SHAREHOLDERS' AGREEMENTS, VESTING SCHEDULES AND CLIFFS

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What’s a Shareholders’ Agreement?

When you start a company with more than one shareholder, investing in a Shareholders’ Agreement is without a doubt, one of the best decisions you’ll ever make. The reality is, co-founders are only people. People are very different - in their ways of working, their visions, their willingness to change direction, their talent at selling their product and their ability to get stuff done. They also go on to have families, divorce their partners and decide to drop it all and go travelling. Shareholder relationships are like every other human relationship and that means, they change. A Shareholder’s Agreement will help protect your company from being forced to change too.

A Shareholder’s Agreement is a private agreement between the shareholders of the company. It can regulate when each shareholder gets their shares (through a vesting schedule), whether there’s a grace period before any shares vest (cliff) and what happens if one of the shareholders doesn’t deliver what they promised.

It also regulates how the company is managed and controls when and how shares are transferred to prevent a scenario where the investor of your dreams comes along and a shareholder refuses to sell or dilute their shares (‘tag-along’ and ‘drag-along’ provisions). It also protects you in the event a shareholder wants to sell their shares so that you have a right to buy their shares first before they offer them to anyone else (‘pre-emption right or ‘right of first refusal’).

What’s more, a Shareholders’ Agreement can also provide a mechanism whereby a person’s shareholding is linked to their employment (e.g. their Directorship), so that if they were to leave they must offer their shares up for sale. It can also include different valuation mechanisms depending on the circumstances under which the relationship with the company comes to an end so if the leaving shareholder is a ‘bad leaver’ (i.e. they leave under bad circumstances) then you only pay a nominal price for their shares.

Finally, if you’re going for investment, an investor will often want to see that you have your “house in order” and that you have documentation in place that regulates the relationship between you and your co-founder (even if they want you sign another shareholders’ agreement once they’ve invested in your company).

What’s a Vesting Schedule?

The concept of a Vesting Schedule originates in the US. In fact, the whole idea of a vesting schedule is not officially recognised in English Law and so the only way to make it effective is by clearly drafting it in your Shareholders’ Agreement.

Unfortunately, some lawyers advise against vesting schedules on this basis but we think it’s having a vesting schedule is a great way to minimise your exposure and create the right motivation and behaviours to give your company a better chance of success.

Having a Vesting Schedule means that instead of all the promised shares going to a shareholder immediately, they become fully entitled to them (or ‘vest’ in them) gradually over a period of time, usually 4 years. This means that if you agreed that your co-founder would take 50% of the company’s shares over 4 years and they decide to leave after 6 months, she would be entitled to only 1/8th of her total 50% (6.25% of the company shares). If she left after a year, she would have ¼ of her 50% (12.5%) and if she left after 3 years, she would keep 3/4 (37.5%).

As mentioned above, because vesting schedules aren’t recognised in English law, there are some tax implications and filing impracticalities with having a vesting schedule in its pure US firm i.e. where the shares actually vest in the co-founder gradually.

A solution to that problem is to sign over all the shares upfront but keep a right to buy them back (“buy-back clause”) through your shareholders’ agreement at nominal value (i.e. the price they were worth when the shares were first signed over to the co-founder) if the shareholder leaves or under-delivers and you ask them to leave.  Over time, the company will retain the right to buy back fewer shares, until the shareholder is fully vested. This is known as “reverse vesting”.

What are the benefits of having a Vesting Schedule?

Having a Vesting Schedule incentivises co-founders to stay in the business longer. The longer they stay, the more of the company they own. It also allows you to set out some clear-cut rules about what you expect from that co-founder so that if she doesn’t deliver, you can ask her to leave and buy back her shares at nominal value. That minimises your risk when you enter into such a ‘partnership’.

What’s a Cliff?

Adding a ‘cliff’ to your vesting schedule is the perfect way to offer a strong incentive to your co-founder without taking too much risk. If you add a one-year cliff in your vesting schedule, you’re effectively saying that if the shareholder leaves or doesn’t deliver what she should within that year and you want them to leave, then they walk away with nothing.

For example, if you agree to give your developer 10% of your business over 4 years with a one-year cliff, and she leaves before the year is up, then she gets nothing. However, as soon as she gets past that first year, she becomes fully entitled to 2.5% of the equity i.e. you can no longer buy her shares back at a nominal value. If you agree to buy her shares back at this point, they will have to be bought for market value after your company is evaluated by an independent person and the value of the shares is determined. On year 2, she gets another 2.5% bringing her total equity to 5% and so on. If she makes it to the 4 years, she gets her full 10%.

Is this right for me?

Vesting Schedules and Cliffs are not suitable in every instance and also, they can vary massively depending on what it is that you want to achieve. Contracts are not just there to protect you but also to create the right behaviours that will help your company succeed in achieving its goals, roadmap and milestones. Considering each company is unique and each founder’s goals are different, it is a good idea to get some guidance and legal support if you’re unsure about what you need.


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Kaveesha ThayalanComment