How to Navigate Your Startup When Surrounded by Piranhas — The Shareholder Agreement explained for entrepreneurs (part 4/4)

Over the last 6 years I’ve talked with around 50+ entrepreneurs about Shareholder Agreements and I noticed it always led to discussions and they are often misunderstood. So in this series I shine some light over the Shareholder Agreement (SHA); the terms used by investors. Why they are important for the investor, what the consequences are for you, the founder.

The first part and second part can be found here, here and here and are a recommended read before continuing, to get the full picture.

The way companies start out and grow differs. A common strategy is choosing to bootstrap (lower the cost and try to grow on the profit margin), which helps the founders to retain as much equity as they can. Most of the startup founders at Holland Startup know they need capital to grow the company. They choose to sell parts of the company to later stage investors, as a consequence all existing shareholders dilute on new investors.

In principle investors invest in Companies to make a return. Returns are gained by receiving proceeds paid as; interest, dividend, or exit proceeds.

Since Holland Startup is in the business of creating high growth companies, we expect you to reinvest as much of your capital in future growth. So we do not expect any dividend payments.

Dividend Policy

The Shareholders have no expectations of future dividend payment from the Company, but in the event of a dividend payment, the Shareholders shall pro rata their shareholdings be entitled to such payment, provided however that the investor shall be entitled to receive from the dividend payments EUR xxx.xxx prior to any pro rata payments.

But in the event of a payout to shareholders we would like to first receive our minimum return before any other shareholder receives its pro-rata part.

In the event of an Exit (14.4 Proceeds) or a Liquidation (payment of liquidation dividend, or bankruptcy or dissolution (ontbinding) of the Company), the Parties shall procure that the aggregate proceeds of the Exit shall be distributed as follows:

• first, the Investor shall be entitled to receive from the proceeds EUR xxx,xxx increased with unpaid and declared dividend (if any) and other unpaid amounts and decreased with any paid dividend (if any);
• secondly, the Founder Holdcos (on a 50/50 division) shall be entitled to receive from the proceeds, if any, EUR x,xxx,xxx, decreased with any paid dividend (if any); and
• finally, the remainder of the proceeds, if any, shall be distributed to all Shareholders (including the Investor and the Founder Entities) pro rata their shareholdings.

Investors in general, and more specifically the backers behind Holland Startup, need a minimum return within the investment time frame to justify the investment and to enable a sustainable investment business.

The Entrepreneurs Perspective

The distribution of earnings is set up in such a way as to protect the interest of the minority shareholder. Entrepreneurs understand Holland Startup will go first when proceeds are distributed to shareholders to provide a minimum needed return. The consequence can be that if proceeds are low, in the event of a poor performing company or liquidation, the entrepreneurs receive less or not their pro-rata at all. But if the company does well then the distribution will be so that everyone will receive their pro-rata part.

Length of agreement

We believe it will take at least six (6) years to create a meaningful company. So it is the intention of the Parties to effectuate an Exit (14.1) as soon as practicable and in any event within 6 years from today.

Before you sign up at Holland Startup, you need to be aware of the fact we build startups to sell our position. If you want to hold on to your company forever or you expect 100% control, Holland Startup is probably not the best place for you.

Because we are an investment fund we need to create an artificial liquidity event to pay back our investors. Most funds run: 5+5. 5 investment years with a holding period of 5 years before an Exit.

Given the nature of our company our fund is designed a bit different. We have a 3+6 structure; 3 investment years with a holding period of 6 years before an Exit.

If after 6 years following today an Exit has not been achieved, the Investor shall have the right to require (14.3 Forced Exit) the other Shareholders and the Company to cooperate in an Exit.

The Entrepreneurs Perspective

At the moment of a sale, it may happen that the entrepreneurs are also forced to sell their shares. The conditions of the sale would be against the same terms and conditions as Holland Startup. All parties are aligned to get the best deal possible.

Forced Exit

In the case of a Forced Exit, we could run into the situation where we have found a buyer, but this buyer only does a deal if he can buy a bigger (eg. 51% or 100% of the company) part than what Holland Startup owns (##%). In this case we need to effectuate a Drag-along clause (22) where we drag you (the founders) in a transfer:

Without prejudice to clause xx, in the event of an offer for the purchase of all Shares by a third party is agreed upon by the Investor after 6 years from today, all Shareholders shall be obliged to also transfer 100% of their Shares to such third party at the same price and other terms and conditions as applicable to the Builder.

The Entrepreneurs Perspective

Without a drag along clause, it could be that a good deal cannot be made for Holland Startup to sell its shares. Future investors may be interested in having majority shares and will only purchase in such a situation. You will get the same deal that Holland Startup is willing to accept. Many times, the buyer is interested in keeping the co-founders onboard, in which case further agreements are made regarding re-investments in the company.

No encumbrance

Although Shares are assets you could encumber at your local bank to get a loan or mortgage, we need to prevent this situation from happening. Because if you can’t comply with the bank covenant, even if it is without fault, the bank takes over your shares and sits on the board. This situation is not in the best interest of the company, so no encumbrance is needed:

A Shareholder shall not establish or create an Encumbrance on its Shares without the prior approval of the Qualified Majority. The voting rights of the Shares shall remain with the Shareholder.

The Entrepreneurs Perspective

The no encumbrance clause makes sure that the people who sign the SHA are the same as our shareholders a few years from now.

Transfer within company

As Holland Startup is an investment fund where changes need to occur from time to time, we request from all entrepreneurs we can transfer our shares within the same organisation. Only to uphold our duties towards our Investors.

19.1 Subsidiary

The Builder may transfer all or part of its Shares to a wholly-owned subsidiary, provided that appropriate transfer back provisions are in place and furthermore provided that the Builder remains jointly and severally liable for the obligations of this agreement.

Selling options

Although we all know it takes up to six (6) years to build a meaningful company, there are two scenarios in which we would like to have the option to sell our shares:

19.2 Other

In addition to clause 19.1, the Builder may transfer all or part of their Shares:

• to an Affiliate, Affiliated Fund or another investor, for purposes of syndication; and
• to any third party as from the date three (3) years after today.

The first one (19.2a) is to make sure we can do our work as venture capital investor. Most of the time a company needs more capital than our fund can provide. In these situations we will look for co-investors who will invest against the same terms as Holland Startup in your company.

The second situation (19.2b) is if after three years the shareholders realize the company is not ideal for a venture backed strategy but should move on bootstrapped. Founders who bootstrap do not need external financing nor are they on a steep growth trajectory. You as entrepreneur will have probably learned Holland Startup is not the best place for you. If this is the case we will look for an option to buy us out. So you have your company and we have a return.

The Entrepreneurs Perspective

As an entrepreneur you know this is needed so Holland Startup can build their fund and act accordingly. All transfer back provisions are in place, it does not influence your position nor does it affect your company. No problem!

Tag-along right

In the case a purchaser makes an offer to all or parts of the company, all other shareholders have the right to sell their pro-rata part. This right is called a Tag-along right:

23 Tag-along

Without prejudice to clause 21, in the event that any or all of the Shareholders wish to transfer some or all of the Shares held by them to a bona fide third party (the Proposed Purchaser) under at arm’s length terms and conditions, the other Shareholders shall each have the right to require the Proposed Purchaser to purchase from said Shareholder(s) the proportional part of the Shares held by said Shareholder(s) under the same terms and conditions as applicable to the transferring Shareholder(s) by giving notice in writing to the transferring Shareholders within 10 business days from the date that the right of first refusal as referred to in clause 21.

The Entrepreneurs Perspective

If a Shareholder finds an offer for his shares, then the entrepreneur also has a right to be part of that deal.