Shareholder Agreement FAQs: How Are Shareholder Loans and Funding Clauses Handled

You may start a company as the sole owner or with a co-owner, family, and friends. Having more than one shareholder brings more initial funding, multiple talents and ideas, but it also creates different viewpoints and conflicts of interest. Many startups often find themselves losing control of their company due to several rounds of external funding. A new entrepreneur may give a significant stake along with voting rights to angel investors, while the investor may only seek protection from downside risk and a share in the profits. Losing voting rights may leave the company in the hands of the wrong shareholders – imagine a fashion boutique having a civil engineer as a major shareholder.

How then do you manage future funding needs without hurting your ownership and interest in the business? Through a shareholder agreement.

A shareholder agreement lays out the rights and responsibilities of shareholders to protect the business and shareholders’ interests and resolve conflicts without expensive lawsuits. So if you need funding in the future, the shareholders’ agreement will clearly specify ways to secure funding and protect voting rights. It plays a vital role when companies have multiple shareholders, including minority shareholders who don’t have a controlling stake.

Essential Items to Consider in a Shareholders’ Agreement

The shareholder agreement sets the ground rules for everything that can affect shareholders’ interests. So when you sit with your co-founder to create the agreement, state in detail

• How profits and dividends will be distributed
• How conflicts will be resolved
• Rules around issuing new shares and transferring or selling existing shares
• Matters that will need shareholder voting
• What happens when a shareholder dies

And the list goes on. In this article, we will focus on clauses governing the issue, transfer, and sale of shares.

How to Manage Future Funding Using a Shareholder Agreement

It is the shares that give shareholders ownership rights. But what if the company wants significant funding? The agreement should specify which source of funding to prioritize: external debt or shareholder capital (equity or loan). This is an important clause, as the path you choose will determine your capital structure. While debt has a fixed interest, equity is expensive, as it dilutes ownership, dividends, and other shareholder rights.

Choosing the Right Funding Option

• Shareholder Loans: If existing shareholders give a loan to the company, a Shareholder Loan Agreement is required. It should specify the principal amount, interest rate, repayment schedule, and whether the loan is subordinated to other corporate debts.
• Shareholder Contributions: The shareholder agreement could make it voluntary or mandatory for shareholders to contribute additional equity capital. It should specify the maximum amount the shareholder could be asked to contribute and the penalties for not contributing. The penalties may include share dilution or forced buyouts.
• When existing shareholders inject capital into the business, their rights are protected. If they can’t provide the necessary funding, the company might have to bring in new investors, which could lead to share dilution.
• Issuing New Shares: The company can bring in new investors either by issuing new shares or Simple Agreements for Future Equity (SAFEs). In SAFE, the investor provides capital in return for a right to convert their investment into equity at a future date. Existing shareholders can include a clause protecting their pre-emptive right to participate in future rounds of funding by purchasing a proportional amount of the newly issued shares.

Revising Shareholder Agreement for New Investors

Since shares are being issued, the new investor has to sign the shareholder agreement. Every new investor round will bring in new investors who may require amendments to reflect their rights and protections.

• Understand Each Shareholder’s Objective: Before making amendments, it is important to identify what each shareholder is trying to protect. Founders may want to protect their control of the company and the ability to exit. Investors may want governance rights and downside protection. Minority shareholders may want anti-dilution rights. The founder can retain full control of the company and still raise funds by giving investors and minority shareholders what they want.
• State Who Has the Leverage: The agreement can state which shareholder has the most leverage, the largest investor, or the founder with the most shares. You can also add voting clauses, which will require either unanimous or super-majority voting for the most important business issues.
• State Amendment Procedure: The shareholder agreement should specify amendment procedures and the need for other shareholders’ consent. Also, the amendments should protect all shareholder classes, including the rights of minority shareholders. In this process, do not make overly complex provisions that are hard to decode.

How a Shareholder Agreement Manages Transfer and Sale of Existing Shares

Speaking of protecting shareholders’ rights, an existing shareholder has the right to exit by selling or transferring their shares. To protect the company from an unwanted shareholder, the shareholder agreement can include certain clauses:

• Right of First Refusal: If a majority shareholder wants to sell their shares, they must first offer them to the company or other shareholders.
• Tag-Along Rights: If a majority shareholder sells their stake, minority investors should have the right to tag along and sell their shares on the same terms.
• Drag-Along Rights: If the majority of shareholders want to sell the company, they could drag the minority along to ensure a 100% sale.

Writing a shareholders’ agreement is an ongoing process. It needs to be reviewed and amended whenever new shareholders are added, old shareholders leave, or there is a change in business structure, such as a merger and acquisition. Certain clauses can have major tax implications. Having a professional by your side can help you make a shareholder agreement your ally in resolving disputes, making major business decisions, and managing taxes.

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