Law for startups — look out for common contractual landmines

This post is the final post in a series based on my Law for Startups workshop at MaGIC in September 2015. It’s a basic introduction to legalities for startup founders. You can access the slides here.

Read the earlier posts for context:

  1. Law for startups in Malaysia — building on the best foundations.
  2. The legal landscape in Malaysia for startups — a hybrid of traditional corporate practices and Silicon Valley models.
  3. Choosing the right business vehicle for your startup or small business in Malaysia.
  4. When should a startup hire a lawyer?
  5. Oversights which could destroy your startup or small business.
  6. The dangers of using “standard” or template legal documents.
  7. How startups can strive for clarity in contracts.

Having discussed in the above posts some principles which startups and small businesses should bear in mind when dealing with legal documentation, this post will address some of the more common contractual landmines — practical tips on some specific terms and conditions to look out for.

I’ve previously discussed some of these clauses in the earlier articles, so will only touch on those briefly here.

What are contractual landmines?

Contractual landmines are clauses which may not cause immediate or short-term harm, but may damage your business later on.

Parties may notice a potentially damaging clause as part of the contractual review process (striving for clarity, which I wrote about earlier). However, sometimes parties consciously decide to “deal with it later” — perhaps due to the urgency of getting a business launched, or to receive investment funds. Obviously the best approach would be to defuse all landmines — removing the problematic clauses from the contract, or revising them — before the final contract is signed.

While some of these harmful clauses may be contained in draft contracts prepared by one of the other parties, founders sometimes plant landmines which damage their own interests. I mentioned in an earlier post how founders who don’t engage lawyers sometimes shoot themselves in the foot by proposing terms which aren’t in their favour even when the other party didn’t ask for it — eg anti-dilution protection, which protects the investor.

Drafting and reviewing a contract requires legal expertise, and startups should always get a lawyer before signing anything — this seems a silly thing to have to say, but there are a surprising number of people who think that they can draft good contracts without hiring a lawyer, as they’ve read a sufficient number of articles online, or are “experienced in business”.

Even if you do hire a lawyer, you should always understand anything that you sign. As a brief guide, I will very quickly run through some of the key issues to look out for in shareholders’ agreements.

Guard your equity ferociously

Don’t give out equity unless absolutely necessary.

Founders can sometimes be too generous with equity, and choose to use it as a reward.

Fees or salaries may be better options to remunerate those who aren’t going to be invested in your business for at least the medium-term (such as advisers and some employees).

Voting rights clauses may cause you to lose control of your business

Most people assume that a party will retain control of a company as long as it continues to hold more than 50% of the shares. This is not always the case.

Control of the voting rights at Board and shareholders level can be just as important as shareholding percentages — and they don’t always go hand-in-hand. A founder can lose control of the company even if she holds more than 50% of the shares, depending on how the shareholders’ agreements governs the voting rights of the parties at Board and shareholders’ meetings.

Here are a few common scenarios related to the composition of the Board, and voting at Board meetings:

  1. Two Founders can appoint two directors. The Investors can appoint two directors. Total four directors.
  2. Two Founders can appoint two directors. The Investors can appoint two directors. One additional independent director appointed. Total five directors.
  3. Two Founders can appoint two directors. The Investors can appoint two directors. One of the Founders’ directors is Chairman. The Chairman has an additional casting vote.

In 1 and 2, control is uncertain. In 1, there is no certainty because there is a potential for a 2-2 deadlock. In 2, there is no certainty because it may depend on how the independent director votes.

In 3, the Founders retain control. If there is a 2-2 tie, the Chairman (one of the Founders’ directors) has a deciding vote.

The following example shows how control can be lost even if the Founders retain more than 50% of the shares:

The ownership of the ordinary shares in company XYZ is as follows:

  • Founder A: 40%.
  • Founder B: 40%.
  • Investor C: 10%.
  • Investor D: 10%.

The shareholders’ agreement contains a list of “Reserved matters” — matters for which the shareholders’ approval requires the affirmative vote of all shareholders. The list of reserved matters in this particular contract includes expenditure above a specified amount, signing of cheques, expansion of business, and change of business direction.

Effectively, for those reserved matters, the Founders have lost control, as even with a combined shareholding of 80%, they need the approval of the other shareholders (the Investors).

Reserved matters essentially change the “value” of shares when it comes to voting rights.

If you have to give out equity, use a vesting schedule

Startups should always consider using a vesting schedule to give out equity over time, and include a cliff for early exits. This applies to the shares of co-founders and investors. I mentioned briefly about how some founders have found it frustrating when proposing vesting schedules to traditional individual investors here, who are not familiar with the concept.

When adopting a vesting schedule, ensure that it works. The share buy-back mechanism which is typically seen in Silicon Valley termsheets is not enforceable in Malaysia. The Companies Act here only allows public companies to effect a share buyback. This is another reason why startups should hire a lawyer and not rely on standard contracts — I’ve seen instances where startups get a standard termsheet or founders agreement from the Internet, and sign themselves up to vesting schedules which fail because the share buyback is unworkable in Malaysia.

“Reverse vesting” — options to purchase reducing over time, set out in a separate option agreement — is common in Malaysia.

Here’s an example of a typical “reverse vesting” scenario:

  • 1,000 shares issued on 1 September 2015, reverse-vesting over a four-year period (which means 250 shares a year), with a one-year cliff.
  • If the party leaves on 1 March 2016 (within Year 1), the remaining shareholder can buy-back 100% of the shares (1,000 shares).
  • If the party leaves on 1 December 2016 (after Year 1 but before Year 2), the remaining shareholder can buy-back 75% of the shares (750 shares), and the departing shareholder can keep 25% of the shares (250 shares).
  • Once 1 September 2019 has passed, the option period is over and the vesting is complete.

Be careful with liquidation preference and participation rights

Poorly thought-out clauses in relation to liquidation preference and participation rights can mean you lose a big chunk of sale proceeds.

I mentioned earlier the importance of achieving clarity in contractual clauses, with a sample of a liquidation preference clause.

Understand anti-dilution protection

I’ve mentioned anti-dilution protection clauses a couple of times in this series as an example of a clause which is sometimes proposed by founders, without realising that it actually “protects” the investor most of the time.

Anti-dilution protection multiplies the effect of equity given out.

These clauses can result in a founder’s shares being severely diluted, or even lead to a founder losing control of the company if there is a down-round.

Here’s a simple scenario:

  1. Investor A puts in RM1.0 million based on the company being valued at RM4.0 million — gets 25% of the company.
  2. Next funding round, the company is valued at RM2.0 million.
  3. Due to anti-dilution protection, Investor A gets 50% of the company on the down-round valuation (RM1.0 million out of the RM2.0 million).

Don’t lose control of transfers of shares and entry of new shareholders

It’s important to always maintain control of who your fellow shareholders are.

Any transfers of shares should always require the approval of the existing shareholders, or at least afford them a first right of refusal.

It is also important that a new shareholder be required to sign a deed of adherence to the existing shareholders’ agreement so that all the terms and conditions governing the relationship between the shareholders and the decision-making in the company are maintained.

Dispute resolution, deadlocks, and exits — always have a way out

I touched on this when dealing with oversights which could destroy your startup — a good shareholders’ agreement must always provide an exit when there is a deadlock.

When the parties can no longer agree on an issue, they must be able to sell their shares, or buy-out the other parties, or resolve the dispute in some way which enables the business to move forward.

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