Founder and early employee shareholder agreements: what can go wrong

A UK shareholders agreement sits alongside the articles of association and governs how founders, early employees and investors deal with each other as owners of the company. However unlike articles of association, these are usually private agreements and are typically not published at Companies House.  Most early stage businesses have some agreement between co-founders and initially these are often informal agreements. Once the business begins to develop, hires employees or considers raising investment, it is worth considering how to govern relations between equity holders. 

Below are typical issues that arise in practice, drawn from founder agreements, early employee share arrangements and the transition from a small team into a properly funded company.

No founder vesting from day one

Founders often incorporate with a straight split of ordinary shares and no vesting. If a co-founder leaves six months later, they keep their full stake. The remaining founders then carry all the work, and any future investor will require the departed founder's shares to be dealt with before they will fund the company.

Reverse vesting on founder shares, typically over four years with a one-year cliff, can avoid this. 

Early employee shares issued without structure

Early employees are sometimes given ordinary shares directly, rather than options, as a gesture of commitment. This can create immediate tax charges for the employee (based on the market value of the shares). Shares issued in the same class will also grant voting rights that rank equally with the founders. Increasingly, we see that Founders are comfortable granting equity to very early employees, akin to additional founders but it is helpful to know the pros and cons. 

An EMI option scheme is a good alternative for UK employees of a qualifying company. It defers tax until exercise, gives the company control over vesting and leaver provisions, and does not clutter the cap table until options are exercised. However to provide certainty companies should typically seek HMRC approved valuations prior to granting EMI options. 

Weak or missing leaver provisions

A shareholders agreement should distinguish between good leavers and bad leavers, and set out what happens to their shares or options. This may be a discussion between parties to determine what is fair. Good/Bad Leaver provisions can be drawn too widely, resulting in unexpectedly lost or retained equity.

If shares are purchased by the Company, share buybacks in the UK also have to comply with the Companies Act 2006, including having distributable reserves or funding the buyback out of capital, which is a separate procedural exercise. 

Drag along and tag along that do not work

Drag along rights let a majority of shareholders force a minority to sell on the same terms in an exit. Tag along rights let a minority join a sale by the majority. Both are standard, and founders should tailor these based on their preferred sale or exit thresholds.

Founders may prefer to have drag or tag provisions specified so that 

Equity grants that do not align with the articles and service contracts

A shareholders agreement does not sit on its own. Share issues, option grants and leaver mechanics all need to line up with the company's articles of association and with the service contracts (or consultancy agreements) of the founders and employees receiving equity. When these documents are drafted in isolation, gaps can become apparent at crucial points.

Typical misalignments include: leaver definitions in the shareholders agreement that do not match the termination triggers in the service contract; share classes or transfer restrictions promised in the shareholders agreement but not reflected in the articles; option grants made outside the scheme rules or without the board and shareholder authorities required by the articles; and vesting or good/bad leaver treatment that assumes an employment relationship the recipient does not actually have.

Director duties treated as an afterthought

Founders who are also directors owe statutory duties under the Companies Act 2006, including duties to promote the success of the company, exercise independent judgement and avoid conflicts of interest. Shareholders agreements often layer investor consent rights and reserved matters on top, and the interaction is not always straightforward.

Reserved matters that require investor approval for routine operational decisions can slow the company down and expose directors to breach-of-duty risk if they act without consent. The list of reserved matters should be genuinely material, not a copy of a precedent.

Getting help

Hythe Legal advises UK founders on shareholders agreements, founder vesting, equity and debt instruments (ASAs, CLAs) and the corporate documentation that sits behind them. If you are setting up your company, bringing in early employees or preparing to raise, do get in touch.