Note: This post was originally written by TechAlliance EIR Colin Macaulay.
I have been using my biotech startup experience to encourage new life-science entrepreneurs to develop their own technologies and to avoid some common pitfalls in their startup journeys. Through this mentoring process I have encountered several common issues that I try to explore in a series of short blogs. These are my own opinions and do not represent those of any institute, company, or client I may have worked with.
In Part-2 of this series, I discussed how a new startup can fail to launch because co-founders end up focusing on their relationship issues rather than on building their business. I discussed the importance of early legal advice to help lead frank, uncomfortable discussions between co-founders about expectations with respect to compensation, share distribution/vesting, effort and commitment to the company. It is crucial to anticipate and mitigate these and other common what-if scenarios up front, before the company begins, and before these issues become real, sabotage relationships and sidetrack the company.
I have had new entrepreneurs ask how to get rid of problematic shareholder’s. I thought I was being pranked. It turned out that some new entrepreneurs didn’t fully understand how shares work, or that once they are owned by other individuals you can’t simply take them back. You are stuck dealing with that shareholder for as long as they own those shares.
In my experience, one of the common factors among early startups with strained shareholder relationships is the absence of a Unanimous Shareholder’s Agreement (USA). This agreement is a legal contract that transfers some responsibilities from directors to shareholders. It lays out the responsibilities and obligations of directors and shareholders in the corporation. It anticipates many of the issues that can arise between shareholders and provides methods to resolve them. Most importantly, it requires all shareholders to be on the same page with respect to their rights and obligations from the beginning.
A USA is not required to create a private corporation. Therefore, some new entrepreneurs will put off this legal “expense” until they feel they need it. When you can feel this, it may be too late. If you have a single director, single shareholder corporation then there is no reason to have a USA. However, if you have co-founders, want to use company ownership to incentivize employees, directors or advisors, or need investment to help create and grow your business, then you should have a USA in place at the beginning. In fact, most firms with investment capital (venture or angel) will require a USA to be in place as a condition of their investment.
Disagreements between shareholders about director performance or the management of a corporation are common. In most cases, shareholder’s express their sentiment with the corporation through voting on resolutions or special resolutions the company puts forward, including the election of directors of the corporation. The majority, or super-majority if required, carries the vote and the company moves forward. A USA does not prevent shareholder disagreements, but it helps get everyone on the same page and it can mitigate how most disagreements play out.
In some cases, especially when relationships are emotionally strained, a hostile shareholder can lose all rationality and do all they can to impede the progress of the corporation by not complying with any company resolution that requires unanimous shareholder consent, such as signing a USA that is needed for financing. This is clearly counterproductive, a major distraction for company directors and management, and hurts all shareholders. However, there are law firms that advocate this tail wagging the dog scenario as leverage for minority shareholders to extract value from a corporation, typically by forcing the company to buy back their shares. This is not a strategy that works with startups as there are no extra resources to buy back shares. Had the startup sought legal advice, had a USA in place from the beginning that allowed the “drag-along” of minority shareholders for major financings, then this would not have been an issue.
Occasionally I hear of predatory startup advisors. These experienced rogues take advantage of new inexperienced entrepreneurs by obtaining shares in a new corporation in the absence of a unanimous shareholder’s agreement and for no significant contribution to the company. The entrepreneur is not only vastly over-paying for “advice” using shares in the corporation, but now they are stuck with a minority shareholder that may not have the best interest of the company at heart and could try and have undue influence on the company or turn hostile as the startup tries to grow and raise investor capital.
With a flourishing startup ecosystem, it is possible to get advice through reputable organizations at little to no cost. At the same time, it is important to work with your legal advisor to anticipate potential problems that could arise between shareholders and how these may best be mitigated through agreements, such as a USA. As you take the reins to begin your entrepreneurial journey, do not underestimate the power of building great relationships with co-founders, mentors, professional advisors, key partners, investors, and of course your customers.