Start-up, shareholders' agreement

Start-up, shareholders’ agreement and investment agreement: How do they fit together ?

The contractual mechanism comprising the investment agreement and the shareholders’ agreement organizes the legal and financial relations between investors and the entrepreneur during the creation and development of a start-up.

What is the purpose and scope of the investment agreement?

An integral part of the shareholders’ agreement, the investment agreement sets out the terms and conditions under which future shareholders will acquire a stake in the start-up.

This agreement takes the form of a memorandum of understanding, signed between the company’s founders and the investors, which governs relations between the parties until the investment is actually made.

Under the terms of this document, the investors undertake to subscribe for a certain number of shares in the next capital increase.

It is at this stage that it is decided what type of financial instrument will be used.

The company may issue ordinary shares or preference shares.

Ordinary or preference shares are sometimes combined with warrants, which can be exercised on preferential terms if certain predefined events occur.

investors to complete the information contained in the business plan presented to investors (business angels, investment funds, etc.).

Beyond the financial aspects, what specific points should due diligence for technology start-ups focus on?

In the case of new technology companies, the audit will focus in particular on assessing the value and ownership of intangible assets such as technology and know-how.

In addition, the investment agreement provides for an audit or “due diligence” to be carried out by the investors.

In this case, it is essential to verify that the target company is the exclusive owner of the rights to the technologies used.

In practice, it is not uncommon to find that these are legally owned by the start-up’s founders.

In such cases, investors make the transfer of technology ownership rights to the company a condition for the disbursement of funds.
It is also important to check that technologies are well protected, i.e. that all protective formalities have been carried out (registration of trademarks, patents, software, etc.).

In addition, contracts signed by the company (commercial contracts, employment contracts) must be checked to ensure that they contain clauses on confidentiality, protection of intellectual property, non-competition of personnel, etc.

At the end of the audit, investors are supposed to have a very good knowledge of the company, i.e. of all the elements which may affect the company’s declared situation, either through the revelation of new liabilities, or through the deterioration of its values.

The results of the audit will thus determine the content of the guarantees requested from the founders, which mainly consist of making the investment conditional on the fulfillment of a certain number of conditions precedent (completion of formalities, drafting or modification of contracts, company bylaws, etc.).
Once these conditions have been met, the investor’s commitment is irrevocable.

In parallel with due diligence, a shareholders’ agreement is drawn up: what is its role and recent developments?

In recent years, the development of venture capital and private equity has been marked by a considerable increase in the use of shareholders’ agreements, extra-statutory and confidential documents designed to organize relations between holders of a company’s capital.

The shareholders’ agreement has the advantage of offering greater scope for the organization and operation of companies.

Originally, this document was intended to organize relations between shareholders and investors; today, it has an additional vocation, that of organizing relations between investors themselves, and constituting a kind of “instruction manual” for contractual relations.

What type of clauses are generally found in a shareholders’ agreement?

Shareholders’ agreements regularly contain two main types of contractual provisions: on the one hand, clauses relating to the organization and control of the company’s management, and on the other, clauses relating to the composition and development of the shareholder base. Generally speaking, there is an infinite variety of clauses that cannot be exhaustively described here.

More specifically, which clauses are critical with regard to the composition of the shareholder base and its future development?

Clauses concerning the maintenance of financial equilibrium are of considerable importance.

These clauses assure investors that changes in capital will not upset the equilibrium on the basis of which they have calculated their risks.

In the case of a share capital increase, two difficulties are likely to arise: the investor may not wish to increase his stake in the company; the capital increase may have been reserved for a third party, without the investor being able to object.

The anti-dilution clause enables the investor to obtain a commitment from the other shareholders, in practice the founders, to sell him the number of shares necessary to maintain his percentage of the capital held prior to the transaction.

This clause amounts to a unilateral promise to sell subject to the condition precedent of a capital increase.
This clause is often combined with a “ratchet” clause, which protects investors against a fall in the company’s value.

In practical terms, the ratchet clause automatically adjusts upwards the percentage of capital held, in proportion to any fall in the company’s value.

Thus, in the event of a capital transaction taking place at a lower valuation than that established at the time of the investor’s entry into the company, a compensation system enables the acquisition value of the investor’s shares to be brought down to the new proposed value.

There are also non-transferability clauses.

For some venture capital companies, the person of the founder(s) may be a decisive factor in the decision to acquire a stake.

It is therefore possible to include a clause in the shareholders’ agreement whereby the founding shareholder(s) undertakes not to sell all or part of the shares held or to be held in the company for as long as the investor remains a shareholder.

Legally, this clause is valid as long as it is justified by a legitimate interest.
Finally, pre-emption and joint exit clauses are commonly used.

What is the legal difference between a start-up and another company?

Time is of the essence for a start-up.
Financial and legal information must be provided on a regular basis.
Monthly reporting to investors is common for this type of company.
Entrepreneurs are obliged to systematically anticipate their financing needs and think several months in advance about the organization of the next round of financing.
As a result, legal documents, particularly shareholders’ agreements, are often revised or recast fairly quickly after they have been drawn up, due to the changing nature of the shareholder base.
Another differentiating factor is employee profit-sharing.

Founders and key managers frequently receive stock options, bonus shares, BSPCE warrants (bons de souscription de parts de créateur d’entreprise) or BSA warrants (bons de souscription autonomes).
These tools can be used to motivate newly-created teams, provided that the company’s valuation does not deviate too greatly from the business plan.

How can a lawyer help with an investment deal?

The lawyer’s role is to strike the right balance between the various interests involved, and to draw up all the contractual documents accordingly.

His role is also to propose investment schemes tailored to the company concerned. Over the last few years, we have seen many contractual arrangements over-dimensioned in relation to the company’s financial resources. This complexity can lead to a considerable loss of time and efficiency.

The lawyer is also called upon to organize the circulation of legal information between the various parties involved, to enable investors or founders to react rapidly. A legal monitoring dashboard is often required.

Finally, the lawyer is often involved in risk assessment and the definition of an investment strategy.