While establishing the company, the founders should adjust their relations with each other in order to avoid future and often unnecessary disputes. Well-set rules can even increase team stability in difficult times. Moreover, you will not avoid an agreement on mutual rights and obligations while receiving an investment.
Founders’ relations are regulated in an obligatory memorandum of association (MoA) (in the case of a joint-stock company in the statutes) and sometimes also in a voluntarily concluded shareholders’ agreement (SHA).
1. Memorandum of Association vs. SHA
The memorandum of association, the statutes and the shareholders’ agreement are 3 different documents, not synonyms!
While the memorandum of association and statutes contain only mandatory corporate data (about shareholders, registered capital, initial directors, supervisory board and such), SHA regulates the rights and obligations in more detail, with emphasis on relations between shareholders (eg. vesting), the system of governance and prevention of future conflicts. Unlike SHA, the conclusion and changes of the memorandum of association are subject to the approval of the general meeting.
While the memorandum of association and statutes are compulsorily stored in a collection of deeds, publicly accessible in the business register, SHA is not published. SHA is therefore a suitable tool for adjusting sensitive relationships between shareholders, such as the method of nominating directors or members of the supervisory board, the conditions for issuing employee shares and stock (ESOP), non-compete clauses or the conditions for the entry of the investor(s).
2. Memorandum of Association
The memorandum of association may, in addition to the mandatory corporate data, regulate other important technicalities. If these technicalities are to be enforceable, they must be included in the memorandum of association. These are the right of first refusal, the prohibition of inheritance of shares, the share of voting rights and profits and similar. It is also possible to specify them (beyond the mandatory legal framework) in more detail in the SHA.
The Right of First Refusal
In the case of a transfer of shares to a shareholder or a person outside the company, you can mandate the right of first refusal. In such a case, the seller must first offer the transferred shares to the other shareholders at the price at which they intend to sell them. If more than one shareholder is interested, they should typically divide the share(s) according to the proportionality of their existing shareholdings. However, you can codify the exact aspects of the right of first refusal in the memorandum of association. The advantage of the right of first refusal is that shareholders have the opportunity to control the entry of third parties into their company.
The Prohibition of Inheritance of Shares
In the case of natural persons, it is appropriate to exclude the inheritance of share(s) (in the Czech Republic, however, this is not possible for a.s. and cooperatives) so that the founders do not lose control of the company. When it comes to inheriting, you have no control over who will inherit the shares, and many times you don’t even know who the heirs are or will be. The ongoing inheritance proceedings against the inherited shares may also cripple or slow down the decision-making of the general meeting.
As a result of the exclusion of inheritance, the share(s) are transferred on the death of a shareholder to the company, which then (ideally on the basis of an agreed system) transfers them to the remaining shareholders. At the same time, the company will pay the heirs for the shares thus acquired.
Voting represents the fundamental ability to manage the company. Startups are characterized by frequent changes in the ownership structure. When allocating voting rights, try to think at least 3 to 5 years in advance and keep a sufficient margin. You have more options. E.g. not every shareholder must have equal voting rights or voting rights proportional to their shareholding. In ESOP, it is common for team members to have no voting rights. Investors also want the founders to have a majority of the voting rights after the seed investment. If they get too diluted, their company may become unattractive to investors.
Consent to the Transfer of Shares
You can secure the control over third-party access to your company by mandating the need for consent of the general meeting of the company to the transfer of share(s). For this purpose, you can also set a higher number of required votes than the legally required majority of votes of the shareholders present. Consent to the transfer of shares can also work in addition to the right of first refusal.
In addition to its non-public nature, the main advantage of SHA is the contractual freedom and flexibility it offers. All or only some of the shareholders may become the parties to it. The company itself can also be a party, especially if you want it to be bound by certain obligations. It is often a matter of fulfilling KPIs, which are the condition for further investment tranches from a new investor. However, it may also be an obligation not to grant an exclusive IP license to a third party (e.g. in the case of a product startup).
In SHA, we recommend agreeing on a sanction mechanism in case of a breach by party (bad leaver). The sanction for such a violation is enforceable in court. A frequent sanction is the obligation of the infringing shareholder to sell their share(s) at a reduced value to other shareholders. The penalty may also be the obligation to return all or part of the investment provided to the investor.
As SHA is a contract, any changes require the signature of all parties. With a large number of parties, the accession of new shareholders or the need to change even one of the SHA provisions may be a nightmare. Therefore, we recommend agreeing on a power of attorney for a party to sign the accession of a new shareholder or an amendment to the SHA with respect to (at least) minor changes.
4. The Basic Institutes of the SHA
The law does not stipulate any mandatory SHA requirements, but there are several standard institutes:
The right to tag-along
The tag-along protects the minority shareholders, allowing them to sell their share(s) together with other shareholders who want to leave the company. The aim is to avoid a situation in which the founders agree with the new buyer on exiting, while “forgetting” to involve minority shareholders. The tag-along thus brings more confidence to the team. Keep in mind, however, that reduced liquidity of shares is the consequence of tag-along.
The right to drag-along
Drag-along usually serves the founders, enabling them to force minority shareholders (investors and team members) to sell their shares in the company’s overall exit. The buyer can make the acquisition conditional on the acquisition of a 100% stake in the company. Drag-along increases the ability of founders to dispose of the company.
Non-competes for shareholders
Non-compete prevents the disclosure of know-how to competitors or the creation of new competition by the shareholders themselves. Its purpose is the commitment of the shareholders that during their time in the company and usually 12 to 24 months after the termination of their participation in it, they will not carry out or otherwise participate in activities that would be of a competitive nature.
Employee shares (ESOP) and vesting
Shares distributed to team members increase loyalty, as team members are not employees in the true sense of the word, but partners. If the company succeeds, they will also benefit. However, shares in the company are not just handed out. Team members must earn them.
Most companies make the acquisition of shares conditional on employment over a 3-4 year period. Sometimes the size of the shareholding is also determined by the fulfilment of the agreed KPIs.
- Reduces the turnover of the team, as its members are motivated to last until the end of the vesting period, especially during difficult periods.
- Reduced team turnover decreases the cost of hiring and training new members.
Vesting can be set up based on the following criteria:
- Time of acquisition of shares: The vesting period is usually between 3 and 4 years.
- Cliff: A kind of “guaranteed minimum”, setting a minimum period (typically 12 months) of participation before the employee is entitled to the first part of the shares. If a team member leaves the company before a cliff occurs, he will not acquire any shares.
- Vesting frequency: After the cliff, the remaining shares may be vested at regular intervals, typically once a year or once a month. Annual cycles represent for some types of ESOPs a lower administrative burden.
- Calculation of the size of the share: For key people, it is usual to agree with them on a share amount (subject to dilution) that they can vest over 3 to 4 years. Other team members typically receive shares tied to the amount of their remuneration, e.g. they vest equity equal to 20% of their monthly remuneration each month. In this case, it is necessary to determine the formula for calculating the value of the company. But there are several other possibilities.
The conditions for founder exit
Vesting is often applied to the founders themselves, who are key to the success of the business and are not easily replaceable. Vesting for founders can also be combined with a lock-up period (long notice period), which allows the founder to leave the startup only after the expiration of e.g. 12 months after the notice is served, while the exiting founder is obliged to train their replacement.
Deadlock shoot out
Exceptionally, a shareholder or a group thereof may deadlock the general meeting. This will prevent the company from functioning. The solution is Russian roulette (shoot out). This most often happens in important decisions, where an absolute majority of all votes is required, e.g. sale of the company, entry of a new investor.
Mechanism: Blocked shareholders may invite blocking shareholders to buy shares from them at a set price. If the blocking shareholders do not take advantage of this offer, they will automatically offer their shares for sale to the blocked shareholders who are obliged to buy them at the same price.
In future investment rounds, in which the share price will be lower than in previous rounds (down round), mechanisms against disproportionate dilution of existing investors’ shares may be activated. You have 2 options: broad-based weighted average and full ratchet. However, these are complicated mechanisms and we recommend consulting experts.
5. SHA Limitations (it is not omnipotent)
SHA should not conflict with the memorandum of association and applicable law. It may be that some provisions will not be effectively applicable in practice, as the memorandum of association regime is always applied to third parties. For example, if SHA excludes shareholding inheritance but the memorandum of association does not, shareholding inheritance will be retained.