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Startup Contracts Explained: 5 Risks You Take - YouTube
Channel: The Rest Of Us
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This is you,
[1]
this is your startup,
[2]
these are your investors,
[3]
and this is your Shareholders Agreement.
[6]
The SHA is a document that is signed
by all shareholders
[9]
and effectively manages how
[11]
the control of the company
is split among them.
[14]
Usually, the bigger the company,
[15]
the longer the SHA and
the harder to understand
[18]
for mere mortals without a PHD in law.
[21]
Anything that's written in the SHA
[22]
is subject to negotiation.
[25]
Therefore, be careful to consider
[26]
these five things before you sign.
[31]
When a company raises cash
from new investors,
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existing shareholders get diluted,
[36]
meaning their percentage hold
of the company is diminished,
[39]
as the new investor receives newly issued shares.
[43]
If you've seen Part 1
[45]
(if you haven't, watch it now),
[46]
you might remember how I said
[47]
that every shareholder gets
diluted proportionally
[50]
to their share in the company.
[52]
So in our case, with a new investor
coming in at 25 percent,
[57]
if you own 40 percent you lose 10,
[59]
if you own 20 percent you lose 5.
[62]
Well, I lied.
[63]
Dilution is NOT always proportional.
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The SHA might include
an anti-dilution clause,
[70]
which exempts a certain shareholder
from dilution completely
[73]
by simply granting him new shares
[75]
when a capital race takes place.
[77]
And if a man isn't diluted,
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because of the way percentages work,
[81]
then others must be diluted
even further in his stead.
[86]
In one famous example,
[87]
the SHA included a clause
[89]
which granted anti-dilution
to all shareholders,
[91]
with only one certain shareholder
taking the hit.
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"Mark!"
[96]
"He's wired in."
[97]
"Sorry?"
[97]
"He's wired in."
[98]
"Is he?"
[98]
"Yes."
[100]
<i>crash</i>
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"How 'bout now, you still wired in?"
[103]
"Security."
[103]
"You issued 24 million
new shares of stock. "
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"You were told that if
new investors came along -"
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"How much were your share's diluted?
[110]
How much were his?"
[112]
"What was Mr. Zuckerberg's ownership
share diluted down to?"
[116]
"It wasn't."
[117]
"What was Mr. Moskovitz's ownership
share diluted down to?"
[121]
"It wasn't."
[122]
"What was Sean Parker's ownership
share diluted down to?"
[125]
"It wasn't."
[126]
"What was Peter Thiel's ownership
share diluted down to?"
[129]
"It wasn't."
[130]
"And what was your ownership
share diluted down to?"
[134]
"0.03 percent."
[137]
To prevent this from happening to you,
[139]
always watch out for dilution in your SHA.
[144]
The Board of Directors is to a company
[146]
much like a Parliament is
to some democracies.
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It elects the CEO much like the
German Parliament elects the Chancellor.
[153]
And they can influence and/or veto
decisions made by the CEO.
[156]
Note that the board is not involved
with day-to-day operations
[160]
and not to be confused with
the Management or Executives of a company,
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even though some of them will
usually also be board members.
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But in general, who gets
to determine the board members?
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Much like voters determine
who's in Parliament,
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shareholders determine who's in the board.
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And in the case of startups
and private companies,
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these are usually the founders,
investors, and others
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such as employees, friends, and family.
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But not every vote bears equal weight,
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once again, much like
in certain democracies.
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<i>ba dum tss</i>
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The number of board seats
a shareholder can determine
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is usually vaguely correlated to
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the number of shares they hold,
[198]
but also to their standing
inside the company
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and their negotiation skills.
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For example,
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in a young private company
with five board seats,
[206]
the co-founder and CEO
might determine two of them
[209]
while only holding a 20 percent stake,
[211]
because he's so charismatic and likeable
[213]
and important to the business,
[215]
while another founder who also
owns the same 20 percent
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gets to determine none.
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A big investor who holds 30 percent
[223]
determines another two,
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while one early investor
with only a 10 percent stake
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determines another one.
[229]
Others, even though adding up
to a total of 20 percent,
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doesn't speak with one voice
[232]
and is out of the loop.
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Once it's agreed who can determine
how many board members,
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then that's what's written into the SHA.
[240]
And once it's signed, the deal is sealed.
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So you better pay good attention
[244]
to the Board of Director's section.
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Say you invested some money
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into a friend's startup at an early stage,
[252]
and now you hold a small stake in it.
[254]
The lead investor is some famous guy
[256]
who went all-in on your friend's idea
[258]
and holds a majority stake in the company,
[260]
including a majority of board seats.
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Things have been going well,
[265]
and one of the big guys shows
some interest in the startup,
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so much so that they want
to buy control of the business.
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Good news for the big guy!
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The only one they have to talk to
[274]
is Mr. Majority over here.
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He can now exit his controlling stake
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for a sweet profit over
his initial investment.
[282]
And you and the other
minority shareholders
[284]
can go f*** yourselves,
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right?
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Not so!
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The Tag-Along clause puts
a big asterisk on that deal.
[290]
It gives the minority stake the right
[292]
to sell the same portion of their stake
[295]
at the same price and conditions.
[297]
And if the big guy just
wants to buy control,
[299]
but not the whole company,
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then they're buying from everyone equally.
[304]
So if you're a minority
shareholder in a company,
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be especially sure to have
your Tag-Along rights
[309]
included before you sign.
[313]
Now maybe you're one of the big investors
[315]
and your exit candidate wants to buy,
[317]
not just control, but the entire company.
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You think it's a great deal,
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but those naggy small investors don't agree
[323]
and tell you "We won't sell our shares!"
[327]
And you tell them, "Yes, you will!"
[329]
And they say, "Make us!"
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Turns out, you can,
[332]
thanks to the Drag-Along clause.
[334]
The Drag-Along gives
the majority shareholder
[337]
the right to force minority shareholders
[339]
to sell their shares at
the same conditions as them.
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So if you happen to hold
a big stake in a small company,
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the Drag-Along clause will be
important to you.
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This is you, this is your startup,
[352]
and these are your employees.
[354]
Employees need incentives,
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and what better way to incentivize them
[358]
than making them co-owners of the business?
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"Here you go!
[362]
Now I can pay you half your salary
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while also making you work harder!"
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But where do these shares come from?
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Who gave away some of their participation?
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The answer to this question
[372]
brings us full-circle
back to the first topic:
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Dilution.
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When a capital race takes place,
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it's decided how many shares
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should be newly created and set aside,
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just to distribute amongst
the foot soldiers:
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the data crunchers,
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the sales guys,
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the managers.
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Where's the catch?
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Whenever shares are
newly created from one end,
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dilution must occur somewhere
on the other side.
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So if the share option pool
is filled up to 10 percent,
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then all existing shareholders will be diluted
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by those same 10 percent of their share.
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But it gets more tricky than that.
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As discussed in 1,
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some shareholders might cover themselves
[411]
against share option pool dilution.
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The new investor, for example,
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made it a condition to his juicy investment
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that he won't take a hit
[418]
from share option pool dilution in this round.
[420]
Bad luck for the rest of you.
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Oh look, the co-founder also negotiated
[424]
his way out of share option pool dilution,
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because he didn't get
any board seats, after all!
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All of this haggling is part of the process
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which might be slipped by you
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if you don't know what to look for.
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But in the case of at least five things,
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you now do!
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Thanks for watching!
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Creating these videos has become
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a very time-consuming hobby of mine,
[444]
and your support has just been spectacular!
[447]
If you want to help me even further
[449]
improve quality and upload frequency,
[451]
then please check out
my brand-new Patreon page.
[454]
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