LEGAL CORNER

The Making of RockStar Incorporated
(Part II - The Shareholder Agreement)

By Daniel A. Shmalo, Esq.

In The Making of RockStar Incorporated, Part I – The Creation Story, we discussed the 3 main organizational documents for a new company. Namely, the corporate charter or articles of incorporation, the bylaws and the shareholder agreement (sometimes called a Buy-Sell Agreement). In Part II below, we discuss the Shareholder Agreement in more detail.

Issues typically covered in a Shareholder Agreement include:

• Elections. Who will be the officers and the directors of the company and whether the initial appointments are designated in this agreement. How and under what circumstances directors and officers are removed and replaced.

• Voting. How voting rights are allocated, whether voting is unanimous, simple majority or a form of super majority. Whether any shareholder or group of shareholders have special voting rights such as blocking rights, or the right to appoint one or more directors.

• Buy-Sell. This is a corporate “pre-nup” and is particularly important when the board is deadlocked or the shareholders have a Hatfield and McCoy relationship. One corporate divorce method is a “chicken buy-sell,” where either side to the dispute can make an offer to buy out the stock of the other side. The other side must either accept the offer to sell, or call the bluff and match it. If it matches the offer, then the side that started the process is the one that must sell their shares. Other valuation methods include appointing a neutral mediator or arbitrator or calling in a third-party professional to set a price for the shares that will be sold.

• Serving Your Time. The normal assumption is that the founder(s) will be actively involved in the company for a period of time, most likely measured in years. This aspect of the business deal among the founders is typically implemented in the original founders agreement or at the closing of a professional investment round through stock vesting arrangements (restricted stock). In a stock vesting (or reverse-vesting) arrangement, the investors (or the company or another founder) have the right to buy back the departing founder’s stock at a nominal price when he leaves the company. The amount of shares that can be bought back at the nominal price declines over a period of years until fully “vested.” In addition, the company often retains the right to buy back the rest of the fully vested stock at its fair market value to ensure that all stockholders of RockStar Incorporated are “active” in the company as current employees or financial investors.

• Keeping it “All In The Family.” Related to the point above, startup companies often limit the ability of founders and other principal stockholders to transfer stock to outsiders. When entrepreneurs form a business, an underlying assumption is that the founders will be sharing control with one another, not unknown parties without either having a connection to the business or the technology or being a financial investor. Thus, in the Shareholder Agreement or some other contractual document, the founders’ right to transfer stock to others is typically limited (e.g. a right of first refusal).

Since stock in a private, pre-revenue startup is not easy to sell, the more likely scenario is actually that of a forced transfer — either the death of a founder resulting in a transfer of the stock to the heirs, a divorce that puts the stock in the control of an ex-spouse, or a bankruptcy proceeding. Contract requirements that give the company the right to repurchase the stock in these situations will give control over these events.

• Drag-Along or Tag-Along. No, this is not the latest children’s game or a fraternity hazing ritual. When the opportunity comes to cash out of a privately held company, a prospective buyer may be satisfied with only obtaining a simple controlling interest but not full ownership of RockStar Incorporated. However, in most cases, a buyer will demand 100 percent ownership or no deal. Fixes for these scenarios can be covered in the Shareholder Agreement with so-called “Drag-Along” provisions, where the holder of a large block of stock can force the others to join in a sale, or “Tag-Along” arrangements, by which the smaller stockholders can require that they be included in a sale by the major stockholders. The Drag-Along is a majority shareholder friendly provision that lets the will of the majority dictate the choice of the minority (N.B. may be subject to state law dissenters rights). The Tag-Along is a way for the minority shareholders to squeeze through a window of opportunity (liquidity) riding the coat tails of the fat cat shareholders (typically investors).

High-growth companies normally go through dramatic roster changes and multiple rounds of investments in their life cycle, and each round can involve extensive revisions to the relative rights of each existing and new class of shareholders. These negotiations and subsequent contract revisions can become exponentially complex, and the outcome of that battle depends on many factors including:

• the urgency of the company’s need for new funds;
• the stage of the company’s business;
• the amount of money and percentage ownership being discussed;
• availability of competing investor groups; and
• the sophistication, savvy, and war-time experience of the parties and their lawyers.

Take Away: Remember the old “Eight P’s” maxim that applies here and in many other areas of corporate law - Proper prior planning and preparation prevents piss-poor performance.

For more complete information, serious analysis, and solid legal advice, contact:
Daniel A. Shmalo, Esq.
dshmalo@360vLaw.com
404.575.4360