The startups’ yellow brick road to success is most often paved with a well-written shareholders agreement (SHA). An SHA can, along with the startup’s articles of association, be classified as the constitution of the startup.
In Nordic Law’s previous post, we presented three key topics that should be kept in mind when the founders of a startup are drafting a shareholders agreement (SHA).
In this part, which was originally published as a guest blog post on Arcticstartup’s webpage, we will focus on other key issues that are equally important when drafting an SHA: The protection of intellectual property rights; Confidentiality, non-competition and non-solicitation clauses; as well as The material breach of the SHA.
The Protection of Intellectual Property Rights
From the startup’s point of view, it is essential that the provisions of the SHA ensure that all the intellectual property rights (IPRs) and know-how of the startup is properly protected. Especially during the on-going tech boom, it should be considered a must for tech startups to protect their IPRs which have arisen or will arise later during the business of the startup. The founders do not want to end up in a situation where the key IPRs do not belong to the startup.
Based on our experience from working with several Finnish startups, we have noted that often the founders have been developing the business of the startup for perhaps several years prior to the actual founding of the startup – during that time, the founders have often already developed certain IP that should be the property of the startup when it has been duly founded. In this context, the SHA should always clearly state that related IP that has been developed or generated before the signing of the SHA shall as well belong to the startup.
Why is it then so important to ensure that all IPRs relating to the business of the startup are the property of the startup itself? We have encountered this question numerous times, although we have noticed that founders of startups have started to realize the value of duly protecting the IPR. Therefore, if your startup’s business is heavily dependent of the developed IP, you should always make sure that the startup’s most valuable property, the IPRs, is properly protected in the SHA.
By duly protecting the IPRs and ensuring that all the IPRs belong to the startup, the startup is also able to attract more investors as very few investors are willing to invest in a startup that is not the owner, or at least the beneficiary, of the IPRs essential to the startup.
Confidentiality, Non-Competition and Non-Solicitation Clauses
Especially regarding startups with several co-founders, it is vital to ensure that the SHA contains the necessary confidentiality clauses. The founders and possible investors and/or working shareholders may have different business interests, some being more active than others in the startup. Properly drafted confidentiality clauses in the SHA help protect the startup from the release of commercial information to competitors or other outsiders. An effective confidentiality clause should be in force during the validity of the SHA and a certain amount of years after the termination of the SHA or after a shareholder ceases to be a party of the SHA. By taking advantage of a comprehensive confidentiality clause that remains in force also for a certain time after a shareholder has left the startup, the startup can in an effective manner protect information from spreading to possible competitors.
Another vital subarea of a startup’s SHA is the non-competition clause – the shareholders of the startup should in general be prevented from competing, directly or indirectly, with the business of the startup. As with the confidentiality clause, also the non-competition clause should be in force during the validity of the SHA and for a certain time after a shareholder has left the startup. However, when incorporating a non-competition clause to the SHA, the founders should always pay close attention to the definition of the term “business” as the non-competition clause is applicable to activities that compete with the business of the startup. Normally to the definition of the term business is not included any business that was not carried out or was not contemplated to be carried out by the startup. For example, if the business operations of the Finnish startup HealthyFinn Oy Ltd has been focusing on health tech, then a non-competition clause should not prevent leaving shareholder Tom to start business operations relating to gaming.
Generally both the founders and possible working shareholders (i.e. key employees) are subject to a non-competition clause. However, regarding working shareholders, meaning especially key employees with minority stakes in a Finnish startup, there are certain restrictions regarding non-competition clauses as the Finnish Employment Contracts Act must also be taken into consideration. Said legislation provides that employees may not, in general, be subject to non-competition clauses that remain in force for over six months after the termination of the employment. As an example can be mentioned coder Tom who is also a minority shareholder at the startup he is working at (i.e. a normal situation in many Finnish startups). As he is classified as a working shareholder, the non-competition clause in the SHA prevents Tom from working at another similar company after the termination of his employment agreement. In general the non-competition period could be more than one year, but as Tom probably would be classified as an employee instead of a shareholder, the Finnish Employment Contracts Act restricts in normal cases the non-competition period to six months.
As investors often are engaged in several investment activities, it is quite rare to find an investor who would accept an SHA that would prohibit the investor from engaging in other investment activities. However, depending on the startup and its field of business, an investor may accept a non-competition clause that prohibits the investor from being a member of the board at a competing startup.
Also, based on our experience with gaming startups, the incorporation of a wide-ranging non-competition clause to the SHA may be subject to quite a lot of discussions between the founders. During the foundational stages of the startup, the startup is not yet generating any revenue, but nonetheless, a possible non-competition clause effectively prevents the founders from having any other activities that compete with the startup.
Why is that a problem you may ask? We have noticed among gaming startups that the custom is that the founders often have various freelancer-based activities that could compete with the startup. For example, the founders of startup FinnGame Oy Ltd are all avid game developers and they have been developing games as freelancers before the founding of the startup. If the SHA of FinnGame Oy Ltd would contain a wide-ranging non-competition clause, the founders would be prevented from offering freelance game developer services to other companies active within gaming, which could have a significant financial impact on the economy of the founders. In that situation the founders should have an open discussion regarding a possible non-competition clause and the effects of it.
One cannot mention the non-competition clause without also saying a few words about the non-solicitation clause, which is closely related to the non-competition clause. The non-solicitation clause is connected to so-called leaver situations – if and when a shareholder leaves the startup, the non-solicitation clause prohibits the leaver from taking with him or her the employees or consultants of the startup. The non-solicitation clause is in force for a certain time after the shareholder has left the startup, making sure that leaving shareholder Tom cannot take with him any employees of the startup. In other words, the non-solicitation clause ensures that important talent to the startup also stays for as long as possible in the startup.
The Material Breach of the SHA
Every so often we have stumbled upon certain startups that have not in their SHAs taken into consideration the risk of a shareholder breaching the rules set in the SHA. In order to avoid time-consuming negotiations regarding the proper sanctions in cases of breach of the SHA, it should contain clear provisions that regulate a material breach of the SHA.
The most common provision relating to the breach of the SHA is the obligation for the breaching shareholder to pay liquidated damages (i.e. a contractual penalty) to the startup and/or the non-breaching shareholders. In addition, the breaching shareholder is also often obliged to pay full compensation for all damages exceeding the amount of the liquidated damages. What is then the correct amount of the liquidated damages? There is, unfortunately, no correct answer to it. However, as a general thumb rule: too low liquidated damages might lead to a situation where the breaching of the SHA becomes economically tempting, but then again, very high liquidated damages may lead to a situation, where instead of developing the business of the startup, the shareholders aggressively strive to “discover” new material breaches of the SHA by the other shareholders in order to be able to present claims regarding liquidated damages. For example, if the liquidated damages are set at 100,000 euros, it could become tempting for shareholder Tom to try to claim that the other shareholders are in breach of the SHA.
It is equally important to clearly define a material breach of the SHA – i.e. what sort of conduct constitutes a material breach. Normally this is achieved by defining certain situations that automatically are considered as material breaches, such as the breach of the confidentiality, non-competition or non-solicitation clauses. In addition, any other breach of the SHA that has not been rectified or cannot be rectified within a certain amount of time after the discovery of the breach (normally 30 days), can be defined as a material breach.
In addition to the liquidated damages, the SHA may also contain provisions stating that in situations of material breach, the startup primarily and the non-breaching shareholders secondarily shall be entitled to redeem the shares owned by the breaching shareholder. Said provision aims to protect the startup and the non-breaching shareholders as it offers an opportunity to “get rid of” a shareholder causing problems – exemplified, shareholder Tom has, once again, caused problems and this time the problem has been classified as a material breach of the SHA. In addition to the liquidated damages, the startup itself and the non-breaching shareholders have got an opportunity to redeem the shares owned by shareholder Tom.
As hopefully this blog post has clarified, a startup should never start the actual business operations before all the founders have signed an SHA. It is always simpler and less time-consuming to agree on the terms of an SHA before the actual founding of the startup and the initiating of business operations. When the actual business operations have already started and the startup has been founded without an SHA, it can become quite of a challenge to get all the founders around the same table to discuss the terms of the SHA, especially if there already is a growing rift between the founders.
Lastly, the next time you are contemplating whether an SHA is necessary, bear in mind the key issues we have mentioned in our blog posts regarding SHAs. If you wish to minimize the risks, you already know the answer.
With a well-written and -functioning SHA, the founders may rest assured that the essential details regarding the startup and its administration are taken care of. In that situation the founders are also able to focus purely on the developing of the startup and the navigating of the startup through its, perhaps challenging, first operative years.
Do you want to know more about a well-functioning SHA for a startup? Then do not hesitate to contact us at Nordic Law, where startups of all sizes receive lean and holistic legal services!