The Importance of Shareholders’ Agreements in Startups

10 February 2016

While startup founders are consumed by passion for their idea and matters of operation they often neglect to adequately manage the affairs between them which inevitably brings them substantial hardship when it really matters. With Cyprus’ new tax incentives to support new and innovative businesses, announcements for “visa startups” and “spinoff universities” and the establishment of startup incubators by respectable organisations in the island, it could be said that Cyprus is making its way into becoming an entrepreneurial startup hub, to benefit local and foreign entrepreneurs but also to attract venture capital and other investors. It is thus quite relevant to address the topic of the importance of shareholders’ agreements in connection with Cyprus companies under which such startups customarily operate.

Surely no entrepreneur enters into a venture with a good friend or a relative thinking they will fall out but when the business kicks off it is often the case that there are differences of opinions or someone feels undercompensated or unappreciated for their efforts, skills or value added. See the example of Facebook for instance.  It is then when disputes between the founders arise and in the absence of absolute clarity on the rights and obligations of each founder against each other and the company the consequences of such disputes could be catastrophic. Enter the shareholders’ agreement!

Shareholders’ agreements generally aim at regulating the relationship between the shareholders and the company and establishing each party’s rights and obligations against each other and the company. By having a shareholders’ agreement there is legal certainty as to a wide range of issues that commonly arise which serves to secure everyone’s interests no matter the point in the lifecycle of the business, change of circumstance or environmental threats and opportunities. Some matters commonly regulated in such agreements are as follows:

Reserved Matters; namely matters requiring the consent of all shareholders before any action can be taken, which customarily includes the issuance of capital (thus dilution), transfer/sale of shares, major financing, amendment of the articles, changes of the name and other important issues idenitifed by the parties.

Management; namely the constitution of the board, representation by founders, the CEO and other officers of the company, their authorities and duties, their remuneration, their appointment and removal and other management related issues.

Exit Clauses; namely the way by which a shareholder can sell his/her shares, valuation methods, rights of first refusal, tag along or drag along rights and other relevant issues.

New Entrants; namely the way by which new persons, or investors can acquire shares, either by transfer or issuance of shares, pre-emption rights and relevant dilution provisions, adherence to the shareholders’ agreement and other issues.

Deadlock;  namely a mechanism to resolve pre-defined situations of dispute, customarily where the parties cannot mutually agree to a reserved matter or there is a tie vote in any type of voting procedure under the agreement or the articles of association.

The above are some very basic clauses normally found in shareholders’ agreement but in the end it comes down to the they type of business and other specific matters which the parties may consider of high importance. These can include non-compete clauses, financing, dividend policy, appointment of auditors and a wide range of other issues.

Its not an easy discussion to have, especially while getting started, but it is in the best interest both of the founders of a startup and any investors coming in later that such an agreement is put in place as soon as possible and way before the business kicks off . The preparation and drafting of shareholders’ agreement should be undertaken by specialist corporate lawyers with the commercial awareness to appreciate the specific nature of innovative businesses, the capacity to understand the concerns of entrepreneurs and investors and the drafting skills to adequately and comprehensively capture all issues with clarity.

For more information on shareholders’ agreements for startups please feel free to contact Varnavas Playbell at Varnavas@playbell.com.