The Simplistic Importance of Shareholder Docs

It is better to address small issues upfront before they can exponentially multiply and permanently damage your venture... and even your friendships.
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So you just came up with the next billion dollar idea, and finally grew the courage to take the plunge and enter the entrepreneurial life. You have a million tasks to accomplish, and there is never enough time nor capital to accomplish all of your goals. There are so many thought processes that are racing throughout your mind. You have to get incorporated, open up the bank accounts, work on perfecting the business plan, initiate the fundraising process, start recruiting talented individuals, commence working on the Beta, analyze what competitors are doing... the list doesn't end and there are only 24 hours in a day.

We all know that in the fledgling stages of a startup it is very chaotic and there are a plethora of tasks to get off the ground. However, one of the biggest oversights that entrepreneurs forget to knock out or structure properly, is the shareholders' agreement. I've seen numerous times where the product, the funding, the talent retention all lead to a successful business, and yet all of that work goes down the drain and gets torpedoed by a lack of planning of the shareholders' agreement. Before analyzing how to best alleviate this, it is important to analyze how an intelligent individual might be oblivious to structuring this the proper way. A common example is the following:

My Partner is my Best Friend... why do I need a shareholder document?

I've seen first-hand so many stories of a start-up environment destroy friendships. While you might be best friends with someone and decide that that individual is the most able partner for this business model, you don't know how that individual will react in the startup zone. The start-up world is an alternate reality where the variables of your friendship have not yet been tested. There is a big difference between enjoying wine tasting events, playing basketball with your friend, or operating in one of the highest pressure cooker environments out there. Working in tight quarters day in and day out with anyone can test the limits of friendships, especially when you are constantly making tough decisions and the sands of time and capital are constantly draining down. Even if your personalities mesh completely, you cannot calculate how your own life will play out, yet alone someone else's. For example, let's say that on day 1 you were an honorable "old school" soul and did a handshake of a 50:50 partnership. After all why waste thousands of dollars on unnecessary legal documents? Let's say after 6 months at the startup, hundreds of hours of your time and employees, and a few hundred thousand dollars were spent from your investors and your partner:

A) Decides he doesn't like the entrepreneurial life and wants to go back to corporate America

B) Gets ill and has to leave the company

C) While his heart is fully invested in the company,he needs other financial resources to support his
family and has to take another part time job

D) Isn't pulling his weight

E) Is getting squeezed between spending time on the startup versus his family

F) One of his parent's gets sick and he has to take care of them

G) An alien kidnaps him

The list of entropic scenarios that could arise in a startup world is endless. If one of the myriad of scenarios above gets played out, then what are you going to do when that partner potentially leaves the company with 50% of the equity? You will either have to buy him out (which always is extremely hairy and taxing to do), leave the Capitalization Table crippled, or dilute him to a figure that "seems" fair for someone to take his place. These scenarios do not forebode well for any stakeholder. It is best to get the expectations, responsibilities, and equity discussions encompassed in a shareholders' document up front. This logic also applies to employee documents as well. If you are an employee, don't jump into a venture until you have the proper employment docs. Conversely, if you are an owner, don't have someone commence working until these documents are finalized. Now someone coming from corporate America might raise their eyebrows that this is a commonplace as breathing air, but with startups a lot of times the sequences of events are not so logically chronological. Thus, the longer that these conversations do not transpire, the greater chance it becomes a ticking time bomb. Even if the business is going flawlessly, I can assure you that it will cripple the business from the inside in a matter of time.

Variables to Consider when Structuring a Shareholder's Agreement

One of the core reasons why partner or employee disputes originate is because of a misalignment of expectations or a lack of the meeting of the minds between the respective parties. The shareholder agreement is a form of legal protection that illustrates what has been agreed upon (as opposed to a reliance on memory or what someone supposedly said months ago), and is a great exercise in that it forces both parties to think about upfront scenarios, compensation, and milestones versus down the road. It is best to conduct these conversations over a beer or in a non-work related environment. Even so, this is not an easy exercise to do, and a lot of times this leads to disagreement between the partners. However, it is better to see someone's thought processes before material connections, capital, and time have been potentially flushed down the drain. Just remember, that no matter how tough it might be to have these conversations, you have a fiduciary responsibility to the company, your investors, your family, your partner, your employees (who are also sacrificing their lives to believe in you and your concept), and yourself to make sure that these variables get properly handled. Spend the few hundred to a few thousand dollars working with an attorney on how to best structure these document. This investment will most certainly save you on the backend.

So what variables should you analyze with your partners? While there are an infinite amount of things that could be incorporated into any legal document, the below can act as a basic checklist to allow you to efficiently think about things before being on the clock with an attorney.

  • Equity %
    • Whose idea was this?
    • Valuing the work done by the different members. (the business plan, intros, what actually materialized from one's work, etc.)
    • Who is Funding the operation? (this is a separate analysis than the sweat equity that is involved with the day to day operations of a managing member)
    • Discussion about voting rights? Who controls the entity?
    • Responsibilities
      • What are the specific titles and responsibilities? (ex: is someone managing 1 individual or a team of 20 people)
      • What are the weekly hourly commitments? (full time, part time, 40hr work weeks)
  • Vesting and Cliff Time Periods
    • Having at least a 1 yr cliff for your employees. You need the proper amount of time to vet your star employees, and without a cliff, you can again cripple your Capitalization Table
    • Industry standard to fully vest is 4 years
  • Milestones (cash or equity compensations)
    • Weighing cash compensation versus equity
    • Creating milestones that are easy, medium, and hard in difficulty
  • Buyout Provisions
    • What is the process for buying out the other members?
    • If disputes can't be addressed, what are the mediation procedures?

The longer that time goes on without the shareholders' agreement being finalized, the higher the chance that a negative outcome will transpire. If this "expectation" conversation does not happen immediately in the startup's life-cycle then either someone is going to potentially get swindled and will harbor resentment, the company will open itself up to potential litigation from disgruntled stakeholders, or simply the energy and resources that are being negatively exerted between the partners and employees will be wasteful versus properly building the business externally.

Therefore, don't be lazy with spending the time and money into figuring out these variables with your partners, and make sure to get a shareholders' agreement conceptualized by a competent attorney. After all, it is better to address these small issues upfront before they can exponentially multiply and permanently damage your venture... and even your friendships.

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