights
  • Pre-emptive rights
  • Affirmative rights
  • Anti-dilution rights
  • RoFO vs RoFR
  • Liquidation Preferences

Undeniably, the Founder’s vision and desire to grow the company and make it to the million/ billion $ club holds more value than the terms of a contract. However, the idea behind this report is to make Founders aware of key terms, specifically, for those who do not have any legal background.

It is advisable that each clause of a shareholder’s agreement is negotiated keeping in mind the long-term vision of the venture and not in haste. A well negotiated shareholder’s agreement should result in sufficient powers for the Founders and act as a catalyst to grow the value of the business, in other words, should make the Founder a “wealthy King” and not just wealthy or a King.

This post is part of our Founder’s handbook – “Negotiating Shareholder’s Agreement”, a comprehensive handbook for founders to negotiate shareholder’s agreement. Click here to download the complete handbook.

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