Startup Contracts Explained: 5 Risks You Take

This is you, this is your

startup

, these are your investors and this is your Shareholder Agreement. The SHA is a document signed by all shareholders and effectively manages how control of the company is distributed among them. Typically, the larger the company, the longer the SHA and the more difficult it is for us mere mortals without a JD to understand. Everything written in the SHA is subject to negotiation. So, be careful to consider these five things before you sign. When a company raises cash from new investors, existing shareholders are diluted, meaning their percentage ownership in the company decreases as the new investor receives newly issued shares.

If you've seen Part 1 (if you haven't, watch it now), you may remember that I said that each shareholder is diluted proportionally to his or her s

take

in the company. So in our case, with a new investor coming in with 25 percent, if they own 40 percent they lose 10, if they own 20 percent they lose 5. Well, I lied. Dilution is NOT always proportional. The SHA could include an anti-dilution clause, completely exempting a given shareholder from dilution by simply granting them new shares when a capital run occurs. And if one man is not diluted, because of the way percentages work, then others must be diluted even more in his place.

In one famous example, the SHA included a clause granting antidilution to all shareholders, with only one of them taking the hit. "Brand!" "Are you connected". "I'm sorry?" "Are you connected." "Is he?" "Yeah." crash "How about you're still online now?" "Security." "You issued 24 million new shares." "They told him that if new investors appeared..." "How much were their shares diluted? How much were yours diluted?" "What was Mr. Zuckerberg's shareholding reduced to?" "He wasn't." "What was Mr. Moskovitz's shareholding reduced to?" "It was not". "What was Sean Parker's shareholding reduced to?" "It was not". "What was Peter Thiel's shareholding reduced to?" "It was not". "And what was your ownership interest reduced to?" "0.03 percent." To prevent this from happening to you, always be careful about diluting your SHA.

The Board of Directors is for a company very similar to what a Parliament is for some democracies. It elects the CEO in much the same way that the German Parliament elects the chancellor. And they can influence and/or veto the decisions made by the CEO. Note that the board is not involved in day-to-day operations and should not be confused with a company's management or executives, although some of these will typically also be board members. But in general, who determines the members of the board of directors? Just as voters determine who is in Parliament, shareholders determine who is on the board of directors.

And in the case of

startup

s and private companies, these are usually the founders, investors and other people such as employees, friends and family. But, once again, not all votes have the same weight, as happens in certain democracies. ba dum tss The number of board seats that a shareholder can determine is usually loosely correlated with the number of shares he owns, but also with his position within the company and his negotiating ability. For example, in a young private company with five board seats, the co-founder and CEO might determine two of them and have only a 20 percent s

take

, because he is very charismatic, likable, and important to the company, while that another founder who also owns the same 20 percent comes to determine none.

A large investor who owns 30 percent determines two others, while a first investor with only a 10 percent stake determines another. Others, although they make up a total of 20 percent, do not speak with a single voice and are out of the loop. Once it is agreed who can determine how many board members, that is what is written in the SHA. And once signed, the deal is done. So you better pay close attention to the Board of Directors section. Let's say you invested some money in a friend's startup at an early stage and now you have a small stake in it.

The lead investor is a famous guy who bet on his friend's idea and has a majority stake in the company, including most seats on the board of directors. Things are going well and one of the big guys shows some interest in the startup, to the point of wanting to buy control of the business. Good news for the big guy! The only one you have to talk to is Mr. Majority who is here. He can now exit his majority stake and make a good profit on his initial investment. And you and the other minority shareholders can go to hell, right?

Not so! The Tag-Along clause puts a big asterisk on that agreement. It gives the minority interest the right to sell the same part of its interest at the same price and conditions. And if the big man only wants to buy control, but not the entire company, then he is buying everyone equally. Therefore, if you are a minority shareholder in a company, be especially sure to include your accompanying rights before signing. Now maybe you are one of the big investors and your exit candidate wants to buy, not just control, but the entire company. You think it's a great business, but those pesky small investors disagree and tell you, "We won't sell our shares!" And you tell them: "Yes, you will!" And they say: "Make us!" Turns out you can do it thanks to the Drag-Along clause.

The Drag-Along gives the majority shareholder the right to force the minority shareholders to sell their shares on the same conditions as them. So if you have a large stake in a small business, the Drag-Along clause will be important to you. This is you, this is your startup and these are your employees. Employees need incentives and what better way to incentivize them than to make them co-owners of the business? "Here you go! Now I can pay you half your salary and make you work harder at the same time!" But where do these actions come from? Who gave away part of their participation?

The answer to this question brings us back to the first issue: dilution. When a capital rush takes place, it is decided how many shares should be created and reserved, only to be distributed among the foot soldiers: the data processors, the salespeople, the managers. Where is the trick? Whenever new shares are created from one end, dilution must occur somewhere on the other side. So if the stock option pool fills up to 10 percent, then all existing shareholders will be diluted with that same 10 percent of their stock. But it gets more complicated than that. As discussed in 1, some shareholders could protect themselves against dilution of the stock option pool.

The new investor, for example, made it a condition for his juicy investment not to be affected by the dilution of the stock options fund in this round. Tough luck for the rest of you. Oh look, the co-founder also negotiated his way out of the stock option pool dilution, because he didn't get any board seats after all! All this haggling is part of the process that could go unnoticed if you don't know what to look for. But in the case of at least five things, now yes! Thanks for watching! Creating these videos has become a time-consuming hobby of mine and your support has been amazing!

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