The Ultimate Guide For Startups on How to Successfully Navigate Their Partnership Agreement
The Right Strategy and Tools for Your Partnership Agreement to Keep You in Control of Your Business
In the ever-growing world of entrepreneurship, we can find a legal institute that many times is not really understood: The Partners Agreement or Shareholders Agreement.
It is a classic in Corporate Law, but it has developed and become extremely popular in the field of startups and alternative financing.
Today it is a must for entry, at least seriously and lastingly, in Accelerators, Incubators, Equity Crowdfunding Platforms or Crowdlending Platforms. But do entrepreneurs and Startups understand this agreement? Do they know its implications and objectives?
Usually startups are involved in a whole series of necessary documentation to obtain funding. They are required to have specifics articles of association, a Partners Agreement with specific contents, etc. However, the entrepreneurs who are behind the Startup do not usually understand all this.
What is a Partnership or Shareholder Agreement?
Starting with the basics, a Partnership Agreement is a private contract or agreement. Something that at first sight has many legal implications. It is an agreement between certain parties through which a relationship is intended to be regulated, and which a priori will only be binding on the parties that sign it.
Traditionally, the Partners Agreement was a figure dedicated to large companies, mainly multinationals. These companies usually have a complex and international corporate and management structure, so it is very difficult to regulate the relationship between the top management and the statutes or legislation of any country. An agreement between this leadership that determines everything that the law does not do, or does it in a different way than the law, has all the logic of the world, and is from the legal point of view the most recommendable.
Is the management structure of a startup that complex? Well certainly not, at least in most cases. But there is something complex: the clash between the interests of the founding partners and the form of funding proposed by the investing partners. A Startup is characterized by a financial input based on the entry of investment partners, which may be the Accelerators or Incubators themselves, mentors, private investors, micro-investors derived from crowdfunding, etc.
Local legislation will depend on each country where the Startup is incorporated, but usually protects the interests of the company. This can be a problem for the financial ecosystem that has been generated around the Startups. Accelerators do not usually want to be part of a company indefinitely, but to increase its value and then leave the company and obtain the returns on their investment. This is a goal that is also pursued by regular investors who come to these accelerators. However, it is necessary a sale of shares to leave a company and obtain the financial returns. The sale of shares in startups is a risk and can lead to the loss of value of the company, something that would harm the startup itself. Faced with legislation that could choose to protect the interests of the company in these cases, the way to protect the interests of investors has been precisely to conclude a shareholders’ agreement.
Not everything is black and white, and since the use of the shareholders' agreement began in the startup ecosystem there has been a great evolution of this legal institution. Currently, the agreement is aimed to protect the interests of founders and investors. But we must always keep in mind the origin of the institution.
Are there several types of Partnership Agreements?
It is not a figure regulated in a specific law, so talking about typology does not make much sense. But it is true that depending on the time when the agreement is concluded, it usually has one content or another.
We may find ourselves at first with the uncommon Future Partners Agreement. This would be an agreement between the members who have the idea that will lead to the future Startup, and that regulate their relationship and the fruits of this until the time of the constitution of the Startup. Using the word partners is meaningless, while the team members can be significantly altered until it is possible to define those who will be the founders. It is certainly the least common, although it could be one of the most relevant. On the way from having the idea and start in their work, until you decide to go to funding and finally form a company, many things can happen, flight of partners, creation of a parallel project, personal empowerment of means of production or assets of the project, etc. Circumstances that can be perfectly regulated in this pact, but that, due to ignorance and lack of means, are not usually even considered.
In a second moment, which is usually immediately before the constitution, or immediately after, we would find the Founding Partners Agreement. It is the most relevant covenant for the accelerators or incubators, practically an indispensable requirement to establish a long term relationship with them. It is an agreement between those who will be the founding partners of the Startup, and through which they will regulate matters of vital importance such as the Intellectual Property developed to date, capital participation, positions, remuneration, permanence, ways of dealing with the entry of new partners, exit etc.
Finally, we distinguish a third type after the incorporation of the company, and characterized by the entry of new partners in the Startup—the Shareholders' Agreement itself.
As we have mentioned, the Partnership Agreement only binds the signatories, so that the Founders Members Agreement, if it exists, would only bind the founding partners, and new investors are usually interested in signing a new covenant that modifies the previous one or adds new clauses. This New Partners Agreement usually occurs, in the field of Startups, with the Accelerators, Incubators, mentors or different investors who close funding rounds with the Startup.
How do I conclude a Partnership Agreement?
So, when it comes to the celebration of a Partners' Agreement, we can go to the written, oral, private or public way, indistinctly. The usual and most recommended form is the private (without notarization) and written.
The only legal specialty is the aforementioned Article 29, which states that for a Partners' Agreement to be binding on the company, it must be known by the company. Basically, this implies that the Partners' Agreements that intend to oppose the corporation must be included in its bylaws -as expressly allowed by Article 28- or must be signed by the corporation jointly with the partners. In the rest of the legal systems we can imagine, the requirements will be the same: freedom of form, but knowledge and express consent of those who may be linked. This is a basic principle in matters of contracts that we find in all countries.
What should my Partnership Agreement include?
The content is the most delicate, complex and important part of a Partnership Agreement. So, we going to analyze the structure first. The structure of a Partners' Agreement will be the usual one in private contracts:
- A heading where the parties, the place and date of signature of the contract will be determined.
- A statement specifying the objective of the agreement, its scope of application, and recognizing the legal capacity of the parties.
- A stipulation that includes all the terms and conditions that will govern the agreement.
What are the usual clauses in a Partnership Agreement?
In analyzing the content of this agreement, we will distinguish the clauses according to the subjects they regulate.
Capital share and partners’ contributions:
The first clause usually refers to the capital of the company and the specific contributions of each partner.
In the case of Startups, it is quite common to take steps prior to incorporation consisting of registering web domains, trademarks, hiring web and technological tools development services, hosting, e-mail, etc. Since it is something before the incorporation, we find that these rights are owned by the partners in a personal capacity, separately or jointly. It can be wanted that they become ownership of the society, or not. Any option is valid, and the founders must choose one in their Founders’ Agreement. However, please note that Accelerators and Incubators usually require all Intellectual Property to be owned by the company.
This clause will also establish the percentage of participation of each partner, and their consequent control of the share capital and decision making.
These clauses usually establish salary guidelines for management roles, remuneration of the CEO or Board of Directors, conditions for the distribution of dividends, etc.
The content of these clauses is aimed at the assignment of roles or management positions, the access conditions, duration, substitutions, etc.
Furthermore, two key points will be regulated: Voting Rights and Veto Rights.
In Spain, since the law regulates when a partner has the right to vote and when not, voting rights seek to determine the necessary majorities for relevant decisions (going to investment rounds, crowdfunding platforms, admitting new partners with a certain percentage of participation, total or partial sale of the Startup, etc.). Although it also admits the possibility of setting up non-voting shares.
Veto rights are especially relevant. They are usually granted to the founders and will allow for greater control over share capital regardless of their percentage of ownership.
Permanence and Talent Retention:
These clauses are closely related to economic rights. We are talking about Vesting, Stock Options, Phantom Shares, Liquidation Preferences, etc.
The Vesting clause can be understood as a permanence obligation of the founder, binding him by means of an economic penalty. By means of this clause, a period of time or Cliff is usually established (normally 1 year) as a requirement for the founder member to take possession of his percentage of shares in the capital stock. After this Cliff, a period of extra time begins (normally 4 years) in which the founding partner must remain in the company to assert the total of his shares. If the founder leaves the Startup before the Cliff, he will lose all his shares, if he leaves after the Cliff, but before the time of permanence, he will lose the proportional part of his shares.
The Stock Options clause is not at all common in Spain due to its unattractive tax configuration. Its implications would be the participation of the employees of the Startup in the share capital, meaning that the employees become capitalist partners. To do so, they acquire shares at a price below the market price, forcing themselves to meet certain objectives or timescales in order to be able to sell them later. In this sense, the increase in the value of these shares or participations is encouraged, which is a consequence of the better operation and performance of the Startup and its employees.
An alternative clause, which is more successful in Spain, is the Phantom Shares. For economic purposes it would work like the previous one. The employees acquire shares in the capital, but fictitiously, that is, they never become capitalist partners and therefore do not have political rights, but instead acquire economic rights. These rights are usually enforced in times of liquidity (financing rounds, capital increases, total or partial sale of the company, etc.) and subject to objectives and deadlines. Again, the economic incentive is in the increase in value of the Startup, which will be a consequence of its better operation and performance.
The Liquidation Preferences clause is of particular interest to investors, especially those who invest significant amounts. It is an insurance in case of loss. If an investor invests a certain amount in the Startup, and suddenly this Startup is sold for less than the value it had at the time of investment, the investing partner will have lost money. The way to avoid this is through this clause, which allows the investor in the case of sale to recover what he has invested and then proceed to the corresponding distribution according to the percentages of participation. It is common to find clauses that even allow the recovery of double the amount invested, a way of ensuring a profit.
Beyond these extremely common clauses, we find other specific (and no less important) clauses of non-competition, confidentiality, exclusivity, etc.
Here we find the most important and problematic clauses of the shareholder agreements in the field of Startups. The clauses relating to the entry and exit of investors. These are stipulations that are intended to protect the interests of the parties, either of the investors (most commonly), of the founders, or of the Startup itself. It is worth going carefully through the most common.
Clause Drag Along: undoubtedly the most controversial, is a clause to drag the rest of the partners. It is the most common clause in the world of Startups, an indispensable basic for the more traditional investors who have adapted to alternative investment (banks and financial institutions that go to Accelerators). This clause allows a partner who wants to sell, if certain conditions are met, to force the other partners to sell along with him. Basically, it allows to empty the Startup of its founders.
Many times entrepreneurs are deluded into believing that the interest of the Startup is being looked after, while the investor has to look after his own interests. The continuity of the Startup may not be in the interest of the investor if a very valuable purchase offer is made (for example, a competitor company wants to buy the Startup to shut it down). It is a clause that involves a great risk, but opens the door to higher funding. Everything depends on the wording of these conditions that will allow the application of the clause.
Clause Tag Along: meant for the defense of the founders It is impossible to permanently limit the transaction capacity of the partners with their participations. In the case of Spain, the partners will have preference in the acquisition of the shares of another partner who wishes to sell, but this does not mean that they will have the liquidity to do so. If a partner wants to sell his or her shares, and the rest of the partners or the company cannot acquire them, there is a serious risk that another new partner with different ideas may enter and seriously harm the Startup. Clearly, we are talking about partners with a high percentage or majority control of the Startup, which usually coincides with the founders. One way to make this situation difficult or to mitigate possible damage is the Tag Along clause. This clause allows the other partners to condition the sale of the partner concerned that they can also sell their proportional share.
In defense of the Startup itself, the clause Lock-upestablish a way to block the attempt of speculation with the capital of the Startup by their own partners. In times of liquidity such as the sale of the Startup (especially upward), capital increases, closing of financing rounds, etc., the temptation arises to sell shares at a value well above the market, to speculate with the share capital. This can have very harmful consequences for the Startup depending on the time it occurs. With the Lock-up clause a time frame can be determined (e.g. 5 years), in which the partners will not be able to sell their shares after these liquidity events.
Finally, among the most common clauses we find that of Non-Dilution. This is a clause that plays in favor of one or several partners to the detriment of the others. The entry of investors and Startups are inseparable elements, which implies an increase in capital, which implies a redistribution of shares. All this translates into the dissolution of the existing shares in the new share capital (decrease of the percentage of participation). There are only two ways to avoid this, on the one hand, the partner who does not want to see his participation diluted can invest again in the company to maintain his percentage of participation, on the other hand, he can demand a non-dilution clause. This clause will mean that in the event of an increase in capital, the benefiting partner will not see his percentage of participation reduced, something which is mathematically impossible, and which is resolved with a greater dissolution of the participations of the other partners.
While these are the most common and complex clauses, there are many others created ad hoc, or more classic. It is extremely important to understand what is being pursued with each clause, what interest is actually being defended, and to what point it can be understood as beneficial to accept these conditions.
Applicable law and jurisdiction:
We will normally find in the Partner Agreements a clause regarding competent jurisdiction (of which country will be the courts to resolve a conflict if any) and applicable law (of which country will be the law applicable to the conflict for its resolution).
How long does a Partnership Agreement last?
A Partners' Agreement does not usually contain clauses that determine its duration, because by its very nature, its duration will be indefinite. However, if the parties agree, the agreement can be terminated, modified, renewed, etc. at any time.
Lawyers and Partnership Agreements
We have already commented above how unusual it is for Startups to turn to professional legal services to deal with the whole range of legal issues that may arise in their early days. And is that in terms of a Partnership Agreement, is even less common, because as we said, the first pact that really raises the Startups is the Founding Members Agreement. At this time it is very common to be in contact with an accelerator or incubator, which is usually the one who begins to require the existence of this covenant, along with the incorporation of the company if it had not yet been carried out. From this point on there are three possible paths: go to the accelerator or the incubator which will offer their own legal team, do it themselves without legal advice, or seek the assistance of an independent lawyer.
As usual, hiring a lawyer is the least common thing when it comes to startups. The Accelerators or Incubators themselves can offer templates of Partner Agreements and even make recommendations and take care of their drafting, as well as provide support and advice with their legal team. In addition, there are many templates of these Partnership Agreements on the Internet.
The first way might seem ideal if not because, as we mentioned at the beginning, Partnership Agreements in the Startups are born to defend the interests of investors who come to the acceleratorsand mainly these entities, which also acquire the status of investment partner in the Startups they help, defend interests that may not be entirely aligned with the Startup and its founders, at least in the long term.
The use of Internet templates is undoubtedly the least advisable and the most risky, there are already many technical and legal elements to be taken into account in this type of agreement, and the use of generic templates often causes serious problems that are difficult to solve in the future.
Again, the attorney route is often not selected because it is too costly, or too expensive for a startup that is at an early stage of its activity. In addition, for the entry of new partners, the Startup is usually already very involved in the system of its Accelerator, and the legal team of the same deals with the new agreements. However, an independent lawyer guarantees the necessary autonomy from the interests of the Accelerator and the investors, and protects the interests of the founding partners from the very beginning, preparing the Startup for its future growth.
How can Gowper help you?
For us there is nothing more important than promoting the use of the legal practitioner as a genuine way of defending the client's interests.
Here, it is important that the Startups and founders, when dealing with the Shareholders Agreement, take the necessary time to reflect on who the lawyer who is handling the agreement represents, the Accelerator, the Incubator, the mentors, the investors, or the founders?
At Gowper we want to put our independent professionals at the service of entrepreneurs. We do this by adapting our services and budgets to the real needs of the client and their financial resources. The growth of a Startup is a success for their lawyer, in an economic, professional and ethical perspective. So that, by actually supporting the founders of the companies of the future, we can lay the foundations for a framework of maximum legal certainty that fosters endless creativity.