The 6 Dangerous Bombs in Share Holders Agreements & how entrepreneurs can diffuse them.

Bakra &Bakri (B&B) – two successful entrepreneurs had just started an e-commerce business to sell their sheep wool online and were a happy lot. They had negotiated their term sheet with Mr. VC (read the prequel to this story) and were sitting back in their cottage backyard, nursing single malts. They always drank “Ballantine 17 years”.

Bose’s garden speakers were playing ‘don’t stop thinking about tomorrow’ by Fleetwood Mac.

Bakra’s iPhone beeped; a message from the VC read ‘Check mail. SHA attached’.

Even while he was pulling away the wool from his eyes, Bakra forwarded the sms and the mail to Rodinhood – the Prince of Entrepreneurs who lived in the forest of Enterprise. Rodinhood was a friend of all the Bakras and Bakris who guided and consulted entrepreneurs in their start up life.

Rodinhood read the message and immediately got down to work.

As he opened the SHA (share holders agreement), he took a deep breath. This was the most important document for any entrepreneur and he was determined to be thorough and fair in his perusal and remarks.

1)   Definitions.

First Rodinhood carefully went through the ‘Definitions or ‘Recitals’ – the bullet like descriptions of key terms in the beginning of the agreement and made sure that they were in order. For instance, Rodinhood checked the definition of ‘FMV’ (Fair Market Value) and checked it read fairly. The recitals are important because there are acronyms used multiple times across the agreement and these acronyms are detailed in the recitals.

Rodinhood considered the definition of ‘Control’ and checked if the explanation defined Control as 50% or 51% or was it a loose, under defined meaning. Each interpretation of the definition of control for instance had a different outcome in the long term. 

 

To keep himself relaxed, Rodinhood was sipping Perrier on the rocks, in his favorite rock glass, garnished with a twist of Lime. Beethoven’s Emperor Concerto was playing in the background. The atmosphere was ‘cordial’ enough to come to terms with an SHA.

 

 

2)   Pre Emptive Rights.

Swiftly, Rodinhood came across ‘Pre Emptive Rights’ (the terms that allowed existing shareholders to participate in a new issue first) – and they seemed fine. But he still went through the section once again.

3)   Representations and Warranties.

On Reps and Warranties – Rodinhood made a side note to ask Bakra and Bakri if they had ‘shared’ everything with Mr. VC?

Rodinhood always believed that it was most prudent to reveal everything about the Company to an investor BEFORE taking in their money. If there were secret promoters or other shareholders, they ought to be made public and given shares before the Company was finally structured. Also, if the Company had received some vague legal threat or was under the cloud of potential litigation, it was most important to reveal it all to the VCs. Thinking ‘let me handle this after I get the money in the bank’ is suicidal for entrepreneurs.

In Reps and Warranties, Rodinhood wondered how Bakra and Bakri had reflected their personal loans invested in the Company and what was their agreement with the VC. Rodinhood personally had a view that all ‘moneys’ of entrepreneurs into their own Company be treated as loans and returned gently over a period of time; post funding. Rodinhood felt that his concept was right because the entrepreneurs were putting in their sweat, blood and tears into this start up which was way beyond a few lacs of money. Besides moneys taken from relatives, friends and even piggy bank savings were best returned to entrepreneurs so that they could focus solely on the business.

The rock glass was sweating as the ice and Perrier got acquainted. The lime slice was quickly become the stranger in the mix.

4)   Restrictions on Transfer of Shares.

Was the next section that made Rodinhood sit up. This SHA locked 75% of the entrepreneurs’ shares in an escrow to be earned back by the entrepreneurs over a period of 3 years.

 

While Rodinhood accepted that VCs needed to ‘lock-in’ entrepreneurs by locking in their entrepreneur shares over the next few years in the Company (post its funding so as to protect the VC’s from founders just walking away), Rodinhood always had the following tenets for entrepreneurs:

 

  • Entrepreneurs could always try and negotiate the maximum number of shares  % ‘outside’ the purview of the lock in. The standard was 25% (so 75% got locked in), but negotiating 33% was not difficult. The unlocked % depended on the life cycle of progress at which time the start up was getting funded (the later the time to funding, the higher the unlocked shares %)
  • The ‘release’ of the locked in shares could be structured ‘monthly’ rather than ‘quarterly’ and at worst ‘yearly’.
  • The maximum period of lock in could be a maximum of 36 months.
  • The MOST important aspect was WHAT would happen to locked/escrowed shares in the event that the promoter LEFT the Company. The best outcome would be for the Company/VCs to buy the shares back from the entrepreneur at Fair Market Value and the worse would be that the entrepreneur shares flowed back to the ESOP pool or to the VCs at the price the promoter paid for them (par value). 

Rodinhood’s rational on fair pricing for the exit price of the promoter (in such extraneous events) was the logic that a lot could happen in 3 years. The industry could change tremendously – the VC’s and other founders may completely want to take the business in another direction. Hence it was important that the VALUE created at the time of departure of the promoter be captured and handed over to her.

 

 

The agreement was now half way reviewed and Rodinhood took a break to stretch his legs.  He changed the Emperor Concerto that had just finished playing the second time to Mahler’s Syphony No 1 ‘The Titan’. Rodinhood needed his favorite symphony to give him a natural high at this point.

 

5)   TAG ALONG rights.

In this SHA, the tag along rights read like they always did.

Rodinhood had one very important point on this. In the part where it was clear that the investors could ‘tag along’ with the promoter in the event that the promoter was selling and the investors also wanted to exit, Rodinhood made sure that in the event of less than a 100% exit of all shares, everyone in the Company sold their shares pro-rata.

To explain his point, Rodinhood added this side note to Bakra and Bakri (B&B):

Imagine if after a few years, your business is doing well, and you meet a Company called Goat and Sheep (G&S) of Britain who have a similar business like yours; but their business is much larger and is publicly listed. G&S love what B&B do and the fact that B&B are in India – so offer to buy B&B out. However, they want only 51% of the Company. As per the existing ‘Tag Along’ rights, while you (B&B) make the effort of finding an acquirer and negotiating the best price, the B&B Company investors (who say would own 60% of the Company) will have the rights to TAG ALONG with B&B.

In the present agreement, the investors in B&B had the Tag Along rights to offer their ENTIRE portion of shares first and then allow the rest to be sold by B&B. Given that 51% was being bought out, it would mean that none of Bakra and Bakri’s shares would be acquired by G&S! This will leave B&B stuck with the Goat and Sheep Company who would never offer to buy B&B’s remaining shares out!

So, in the event of a partial sale, it was critical to negotiate ‘pro-rata’ tag along rights so that in case of, say  51% being acquired by Goat and Sheep, EVERYONE in the B&B Company has a right to tag along – thereby benefiting promoters, investors and of course ESOP share holders. This pro rata tag-along was very important when strategic companies acquired operating firms.

Rodinhood took the last swig of what remained of the Perrier and chewed on the ice cubes that had come along. The twisted lime now looked like a complete stranger in the glass.

6)   DRAG ALONG rights.

Came next. Rodinhood thoroughly went through the clauses and they read exactly the way they were supposed to. He sighed. He had no comments to make on the same – despite having fought and won a bitter battle on these same rights. Just to make B&B understand the implications of DRAG ALONG - Rodinhood inserted a hyperlink of his classic blog post (the toughest decisio... relating to this subject for Bakra and Bakri’s reference reading and left it at that.

 

The rest of the document read fine. Rodinhood made sure to point out that it was nice to keep the Board as small as possible (two from the promoters side and one from the investors), so as to be able to accommodate a larger board with subsequent investments.

 

Finally, Rodinhood made a footnote for B&B to diligently make sure that the Conversion, Liquidation Preference and ESOP clauses were in accordance with what was negotiated in the term sheet. These 3 terms were as important as the 6 terms described above.

 

The evening had burst into the night. Rodinhood smiled as he mailed the SHA with his remarks to Bakra and Bakri. He was happiest helping fellow entrepreneurs and this was truly one of those moments.

*****

 

Tags: Conversion, Drag Along Rights, ESOP’s, Entrepreneurs, Liquidation Preferences, Lock-In’s, Pre-Emptive Rights, Representations and Warranties, Restrictions on Transfer of Shares, Rodinhood, More…SHA, Share Holders Agreements, Tag Along Rights, VC

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Nice point. Varun - can you elaborate it here for the audience!

This is very informative and useful!

This is of great help. I have not dealt with VC's yet and have little knowledge in this area. This surely helped grow it a little :)

Fantastic. This is very educative.

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