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Starting a business with a friend? 3 reasons you need a legal agreement

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Starting a business with a friend can seem like a great idea, but it can be fraught with danger. You have a superb idea and a co-founder to help you bring it to life. You have different skills but the same passion. You’re on a tight budget. You both know what you want, why would you need a legal agreement?

There are 3 key reasons that shareholders in a company need a shareholders agreement. If you are sole traders, or two separate companies, you need a partnership or joint venture agreement. I’ll cover that in a later blog post.

The 3 key reasons that you need a shareholders agreement are:

1) To agree roles.
2) To agree powers.
3) To resolve disputes.

1. Roles – What are you both doing? When? How?

I’ve advised hundreds of companies, and one of the biggest areas of dispute is roles and work output.

New businesses cannot usually pay market-rate salaries. Founders may receive no salary, or a low salary, plus shares. Two founders may have 50% each, or a different split e.g. 75% and 25%.

You need to clearly agree the areas you will each cover, the time you will put in and the results you want to achieve. You do not want to be too detailed, as new businesses need to be flexible. You do not want to be too vague, as if one of you works far harder than the other, there is likely to be a dispute.

2. Power – Who decides what? Including spending money and issuing shares.

What decisions require both of you to agree, and what decisions each of you can make on your own? For example, you may meet to agree the goals and focus each month, then assign areas of responsibility. Each of you can make the decisions about your individual areas.

Another area to agree upon is spending company funds. Do you both need to agree on all expenditures? Can you have a limit for single-person decisions, e.g. under $100, $1,000 or $10,000 depending on your business size?

Who decides when new shares are issued? This is crucial, as issuing shares to new parties means that the existing shareholders are diluted. If you are 50:50 shareholders, generally both of you must agree to issue new shares. If there are majority and minority shareholders, then the majority shareholder may want to decide alone. The minority shareholder runs the risk of being diluted.

Apparently this was an issue for Eduardo Saverin, one of the three Facebook co-founders. It is said that Saverin signed a shareholder agreement giving him approximately 30% of the new company but giving Mark Zuckerberg voting rights. Zuckerberg could issue new shares without needing Saverin’s consent. Zuckerberg issued shares to investors and Saverin’s share was whittled down over the years to less than 5%.

3. Exits and disputes – What if someone wants to buy us? What if my co-founder and I cannot agree?

You need to agree what you will do if one of you wants to sell your shares, including in a buy-out offer. A drag-along clause says that one party (Party 1) can force the other party (Party 2) to sell their shares to the buyer. This lets the buyer buy the whole business, not just one shareholder’s shares. The purchase for Party 2 needs to be at the same price as the price per share paid to Party 1, to protect Party 2.

A tag-along clause lets Party 2 join or tag-along on the sale, same price as the price per share paid to Party 1.

It is wise to agree what you will do if you have a dispute and cannot work together. A well-advised company will set out how to resolve a dispute, including in a shareholders’ meeting or external mediation. If the dispute cannot be resolved between you, or with a mediator, you need to know who will leave the business, and what happens to their shares. One shareholder may be able to buy the other shareholder’s shares. You need to agree the valuation, e.g. a set formula or market value.

Your co-founder can be the difference between success and failure.

Agree upon the ground rules and the road-map early, in a comprehensive shareholders agreement. Once you have a strong foundation, you and your co-founder can focus on business growth and success.

Have you got a question about starting a business with a friend? Ask it in the comments below!

About Ursula Hogben


Ursula Hogben is the co-founder and General Counsel of LegalVision ILP, a commercial law firm, with free legal information, online services and fixed-fee prices. Follow Ursula on Twitter: @Ursula.Hogben

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