Switzerland Update: How to create better shareholders’ agreements—a lawyer’s perspective

A lawyers view with Christian Wyss.

Christian, what are the topics with the most conflict potential in a shareholders’ agreement (SHA)? 
Let me start with the “double trouble” topics that lead to conflicts both at the negotiation stage and when they become relevant a few months or years down the road:

• Founders’ non-compete: It’s highly debated whether the founders’ non-compete belongs in the shareholders’ agreement. Many argue it should only be addressed in the employment contract. Investors rightly demand that the founders do not compete with the startup regardless of where the topic is addressed. The challenge for investors is that the business of a startup may not be entirely set in stone. Also, the startup may add further lines of business in the future. On the other hand, the founders usually spent most of their careers in areas related to the startup. They need an opportunity to earn their living in their field of expertise even after leaving the startup. A balanced solution requires a thorough understanding of the startup’s business, must take into account the strength or weakness of the startup’s intellectual property rights, and may include certain mechanisms to quickly determine whether a certain activity actually is competing or not. Nevertheless, a certain grey area remains in most cases.
• Penalties for failure to fund: If an equity financing is divided into several tranches or milestones, the question is what happens if an investor fails to pay a subsequent tranche or milestone amount. As soon as there is more than one investor, the startup, the founders, and the investors all have an interest in there being a penalty provision for this situation. The usual penalty is converting the defaulting investor’s preferred shares into common shares at a certain ratio (10:1, 3:1, 1:1). The exact mechanism is usually less decisive for the startup. For each investor, their desired mechanism depends on how likely they consider it to be that they could be the one defaulting. Because many nuances influence the enforceability of the penalty, discussions on shaping and enforcing such penalties often lead to heated discussions. 

A next bucket of topics has a high conflict potential during the negotiation stage but rarely leads to conflicts after signing the shareholders’ agreement:

• Board composition: Having a board representative is key for most investors. For the startup, keeping the board as small as possible is important to make decisions quickly. Also, a small board makes it easier for the chairperson to conduct meetings efficiently. However, the board will inevitably grow as more investors join. In later financing rounds, asking existing board members to step down in favor of new board members is delicate and may lead to disappointment. This also applies to founders, independent industry experts, or previous investors. Given that in addition to the board members, board observers and many C-level executives are also invited to (parts of) the board meetings, however, keeping the board at a reasonable size is crucial. Also, foreign investors sometimes ignore that even in late-stage financings, Swiss law entitles the common shareholders to at least one board representative.
• Liquidation preference and dividend preference: Negotiating liquidation preference and dividend preference is closely related to the valuation of the startup. It is important for founders and existing investors to understand that getting a lower valuation with moderate preference rights might be as good of a deal as getting a much higher valuation with very investor-friendly preference rights. It is important to distinguish between non-participating liquidation preference (i.e., investors only get the higher of the preference amount or their pro-rata share of the exit proceeds) and participating liquidation preference (i.e., investors get both the preference amount and their pro-rata amount of the remaining exit proceeds). With regard to dividend preference, it is important to distinguish between cumulative dividend preference (i.e., investors are entitled to a certain percentage of their investment every year, usually paid at exit) and non-cumulative dividend preference (i.e., investors are only entitled to a dividend for a particular year if the shareholders actually resolve to pay a dividend for that year).

A third category of topics often seems less important at the negotiation stage but will lead to conflicts when they actually are to be applied:

• Veto rights: Veto rights on some issues for a particular group (e.g., series A shareholders, common shareholders, founders, etc.) are industry standard. What must be avoided is giving a veto right to a particular shareholder or board member rather than to a group. Such an individual veto right is a blunt invitation to use it as leverage for unrelated issues. Therefore, even if exercised in good faith, very likely, someone will assume that the veto right was used for improper motives. The dispute is inevitable.
• Drag-along: Actually enforcing drag-along rights in the context of an exit transaction is very difficult. The challenges consist, on the one hand, in a number of corporate and securities law issues that complicate enforcing a drag-along, and on the other hand, in the fact that potential acquirers are not at all thrilled to wait until a court will have decided on enforcing the drag-along. Thus, the SHA should explain the requirements and the procedure of the drag-along clearly and understandably for all shareholders, leaving as few loopholes a possible. This is often sufficient even for shareholders who do not actually wish to sell to nevertheless submit to the drag-along.

Which parts of a shareholders’ agreement are often overlooked or even forgotten that both parties should check (e.g., information rights, representation, and warranties)?
A topic that sometimes gets neglected as a pure “boilerplate provision” is confidentiality. Tricky issues include putting adequate confidentiality obligations on universities and academic founders no longer employed with the startup, controlling the flow of information within corporate groups (in particular when dealing with corporate venture capital), and deciding under which circumstances investors may use confidential information to build new syndicates or start discussions with potential acquirers.

Another topic that sometimes gets overlooked is that founders and other early stakeholders must assign intellectual property rights to the startup. When negotiating this provision, the founders’ obligations toward their former employers, other employment law aspects, existing license agreements, and the particular role of academic founders employed by universities must be taken into account.

Do you recommend having a founders’ agreement that is separated from or integrated into the shareholders’ agreement?
Transparency is important to foster mutual trust between founders and investors. Most investors ask anyway about founders’ agreements at some point during due diligence or negotiation. Also, at least from a factual point of view, enforcing a provision everyone knows is much easier than enforcing a provision known only to (certain) founders. Thus, I recommend integrating the founders’ agreement into the SHA.

Another question is at which point in time the founders should disclose the content of their founders’ agreement. Reverse vesting provisions, lock-up periods, non-competes or the like could inspire investors to ask for similar provisions in the SHA. Also, their existence in a founders’ agreement serves as an argument why similar provisions are legitimate in the SHA. Thus, it makes a lot of sense to disclose the contents of the founders’ agreement only after these issues have been negotiated with the investors. 

By Christian Wyss, Vischer, Switzerland, a Transatlantic Law International Affiliated Firm.

For further information or for any assistance please contact switzerland@transatlanticlaw.com

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