Introduction: When founders and private equity firms come together to grow a business, they often enter into shareholder agreements and establish bylaws to govern the company’s operations. However, some seemingly innocent and fair provisions can have unintended consequences, ultimately leading to the founders being squeezed out. In this article, we will explore specific provisions that can reduce a founder’s influence and offer suggestions on how to protect their interests.
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CEO Appointments and Stock Options
A common practice in shareholder agreements is the appointment of a CEO to lead the company, often accompanied by generous stock options as an incentive. While this may appear to be a fair arrangement, it can dilute the founder’s shares and reduce their voting power. To avoid this, founders can insist on offering non-voting shares for stock awards, ensuring that their voting power remains intact.
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Supermajority Voting Requirements
Bylaws may contain provisions requiring a supermajority vote for significant decisions, which can seem like a fair way to ensure consensus. However, this can also work against the founder if they hold less than the required supermajority percentage. Founders should carefully consider the implications of such provisions and negotiate terms that protect their ability to influence critical decisions.
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Drag-Along Rights
Drag-along rights allow majority shareholders to sell their shares and require minority shareholders to sell their shares under the same terms. While this provision can protect investors, it may also result in the involuntary sale of the founder’s shares, effectively pushing them out of the company. Founders should negotiate drag-along rights with caution, seeking to limit their application or exclude themselves from such provisions.
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Preemptive Rights
Preemptive rights give existing shareholders the right to purchase new shares before they are offered to others, ostensibly to protect their ownership stake. However, if the founder is unable to match the purchasing power of private equity investors, they could see their shareholding diluted. Founders can negotiate limitations on preemptive rights to maintain their ownership percentage.
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Board Composition and Voting Rights
Shareholder agreements often detail the composition of the board of directors and the voting rights of shareholders. Provisions that favor private equity investors, such as granting them the right to appoint a majority of directors, can sideline the founder’s influence. Founders should negotiate board composition and voting rights to ensure their ongoing involvement in decision-making.
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Filling Vacancies on the Board of Directors
Another area where founders should pay close attention is the process for filling vacancies on the board of directors. For example, consider the following provision from Section 4 of Article III of a corporation’s bylaws:
“Vacancies. Vacancies in the Board of Directors may be filled by a majority of the remaining directors, though less than a quorum, or by a sole remaining director, except that a vacancy created by the removal of a director by the vote or written consent of the shareholders or by court order may be filled only by the vote of a majority of the shares entitled to vote represented at a duly held meeting at which a quorum is present, or by the written consent of holders of all shares entitled to vote for the election of directors. Each director so elected shall hold office until the next annual meeting of the shareholders and until a successor has been elected and qualified.”
This provision may seem reasonable, but it can create situations where a vacancy caused by the removal of a director can only be filled by the unanimous written consent of all shareholders. This requirement can give private equity investors significant leverage and allow them to use technicalities to control the appointment process, potentially sidelining the founder’s influence.
To safeguard their interests, founders should negotiate the terms for filling board vacancies, ensuring that they have a say in the appointment process, and avoid situations where private equity firms can exploit technicalities to gain control. This could involve modifying the requirement for unanimous written consent or establishing alternative mechanisms for filling vacancies that provide more balanced representation.
Conclusion: Protecting the Founder’s Interests Founders must be vigilant when entering into shareholder agreements and establishing bylaws, as seemingly innocent provisions can have far-reaching consequences. By carefully scrutinizing these provisions and negotiating terms that protect their interests, founders can maintain their influence and vision within the company, ensuring its continued success and growth.
About the Author: James Daily
James Daily is an accomplished attorney and entrepreneur with extensive experience in litigation, fiduciary abuse litigation, and corporate governance. As a trusted consultant and parliamentarian, he has advised numerous companies on board meeting proceedings and best practices.
James has written for prestigious publications such as Entrepreneur and Forbes, sharing his insights on legal strategies for businesses and the art of reading and influencing people in the courtroom. His expertise in the field has been recognized through articles that highlight his journey from whistleblower to millionaire.
Having worked closely with founders and private equity firms, James possesses a unique understanding of the challenges they face. His firsthand knowledge of the delicate balance between retaining founders’ vision and navigating private equity partnerships makes him a credible and valuable resource in this field.
