Stockholders (Investor Rights) Agreement

Joseph W. Bartlett, Special Counsel, McCarter & English LLP, Co-Founder of VCExperts

McCarter & English LLP

2002-08-02


It would be technically possible to include all the provisions of the term sheet in one agreement, the Purchase Agreement discussed above, but it is usually not convenient to do so because of the several parties to the financing documents—the company, the founder, the investors, and the key employees; usually none are parties to all the promises entailed in the financing. If counsel were to draft an umbrella agreement, it would be necessary in each subsection to specify not only who was promising what, put to whom and with whom, and to make sure that no party to the umbrella agreement inadvertently wound up becoming bound to a promise that he lacked the power to perform. Accordingly, the Stock Purchase Agreement is usually accompanied by a Stockholder's Agreement, an agreement by and among the founder in his capacity as a stockholder and the investors. The company may, on occasion, be made a party to this Agreement for the sake of convenience, but usually only in a supportive role.

A principal reason for a separate Stockholders Agreement, as earlier suggested, is that the company does not control who sits on its managing board, the board of directors; an agreement signed by the company purporting to govern who sits on the board would be circular in the sense that the subordinate would be pretending to exercise power over the supervisor. Therefore, it is advisable to record the understandings, if any, on that important issue in an agreement to which the holders of the majority (or, better, all) of the voting shares of the company are parties, since the board is elected by the stockholders. In its simplest form, the stockholders will get together (all or a majority of them) and agree to: (1) maintain a board of X number of people; and, (2) either elect specified individuals to the board, or, more commonly (and prudently since individuals are mortal and/or they change their minds about serving on boards), specify how representation on the board is to be allocated among the stockholders. The common stockholders, for example, will be allocated X number of directors and the preferred stockholders, Y number; each class of stock will be given the power to remove their own directors and replace them as they see fit. The agreement may, further, provide for a so-called control flip, meaning that if the fortunes of the company deteriorate, the preferred stockholders will get more board seats, either vesting control in them for the first time or reinforcing their already-existing control.

Topics

Introduction to Venture Capital and Private Equity Finance