SWIMMING WITH SHARKS: Survival Tips for the Entrepreneur in All of Us

Survival Tips for the Entrepreneur in All of Us

Does this sound familiar? Manoj Malkani, a young Indian entrepreneur with ambitions of conquering the American market, recently called my office in a panic. “They stole my company!” he cried. After agreeing to meet him at the local Starbucks, I surmised that Mr. Malkani had probably lost a majority interest in “GuyFriday”, his nifty little start-up company that provides temporary “gophers” for busy lawyers and small business owners.

Like many start-up company owners, Mr. Malkani was starving for cash when he was approached by some fairly unsavory venture (some say “vulture”) capitalists (“VCs”). Also like many start-up company owners, Mr. Malkani had never entered into a shareholders’ agreement with the co-founders of GuyFriday. He failed to contact a lawyer before signing a shareholders’ agreement and other ancillary documents with the VCs, all of which, in effect, severely diluted his ownership interest in GuyFriday.

If Mr. Malkani had called me when he first formed his company, I would have told that all entrepreneurs, no matter the size of their companies, should visit a competent attorney and enter into an air-tight shareholders= agreement with their co-owners before approaching VCs for outside funding. Otherwise, these entrepreneurs run the risk having the terms of the shareholders= agreement dictated to them by the VCs. The truth of the matter is that the majority of VCs are ethical, and they will tell the entrepreneur to seek legal advice before signing anything. Nonetheless, it is wise for company founders to enter the financing game equipped with a working knowledge of how to best protect their ownership interests.

And now back to our story. Arriving at Starbucks, I found an obviously distraught Mr. Malkani nervously drinking his hyper-caffeinated cappuccino. He calmed down sufficiently enough to tell me his tale of woe: “I just don=t understand it,” he said. “The VCs told me everything would be fine. All I had to do was sign some papers and they would give me $2,000,000 to run my company. It was like a dream come true. I needed some really serious cash to keep things afloat. They even said that one day GuyFriday would go public, and then I would be rich. Yeah, right! Now I just found out that they=re selling the company to some huge investor. My ownership interest in the company has shrunk down to next to nothing, and the VCs’ lawyer told me there is nothing I can do to stop the sale. That’s when my dad told me to call you. Here are copies of all the agreements that I signed. What should I do?”

I began reading the shareholders’ agreement between the VCs on one hand, and Mr. Malkani and his co-founders on the other hand. I could not believe my eyes. “Mr. Malkani,” I said. “Do you know what all of these terms mean?” “The VCs explained some of it to me, and I trusted them,” he replied. “I read about the $2,000,000. Isn’t that the most important thing, and all the rest is just legal stuff?”

Sadly, I realized that although talented, Mr. Malkani lacked the financial, business and legal sophistication even to begin to understand what he had signed. By the time I finished explaining the relevant (and egregious) portions of the shareholders’ agreement, he was in a state of shock. “How could they have done that to me?” he cried. “The terms of this agreement basically allow the VCs to do with my company whatever they please. And after years of pouring my heart and soul into GuyFriday, it’s going to be sold out from under me, leaving me with far less cash than I deserve.”

The above scenario reflects a harsh reality of today’s economy: bright, young entrepreneurs who are the founders of hot new companies will most likely be taken advantage of – unless they take the time to educate themselves about the financial, business and legal implications of getting outside funding. Many of the important considerations that must be weighed by these entrepreneurs are beyond the purview of this article. The scope of this article is limited to giving readers an overview of certain “vocabulary words” found in typical shareholder agreements.

Dilution Issues. VC funding is usually just one phase of financing that a company will go through. During its life, a start-up may seek equity capital from friends and family, angel investors, VCs of all shapes and sizes, institutional investors, and, in relatively few cases, the public equity markets. In the case of any subsequent equity financings (“Future Financings”) initiated by the company, wherein the company issues shares to new financing parties, owners of the company who were shareholders prior to the occurrence of the Future Financing will face the prospect of owning proportionately less of the company (this result is known in financing parlance as “dilution”).

Sophisticated start-up founders know that in any Future Financing, their proportionate share of the company will be diluted. In most circumstances, such dilution is acceptable because everyone ends up owning a “smaller piece of a much larger pie.” However, an important question that should be raised during the negotiation process amongst co-founders, or between co-founders and VCs, is whether shareholders will bear the dilutive effects of a Future Financing proportionately, or will the dilutive “brunt” of any Future Financing be borne by some shareholders more than others. Internet entrepreneurs should stick to their guns and demand from VCs that such dilutive effects must be borne proportionately. In addition, founders should consider drawing Aa line in the sand@ – that is to say an ownership percentage beneath which they will not be diluted (e.g. no matter what happens in a Future Financing, the entrepreneur will not own less than 51% of the company).

When discussing Future Financings, entrepreneurs being courted by VCs should be careful to demand “preemptive rights” identical to those that VCs assuredly will want for themselves. Upon the occurrence of a Future Financing, typical preemptive rights give each shareholder the prior right, but not the obligation, to purchase a number of shares of the company’s capital stock equal to (i) such shareholder’s then aggregate proportionate ownership of the company’s stock, multiplied by (ii) the number of shares of stock to be sold in such Future Financing. Preemptive rights empower entrepreneurs to maintain their percentage ownership of their companies; provided, of course, that the entrepreneurs are able to come up with cash at the time of a Future Financing.

Tag-Along Rights and Drag-Along Rights. In their quest for working capital, entrepreneurs sometimes will give away the lion’s share of their companies= stock. Such was the case for Mr. Malkani. In exchange for a $2,000,000 investment, he gave the VCs 85% of the capital stock of GuyFriday. As a result, Mr. Malkani became a minority shareholder in the company he founded. Later, when the VCs were approached by a major internet portal company and offered $10,000,000 for their shares, they jumped at the chance. Unfortunately for Mr. Malkani, the major player was only interested in acquiring the VCs= 85% of GuyFriday. If Mr. Malkani had demanded that “tag-along rights” be included in the shareholders= agreement, he could have avoided the pitfall described above.

Tag-along rights generally give shareholders the right to participate pro rata at the same price, and upon the same terms and conditions, in any sale of shares of capital stock of the company by any other stockholder to a third party purchaser. Tag-along rights protect minority shareholders from being “frozen out” in cases where majority shareholders attempt to sell their shares to a third party. In Mr. Malkani’s case, tag-along rights would have given him the right to sell 85% of his shares to the third party purchaser.

Drag-along Rights (also called “bring-along rights”) are the flip-side of tag-along rights. Upon the sale of majority shareholders’ shares to a third party purchaser, drag-along rights enable majority shareholders to force minority shareholders to sell their shares to such third party purchaser at the same price, and upon the same terms and conditions, governing the sale of the majority shareholders= sale of shares to the third party purchaser. In effect, drag-along rights prevent recalcitrant minority shareholders from holding up the sale of the company.

Rights of First Refusal. In cases where shareholders desire to sell their shares of the company’s stock to a third party purchaser, rights of first refusal require that such shareholders first offer to the company, and then to the non-selling shareholders, the right to purchase all of such shares at the same price, and upon the same terms and conditions governing the proposed sale to the third party purchaser.

Minority as well as majority shareholders can benefit from rights of first refusal. In cases where a selling shareholder proposes to sell his shares to a third party shareholder that the non-selling shareholders do not like, rights of first refusal can, in effect, block the sale. Of course, a blocked sale is contingent upon the company or the non-selling shareholders, as the case may be, actually having the money to exercise their rights of first refusal.

Board Seats. Whenever possible, entrepreneurs should try to maintain control a majority of the directors on the board of the company. Of course, this is not always realistic when VCs are throwing $2,000,000 your way. Nonetheless, people in Mr. Malkani’s position should consider making certain decisions contingent upon the unanimous, or at least a super-majority, approval of the board of directors. Such decisions can include the whether the company should (i) amend its Certificate of Incorporation or Bylaws; (ii) purchase of any interest in the stock, assets or business of any corporation, partnership or other entity other than in the ordinary course of business; (iii) select or discharge officers of the company (this should be of the utmost concern to a founder of the company); (iv) merge, consolidate, dissolve, liquidate or cease its business activities; (v) enter into, modify or terminate any lease, contract or agreement with a term of one year or more; (vi) sell or purchase any asset other than in the ordinary course of business; or (vii) borrow money.

Registration Rights. Shareholders in companies like GuyFriday own private company stock – not publicly traded stock. However, under certain circumstances shareholders may want to have the right to ask the company to register their shares with the Securities and Exchange Commission. It is not unheard of for shareholders, after holding their shares for an agreed upon lock-up period (e.g. one year at a minimum), to have the right to demand that the company register their shares with the SEC (“Demand Registration Rights”). In addition, shareholders should have the right to include their shares of stock in any registration statement filed by the company with the SEC on its own behalf (e.g. in an IPO) (“Piggyback Registration Rights”).

In the real world, however, most start-ups do not go public. They are bought out by larger companies, go bankrupt, or grow organically and stay private. Nonetheless, there are those rare companies that “go all the way” and tap the public equity markets. Therefore, it is never a bad idea to include registration rights in a shareholders= agreement – even for a company as small as GuyFriday. Being able to force the company to register his or her shares with the SEC gives the shareholder the ability to turn otherwise restricted stock that cannot be traded into freely tradable stock, thus making the shareholder’s investment more liquid.

Conclusion. The issues raised in this article are not intended to be legal advice. Entrepreneurs that are in the process of growing their companies are encouraged to speak with their lawyers, accountants and financial advisors. Nonetheless, it is my hope that the foregoing article serves as an impetus for entrepreneurs to learn more about concepts that arise in negotiating a shareholders’ agreement.

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