How to avoid and resolve disputes between founders and investors
As your business grows, you will want to seek new investment. Investment is essential, but it is likely that in bringing in new investors, founders will have to dilute their equity stake and give up some control of their business. Those investors are likely to insist on new agreements being put in place regarding their investment and the ongoing governance of the business, which will include detailed provisions relating to, among other things, founder vesting and departures. This would likely supersede any arrangements that the founders may have agreed in a co-founder agreement.
Common pressure points
If potential issues are not properly considered at the outset when seeking funding, then disputes can arise between founders and investors later down the line. In particular, you will want to consider:
- Board composition, as new investors may insist on appointing a board representative. They will be able to vote at board meetings and influence the direction of the business, as well as having the ability to block certain operational matters as mentioned below.
- Shareholder governance, as , whilst they may have a minority stake, new investors may own a substantial number of shares in your business. That will give them considerable sway on matters which require shareholder approval. They will usually have contractual veto rights on certain key matters including economic rights relating to the shares and certain operational matters which would otherwise be approved at board level. In some instances, the investor may take a majority stake which will amplify these issues and will need to be separately considered.
- Your shareholding will be diluted, meaning you will have lost a degree of control of the business and will receive a smaller portion of the payout on exit.
- Depending on the structure of their investment, the investors may also receive their payout in priority to you on liquidation or exit, particularly at low valuations.
Potential solutions
When negotiating the terms of new investment into your business, try to ensure that your key rights are protected.
- Make sure you really understand the term sheet. Investors negotiate term sheets every day, and whilst some term sheets might seem innocuous on their face, they have potentially far-reaching effects. Make sure you know what you are signing up to, and have a lawyer review it before you sign. Even though term sheets are not normally legally binding, the investors will expect the final documents to reflect the term sheet, so this is the time to negotiate any key points.
- Consider the composition of the board in order to ensure that you retain control of the business as far as possible, including participation / membership of the key committees such as the remuneration committee. Make sure your right to a board seat is entrenched for so long as you remain a service provider for the business and a shareholder.
- As new investors enter the business, founders may end up owning only a minority stake in the company. Amend the shareholders agreement to protect your decision making capabilities, in particular to try to retain control over the ultimate sale of the company and associated drag along rights.
- When negotiating the structure and terms attached to new classes of shares, consider what is being given away as well as the potential benefits that such investment can bring. Think about the method of share valuation, the likely amount that preferred shareholders will receive on exit, and whether there are any terms you want to include to prevent new investors from being able to “club together” to control shareholder decision making.
What to do if a dispute does arise
If your rights are protected in the shareholders’ agreement or the company’s articles, that should prevent some disputes from ever arising. If those rights are being infringed by a shareholder’s (or director’s) conduct, then you can point to those agreements when arguing your position and trying to find a solution. Ultimately, it may be that you are able to bring a claim or even seek injunctive relief (i.e. a court order to stop something from happening), though this is expensive and time consuming. However, being aware of the legal remedies available to you will strengthen your position and help you to negotiate a solution.
If decisions are being taken in the business which are unfairly harming your interests as a shareholder, you can bring a claim for unfair prejudice. Conduct must be both prejudicial (meaning damaging to your interests as a shareholder) and unfair (meaning objectively unjust). Examples of unfair prejudice include dilution of a minority shareholder on a different basis to others, breaches of the company’s articles of association or shareholders’ agreement and poor management of the business’s finances. The court has a broad discretion to award remedies for unfair prejudice, including a share buyout or changes of management.
You should also be aware that if a shareholder feels that the business is being mismanaged, they could also bring a derivative claim – meaning a claim as a shareholder on behalf of the company – against the company’s directors or another party. You should be aware of your duties as a director and seek advice on corporate governance issues in order to ensure that you do not fall foul of these potential issues.
