Losing Control – 5 Issues to Consider When Bringing an Investor into your Startup

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Losing control of your company is a nightmare scenario for many entrepreneurs, but if you’re a successful business the chances are you’ll want to bring in an investor in order to grow as quickly as possible. This approach is transformational but high-risk. On one hand, the founder and investor will generally work together in the best interests of the company. On the other hand, there can be tension between the powers of the founding shareholder and the incoming shareholder.

This article sets out the five key questions you should ask yourself when negotiating a Shareholders Agreement. In particular, it discusses:

What rights, power and obligations will you and the investor have?

How will you break a deadlock?

What to do if a Shareholder wants to sell?

Who has rights to appoint and remove a Director?

Will the investor have the right to appoint a Director? This is likely to be a threshold requirement for the investor.

Who can remove a Director? The investor’s right to appoint a Director is compromised if the founder can remove the investor’s Director.

What voting power and rights will each Director have?

The Company is managed by or under the direction of the Board of Directors. Generally, the Board makes decisions, unless the

Shareholders Agreement, Constitution or Rules says a decision must be made by the Shareholders at a General Meeting.

It is crucial to determine what power each Director has, including:

Will each Director have 1 vote, or will their voting power reflect their percentage shareholding?

If each Director has 1 vote, in a 2 Director company, how will you break a dead-lock? See point 3 below.

If Director’s votes reflect their shareholding, what can the majority Director decide alone? What requires a unanimous vote, i.e. both Directors?

In a 2 shareholder 2 director company, Board decisions generally need to be made by both Directors for the company to move forward in harmony.

How to break a dead-lock between Directors?

What to do if you cannot resolve a dispute? This can be addressed in the Shareholders’ Agreement. Some solutions are:

(a)Require the parties to meet to resolve the issue, i.e. first the Directors meet, then (if different people) the Shareholders meet, then the parties may go to a third party to help resolve the dispute. What if the dispute is still not resolved?

(b)Agree in advance that you will be bound by the decision made at alternative dispute resolution. What if you do not want to go to a third party?

(c)The majority Shareholder can buy out the minority Shareholder at an agreed price, e.g. fair market value as determined by an independent valuer. The risk is that the majority Shareholder will refuse to agree a solution, to trigger this clause. The benefit is that it gives a way forward if there is a severe relationship breakdown. It allows the founding Shareholder to keep control of the company.

Please note: A Director must exercise their powers and discharge their duties with a reasonable degree of care and diligence, in good faith in the best interests of the Company and for a proper purpose.

What decisions will the Board make, as compared to Management?

The Shareholders Agreement sets out how often the Board meets and what they decide. If you are an Executive Director (employed by the company e.g. as CEO) you may prefer more decisions to be made by management. For example, the company must operate in accordance with the annual business plan, and management decides the business plan. The Board of Directors must however review and approve the business plan each year.

What if the investor wants to sell?

The founder needs rights so they are not left with an unfamiliar and possibly adverse shareholder. Protections include:

(a)Right of first refusal, so the founder or the company has first option to purchase the investor’s shares;

(bTag-along rights, so the founder ‘tags-along’ with the purchase, at the same price that the buyer is paying for the investor’s shares, which generally must be no less than market price.

Vice versa, the investor may seek drag-along rights, so it can ‘drag’ the founder to sell to the buyer, at the same price as the investor is selling, which must be no less than market price.

In conclusion, the right investor can transform a start-up. Taking the time to agree a Shareholders Agreement, to negotiate key issues, settle key terms, and set out a road map, builds a strong foundation for a successful relationship.

 

Important: This information is a summary and an overview. It is not intended to be comprehensive and it is not legal advice. Your use of this information is not intended to create and does not create a solicitor-client relationship between you and Hogben Group Pty Ltd. © Hogben Group Pty Ltd 2013

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