Questions

How can I protect my interests as a minority shareholder in an incorporated company?

A few months ago, a CEO of a three-year-old startup (New york LLC) offered me an amazing opportunity to work for his firm as a co-founder (CTO) for an exchange of 35% equity in the company. The offer was contingent on successfully developing the technology needs. I have put a lot of effort in the last ten months to come up with a software and technology infrastructure that is necessary to drive the business. He is pleased with the product and we are ready to go live. Now he says instead of running the business with the current company (LLC), he wants to incorporate a new C-Corp in the Delaware state – as it actually helps us raise investment from VCs. He has devised the equity split as below for the new Inc. 10,000,000 total shares authorized 7,000,000 common 3,000,000 preferred 4,000,000 issued Value $0.00001 1,400,000 CTO (35%) 1,520,000 CEO (38%) 400,000 A Family member of CEO (10%) 280,000 A Family member of CEO (7%) 200,000 A Family member of CEO (5%) 100,000 A Family member of CEO (2.5%) 100,000 A Family member of CEO (2.5%) Only CEO and CTO are going to be the board members. My major concern here is how to protect my interest as a minority shareholder. Also why only 40% of shares are issued, remaining 60% are unissued. Why he wants to authorize so much preferential shares, 30% and another 30% common shares unissued. I have gone through a number of Internet articles that suggest startups typically authorize 10-15% preferential shares, but no attorney suggests 30%. Should I be concerned, as I have got only 35% shares, which is less than 38% that CEO has allocated to himself? What could be the worst situation I may encounter in the future? I read that Delaware state incorporation laws don’t protect minority shareholders. When I suggested him to reduce his stake by 3% by transferring it to one of his family members in order to make his stake equal to mine, he got so agitated and he declares he would NOT do that. He is not willing to change any of the above structure.

3answers

This is not tax or legal advice. Two things stand out - usually people leave it up to the investors to ask for preference shares and also I see a lot of family members in that cap table. He could pool them into one entity to make the structure less complex IMO. You'll want to make sure typical protections are in place but the structure of the company (anti-dilution protections). Furthermore I didn't hear you mention vesting? You'll want to pay attention to how the sale is done (making sure the assets are acquired by the DE C-Corp but short of that, you have a board seat and over a 3rd of the company. Him being at 35% as opposed to 38% will make little difference unless there is something specific in the shareholders agreement I'm missing.

They can probably remove you from the board in shareholders quorum but they cannot take your shares, if your shares are vested.


Answered 3 years ago

Hi, I'm not an attorney and you should probably seek advice from an attorney that specializes in this area of practice for specific advise.

In my 2014 book, Invest Local, I explain why it never makes sense to be a minority equity stakeholder in a small business.

Regardless of where the incorporation occurs or the documents you have in force, your future is tied to your relationship to this other shareholder. Any disagreements can have a devastating impact on your wealth, regardless of how 'right' you are. For example, do you have the financial resources to enforce your rights through the legal system?

The only question in my mind is can you trust this person and do you have a great working relationship? If you're uncertain in any way then you should probably have a 'plan b.'

Perhaps the securities you hold should have some kind of option that can convert them into debt under the right circumstances. This would put a minimum on the amount you are due if things fall apart.

Cheers and best of luck.

Arrange a call if you'd like to brainstorm together.

David


Answered 3 years ago

A few things:

Delaware corporations have a default franchise tax that is calculated on a share basis - if there are 10MM shares, then, even if the company has no revenue or assets, it would still owe the state around 75,000 dollars per year in franchise tax.

The board itself does not control the company, insofar as the board serves at the pleasure of the shareholders - if you are issued 35% of the shares (I'm not sure where you are in that capital stack you provided), then you functionally have almost as much control of the company as the CEO and CTO.

How large is the board itself (according to the Corporate Bylaws)? - Normally a board is an odd number (5, 7, etc), and the chairman of the board only votes when a stalemate exists.

None of you are majority shareholders - a majority shareholder is one that controls, either directly or by proxy, 50.01% of the shares. That doesn't seem to be the case here.

I suggest you have a corporate lawyer look this over - it seems like a sloppy setup right now, with someone at the helm that doesn't really understand the corporate structuring and its impact on a startup.

In reality - an LLC is 100% cool for the stage you are at - and a heck of a lot simpler to deal with.

We can always hop on a call for a few minutes, and I can give you some more feedback, and intro you to a few very strong attorneys that practice in this space.


Answered 3 years ago

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