by Jody Doyle
If you’re in the process of starting a new business and want to do things right, you probably already know that it’s important to have the necessary “founding documents” – your memorandum of incorporation and shareholders’ agreement – in place. But do you know what they should cover? This is a guide to the five most important issues every start-up team should consider.
1. What is the relationship between shareholders and funders?
In a well-established company this isn’t an issue: Shareholders have no obligations to provide any kind of funding or other support at all. But nobody gives away shares in a startup without expecting something in return. So, what contribution is each shareholder going to make, and how is that going to be compensated in the long run?
This gets especially complicated in startups because it’s quite typical for the founding shareholders to put a lot of their own money into the business, either in cash or in salaries not taken. A common way to handle this is to specify that loans should always be repaid before dividends are declared. A more hard-nosed option is to decide that whoever can contribute more funding gets more of the shares – this would involve a “call option” or a right to convert your loan into shares. There are other options too, each with different implications in the long term. Choose a lawyer who can explain it all clearly and help you choose the option that works for you.
2. What is the link between shareholding and decision making?
Being a shareholder doesn’t give you any automatic rights to decide how the company should be run on a day-to-day basis. One common mis-perception is that a right to appoint directors effectively affords the appointing shareholder this control– this, however, is is incorrect as any director must act in the best interests of the company (being the body of shareholders, and not the shareholders who appointed them), or face sanction in accordance with the Companies Act, No 71 of 2008, as amended.
So, if you’re a shareholder who wants to maintain a degree of control over the company, you will want to specify certain “reserved matters” which place restrictions on the decision making ability of the directors. If you ever want to bring in a venture capital or angel investor at any stage (and we haven’t yet met a tech startup that doesn’t) they will definitely demand some of these rights. Thinking about these issues right at the start, and drawing up founding documents that reflect what you’ve agreed on, will put you in a stronger negotiating position later as well as saving you grief in the short term.
3. How do you want to tailor the provisions of the Companies Act to suit your needs?
The new Companies Act has been designed to accommodate the needs of a diverse range of companies, from the largest blue chip corporates to the smallest young startup. Primarily, it achieves this by way of a range of default, but “alterable provisions”, which can be adapted in a company’s Memorandum of Incorporation – but if you want to take advantage of these provisions, you have to do some work. An off-shelf memorandum of incorporation won’t cut it.
For example, the default in the Act is that a private company must have a minimum of one director. You can agree to set the minimum higher – but that must be specified in the Memorandum of Incorporation.
4. What consensus is needed to make any changes to your agreements?
This is the stuff boardroom battles are made of and relates to amendments to the agreement. They are always subject to certain requirements (voting thresholds, in the context of an MOI, and (usually) unanimous agreement in the case of shareholders’ agreements.
We’ve seen agreements, for example, which specify that ordinary shareholders don’t even have to attend shareholders’ meetings in order for it to be valid. So if your friendly venture capitalist, to whom you issued shares with certain extra rights attached, decides to hold an important meeting when you’re out of town, there’s nothing you can do about it. It’s important to know all the options right at the start, so you can decide what your position is.
5. What will you do when someone wants to exit?
Three friends decide to start a company together. Two years later one of them makes a deal to sell his shares to someone else. Would you allow that? Would you want to insist that if one person exits, the others have a right to sell their shares to the same buyer as well? What if two people want to sell and one doesn’t? Can the majority force a sale, or not? The consequences of what you agree at the start can be very big indeed; the advice of someone who’s see it all a few times is indispensable.
On the face of it, company law is very dry stuff – a few minutes with the Companies Act will make the average entrepreneur’s eyes glaze over pretty quickly. But the specific dry legal clause you choose could have very dramatic consequences later on. Taking some time and spending a bit of money to get an expert to explain it all to you is an investment worth making.
* Jody Doyle is a partner at Dommisse Attorneys.