I’m often asked by clients whether startups should have a separate stockholders’ agreement among the founders.  The answer largely depends on whether they have or will have certain other startup documents in place. 

First, some background on stockholders’ agreements.  These are contracts entered into by owners of privately held companies to manage the following governance and ownership issues:

• Board Composition:  Every corporate statute provides that the business affairs of a corporation are to be managed by a board of directors, which sets policy, makes major decisions and appoints officers to whom the day-to-day management of the company is delegated.  So it makes sense to determine in advance the size of the board, who the directors will be and how those directors could be removed and replaced.  Without an agreement, the default standard would be majority rule, meaning that one or more stockholders with a majority of the outstanding shares would be able to elect the entire board.  A stockholders’ agreement ensures board participation in the manner envisioned by the founders.

• Vesting:  Vesting is the mechanism by which the founders and other service providers receiving shares in the company in exchange for services actually earn those shares.  If a person owning shares subject to vesting leaves before any portion of the shares has vested, the company would have the right to repurchase the unvested shares, usually for the amount paid by the stockholder for the shares or for par value if the shares were issued without cash consideration.  A standard vesting schedule for growth companies is four years, with 25% vesting after one year and the remainder vesting pro rata on a monthly basis over the following three years.  Without vesting, a person could walk away with all shares intact, even those shares not yet earned, which is unfair to the company and the other stockholders.

• Restrictions on Transfer:  Companies have a legitimate interest in keeping tight control over share ownership.  This is accomplished through various restrictions on transfer.  If a founder dies, is incapacitated, leaves the company or becomes divorced, the other founders and/or the company should have the right to buy the exiting founder’s shares at a price or price mechanism that is pre-determined.  If a founder wants to sell his shares, the other founders and/or the company should have a right of first refusal.  The other founders may choose to be sellers rather than buyers, in which case there should be tag-along or co-sale rights in favor of those other founders which if exercised would obligate the primary selling founder to require his buyer to also by the shares of the other exercising founders, if necessary on a pro rata basis.  Without transfer restrictions, shares may wind up in the hands of someone undesirable, such as a competitor, heir or ex-spouse.

• Decision-Making:  As mentioned above, the board of directors is tasked with managing a corporation’s affairs.  Nevertheless, the law requires certain fundamental transactions, such as mergers, to be approved by the stockholders.  The founders may also decide in advance that certain additional major decisions require some vote threshold of the founders.  These could include issuing preferred stock, borrowing money, sale of the company and conflict transactions.

So given the protections and predictability that stockholders’ agreements provide, why shouldn’t a startup have one for its founders?  There are a number of reasons.

First, as to corporate governance, the corporate statutes of most states have a decent set of default rules covering most governance basics.  Gaps in these statutory default rules with respect to governance can generally be filled by a corporation’s by-laws.

Second, restrictions on transfer of shares in a startup should already be covered in restricted stock purchase agreements between the company and each of its founders (as well as employees and other service providers who receive stock for services).  These stock purchase agreements will usually contain vesting provisions under which the company will have a repurchase option to buy back unvested shares from departing stockholders. Similarly, provisions governing intellectual property to be used or created by the company should be covered in IP assignment agreements.

Third, venture capital investors will almost always insist on various governance and transfer restriction agreements which would necessitate amending or terminating any preexisting stockholders’ agreements.  Depending on the circumstances, it may be difficult to satisfy the consent threshold needed to approve the amendment or termination, for example if the amendment section of the agreement requires unanimity and particularly if one of the founders who was party to the original agreement has left the company but still owns shares and is not being cooperative.

Fourth, a well-drafted restricted stock purchase agreement will likely contain several helpful features not typically found in most stockholders’ agreements, such as escrow of unvested shares, 83(b) elections and lock-up periods following a public offering. 

Key Takeaway

A typical growth startup need not go through the trouble and expense of a separate stockholders’ agreement because the corporate statute and other standard startup documents provide a solid governance structure and the company is better served by saving the cost of preparing a stockholders’ agreement.  On the other hand, startups that do not enter into restricted stock purchase and intellectual property assignment agreements should seriously consider entering into a stockholders’ agreement.