Last week I watched, live, a promising young start up die because of pesky paperwork and a VC that felt the need to go the distance when it came to covering thy butt. It was ugly and it will be nothing shy of a miracle if the lawsuits don't come flying.
[cue the Dragnet Theme]
The story you are about to read is true, only the names have been changed to protect the innocent. Okay, to protect the stupid, greedy, and confused as well.
Start Up is rocking along with a little service. Has paying customers, solving a problem, but is in expansion mode, running out of credit cards/mortgage to pay the bills. In fact, hosting facility, etc, are all pounding on the door looking for payments.
A VC offers up a term sheet, does due diligence, and decides, yep, we're in, let's go to legals. The terms are negotiated, everybody appears happy, capital is ready to transfer.
VC lawyers offer up the shareholders agreement as one of the documents that needs to get signed off by all the shareholders. No problem. Well, almost no problem. Turns out that when the friends and family round was being done, lots of shares were handed out to lots of people for help. A little code help? Here, have some shares. Dropping a pizza by? Here, have some shares. Some cash? Bless you, here, have some shares. You get the point. All told, 42 shareholders which owned 22% of the company. 42 people spread out over three countries. 42 signatures required. And, as fate would have it 21 missing shareholders. Moved, not returning phone calls, no emails, etc.
The VC refused to close without the signatures and, to make a long (painful) story short, the company died for lack of funding.
There are a few lessons inside of this train wreck but here is the big one I'd like to point out.
Shareholders agreement, minority rights and voting trusts are things you need to learn about before you give out the first share of your company.
The most important thing you can do is create a voting trust/minority shareholders agreement for all these 100 share or 1000 share things you will likely do in exchange for services or cash. Most people that help a start up are generally doing it to help you, to be nice, not looking for the retirement investment. They are taking a bit of a flyer on you. Toward that end, those people are about as passive as you can get. They should have no problem signing up for a structure that basically has them along for the ride. I'm not a lawyer so in non-legal terms you need to have an agreement in place that accomplishes these objectives:
- Prevents you chasing around the globe for shareholder signatures.
- Puts the minority shareholders in a voting trust
- Has a specific agreement that clearly identifies the rights/privileges of the minority shareholders.
To accomplish this, draw up a voting trust for everybody who has less than a certain percentage of share ownership. You can use less than 10% or whatever number but spell it out and ensure the language is clear and reviewed by a qualified lawyer. In some jurisdictions, you can't contract out of certain rights, so ensure you know what you can/can't do with respect to voting, etc, where you form up the company.
Also, ensure that things like shareholders meetings, participation rights, etc, are specifically spelled out in the minority shareholders agreement. With a voting trust of all the minority shareholders in place, you can vote/sign/represent them, you can spell out that notifications for meeting go to the trustee and -as an example- the trustee can waive notice. That for example, makes sure that if you have to call a shareholders meeting you can do it on a moments notices, without a waiting period, etc, etc.
Signature requirements and notification requirements also need to be spelled out so that when you sell the company and some random person with 1000 shares goes missing, the sale doesn't die.
One thing you, as the founder, should consider as a back up or comfort for the VC is an agreement that basically says if there is a problem with a shareholder (like your Uncle Ned), you are responsible for the financial risk. If Uncle Ned screams that he should have been able to buy more shares or whatever, any resulting payments to Ned is your problem. This can sometimes prevent the deal from being held up waiting for a random signature. For some, this will be enough comfort, for others (see above), it won't be.
The point I'm making here, folks, is don't go to the office supply store and buy those fill in the blank shareholder agreements and stock certificates. Make sure when you start, you start with the structure that will allow you to take professional money sometime in the future.
The company you save, may be your own.
awesome advice for startups and easy to follow.
Posted by: howard Lindzon | February 24, 2007 at 21:12
On a related subject, I was told that it's a bad idea to give or sell stock to family or friends, because of a SEC requirement that all shareholders are "qualified investors." The SEC set up these requirements to keep us from scamming little old ladies out of their retirement funds. That makes sense, but it also makes it difficult to know what early-stage startups are actually allowed to do. Could you, or perhaps a lawyer colleague, fill us in on what's permissible?
I realize you're in Canada so the law is totally different for you. I'm not sure if you invest in USA-based companies or purely Canadian companies.
Thanks -- love your blog, very insightful!
Posted by: Ryan | February 24, 2007 at 21:15
Damn I wish you would have been here to stop by PodCamp this weekend. THis is the stuff I need. LoL
Posted by: Jeff | February 24, 2007 at 22:07
Great article... would love to see sample agreement(s). Can you post a link for us? Thanks!
-chrisco
http://www.buzzpal.com
Posted by: chrisco | February 25, 2007 at 01:07
I almost hit a similar problem with a software deal where we decided to reduce complications and legal cost to handle most of the publishers changes first (not all of them, we were still consulting with the lawyers), and then came in at the end with some minor changes.
It came very close to being a deal breaker because the publisher had dragged things out over so long with their side of it, that the time to make the changes we wanted hadn't been factored into the schedule.
I think in future deals I might lay out as much as possible to start, but it worries me that if you show all your cards straight off, you can destroy any chance of a deal too early, or lose some leverage.
Posted by: Andy Beard | February 25, 2007 at 02:46
Great advice; I would add that if you're a startup and already got yourself entangled in equity/investor complications, be sure to see a lawyer about rolling everyone up into an LLC (or otherwise addressing the issues) before you try to raise venture capital.
This particular story is surprising. When considering an investment that has passed the initial hurdle and is worth a closer look, one of the first things I ask about is the existing investors: who they are, what are the terms, what's the cap table, etc. It's unusual to run into a surprise like that late in the process.
Posted by: A U.S. VC | February 25, 2007 at 12:50
One way to keep from messing up the cap table is to convince people to accept option grants rather than shares.
Option grants don't carry any voting privileges, and thus don't require the usual last second signature chasing that shareholders do.
As a side note, even in a deal with all professional investors, the probability that all your investors are in the country at any given time, can be low. Best to give your investors plenty of warning!
Posted by: Chris Yeh | February 25, 2007 at 22:18
I'm not sure I understand how a tiny minority could kill a deal like that?
Posted by: pwb | February 25, 2007 at 23:12
PWB,
If the VC wants 100% compliance with respect to signatures on a shareholders agreement and one person holds out or isn't available, the deal can die.
Posted by: Rick Segal | February 26, 2007 at 00:49
@howard - you might want to take a look at this article in Inc. - seems to be a pretty good summary of the us rules...
http://www.inc.com/articles/1999/11/15743.html
@pwb and rick - sometimes the reason for this is because the VC wants a "unanimous shareholder agreement". as the name implies, it must be signed by all shareholders. ontario and canadian corporate law gives such agreements special status - e.g. transferees of shares don't actually need to sign them to be bound by them - and a bunch of other things.
Posted by: David Ma | February 26, 2007 at 12:51