Shareholder Agreements: Avoiding Co-Founder Disputes

Why Co-Founders Need Shareholder Agreements

Most Canadian startups begin with two or more co-founders who are friends, former colleagues, or classmates. Everyone is excited about the opportunity, committed to the vision, and confident they'll work together forever. So they skip the shareholder agreement, figuring they'll "deal with it later" or "we trust each other, we don't need legal documents." This is one of the most expensive mistakes founders make.

Co-founder disputes are the leading cause of startup failure after running out of money. When co-founders disagree about strategy, equity splits, work contributions, or exits, the lack of a shareholder agreement turns manageable disagreements into company-destroying conflicts. Without clear rules for decision-making, departures, and equity ownership, co-founders end up in expensive litigation, investors refuse to fund the company, and the startup dies. A shareholder agreement prevents this by establishing clear rules when everyone is still getting along.

What Is a Shareholder Agreement?

A shareholder agreement is a contract among all shareholders (typically the co-founders in an early-stage startup) that governs their relationship and the management of the company. It supplements the articles of incorporation and bylaws by addressing issues that corporate statutes don't cover: equity vesting, decision-making processes, transfer restrictions, dispute resolution, and what happens when someone leaves or the company is sold.

Shareholder agreements are private contracts between shareholders, not public documents filed with the government. This privacy allows you to include provisions that wouldn't be appropriate in public corporate documents, such as specific vesting schedules, personal commitments from founders, and detailed exit procedures. The agreement binds all current shareholders and typically requires new shareholders to sign on as a condition of receiving shares.

Equity Vesting: Protecting Against Early Departures

Equity vesting is the single most important provision in a shareholder agreement. Vesting means that founders earn their equity over time rather than receiving it all upfront. This protects the company and remaining founders if someone leaves early. Without vesting, a co-founder who leaves after three months still owns their full equity stake, even though they contributed almost nothing. This creates massive problems when raising investment or recruiting new team members.

Standard Vesting Terms

The standard vesting schedule in Canadian startups is four years with a one-year cliff. This means founders earn 25% of their equity after one year (the "cliff"), then the remaining 75% vests monthly over the next three years. If a founder leaves before the one-year cliff, they forfeit all unvested shares and the company can repurchase them at nominal value. After the cliff, they keep whatever has vested but forfeit the rest.

Vesting typically begins on the company's incorporation date or the date the shareholder agreement is signed. Some agreements include credit for work done before incorporation, allowing founders to vest a portion of their equity immediately to reflect their pre-incorporation contributions. This is reasonable if founders have been working on the company for months before incorporating, but be careful not to give away too much equity for pre-incorporation work that may not have been as valuable as it seemed.

Acceleration Provisions

Acceleration means vesting speeds up under certain circumstances. Single-trigger acceleration vests all equity immediately upon a change of control (acquisition or merger). Double-trigger acceleration requires both a change of control and termination without cause within a specified period (typically 12 months). Most shareholder agreements include double-trigger acceleration to protect founders from being acquired and immediately fired, but avoid single-trigger acceleration as it can make your company less attractive to acquirers.

Decision-Making and Governance

Shareholder agreements define how major decisions are made, preventing deadlock and ensuring important matters receive appropriate scrutiny. Without clear decision-making rules, co-founders can paralyze the company by disagreeing on critical issues. The agreement should specify which decisions require unanimous approval, which require majority or supermajority approval, and which can be made by management without shareholder approval.

Reserved Matters

Reserved matters are decisions that require shareholder approval rather than being delegated to management. Common reserved matters include issuing new shares or securities, selling or acquiring significant assets, taking on debt above a certain threshold, changing the business direction, appointing or removing directors, and amending the articles of incorporation or shareholder agreement. These matters are too important to be decided by management alone and require shareholder consensus.

For each reserved matter, specify the approval threshold. Unanimous approval (all shareholders must agree) is appropriate for fundamental changes like selling the company, changing the business direction, or amending the shareholder agreement. Supermajority approval (typically 66% or 75%) works for significant but not fundamental decisions like large acquisitions or major debt. Simple majority (more than 50%) is sufficient for routine reserved matters.

Avoiding Deadlock

Deadlock occurs when shareholders cannot agree on a decision and the approval threshold cannot be met. For 50/50 partnerships, deadlock is a serious risk. To prevent it, include tie-breaking mechanisms in your shareholder agreement. Options include appointing a neutral third party to cast the deciding vote, requiring mediation or arbitration when deadlock occurs, or giving one founder a tie-breaking vote on specific categories of decisions.

Another approach is to avoid 50/50 splits entirely. Even a 51/49 split eliminates deadlock risk while still being close to equal. If you insist on 50/50, consider rotating decision-making authority by category (one founder has final say on product, the other on business development) or by time period (alternating quarters or years).

Transfer Restrictions: Controlling Who Becomes a Shareholder

Transfer restrictions prevent shareholders from selling or transferring their shares to outsiders without the company's or other shareholders' consent. This ensures that you don't end up with unknown or unwanted shareholders. Most shareholder agreements include a right of first refusal (ROFR), giving the company and other shareholders the right to purchase shares before they're sold to a third party.

Right of First Refusal (ROFR)

A ROFR works like this: if a shareholder receives an offer to purchase their shares, they must first offer those shares to the company and other shareholders at the same price and terms. The company typically has first priority to purchase, followed by other shareholders pro rata (in proportion to their existing ownership). Only if the company and shareholders decline can the selling shareholder sell to the outside buyer.

ROFRs protect against unwanted shareholders and ensure that equity stays within the founder group or goes to the company. They also give remaining shareholders the opportunity to increase their ownership when someone exits. However, ROFRs can make shares less liquid and harder to sell, which is why they're typically waived for sales to approved buyers (family members, trusts, or in connection with a company sale).

Tag-Along and Drag-Along Rights

Tag-along rights (also called co-sale rights) allow minority shareholders to participate in a sale if a majority shareholder sells their shares. If a founder with 60% ownership receives an offer to sell their shares, tag-along rights let the 40% shareholder sell their shares to the same buyer at the same price. This protects minority shareholders from being left behind in a partial sale.

Drag-along rights allow majority shareholders to force minority shareholders to participate in a sale. If 75% of shareholders approve a sale of the company, drag-along rights require the remaining 25% to sell their shares on the same terms. This prevents minority shareholders from blocking acquisitions and ensures the company can be sold if the majority agrees. Drag-along rights are essential for making your company attractive to acquirers, who typically want to buy 100% of the company.

Founder Departures: What Happens When Someone Leaves

Founder departures are inevitable. Someone gets recruited away, loses interest, has personal issues, or simply isn't working out. Your shareholder agreement must address what happens to a departing founder's shares, role, and relationship with the company. Without clear departure provisions, you end up with passive shareholders who no longer contribute but still own significant equity and have voting rights.

Good Leaver vs. Bad Leaver

Many shareholder agreements distinguish between "good leavers" (founders who leave for acceptable reasons) and "bad leavers" (founders who leave for unacceptable reasons). Good leavers typically include those who resign with notice, are terminated without cause, die, or become disabled. Bad leavers include those who are terminated for cause, breach the shareholder agreement, or resign without notice.

The distinction matters because it affects the buyout price for unvested shares. Good leavers typically receive fair market value for their vested shares and may keep some unvested shares. Bad leavers forfeit all unvested shares and may be required to sell vested shares at a discount or at cost. This incentivizes founders to leave on good terms and penalizes those who harm the company.

Buyout Provisions

Buyout provisions specify how the company or remaining shareholders can purchase a departing founder's shares. Typical provisions give the company the right (or obligation) to repurchase unvested shares at nominal value (the price originally paid, often $0.01 per share). For vested shares, the company may have a right of first refusal at fair market value, allowing it to buy the shares if the departing founder wants to sell.

Determining fair market value can be contentious. Options include using the most recent financing valuation, hiring an independent appraiser, or using a formula based on revenue or EBITDA. For early-stage companies with no revenue, the most recent financing valuation is typically the most defensible approach. Include a mechanism for resolving valuation disputes, such as each party appointing an appraiser and the two appraisers appointing a third if they disagree.

Dispute Resolution

Despite your best efforts, disputes will arise. Your shareholder agreement should include a dispute resolution process that encourages resolution without litigation. A typical escalation process starts with direct negotiation between the disputing parties, then mediation with a neutral third party if negotiation fails, and finally binding arbitration if mediation doesn't resolve the dispute.

Arbitration is faster and cheaper than litigation, and keeps disputes private rather than creating public court records. However, arbitration awards are difficult to appeal, so you're stuck with the arbitrator's decision even if it's wrong. Some agreements use litigation as the final step instead of arbitration, accepting the higher cost and public nature of litigation in exchange for the ability to appeal.

Other Important Provisions

Confidentiality and Non-Compete

Include confidentiality obligations requiring founders to keep company information confidential during and after their involvement. Consider non-compete and non-solicitation clauses preventing founders from starting competing businesses or recruiting employees and customers, though remember that non-competes are difficult to enforce in Canada and banned for most employees in Ontario.

Intellectual Property Assignment

Require all founders to assign any IP they create for the company to the company. This ensures the company owns all its technology, content, and other IP rather than individual founders. Without IP assignment, a departing founder might claim ownership of code or other IP they created, creating massive problems for the company.

Dilution Protection

As you raise funding, founders' ownership percentages will decrease. Some shareholder agreements include anti-dilution provisions giving founders the right to maintain their ownership percentage by purchasing additional shares in future financings. However, most investors will require you to remove these provisions, as they interfere with the investor's ability to set pricing and terms for their investment.

When to Create a Shareholder Agreement

Create your shareholder agreement as early as possible, ideally at incorporation or within the first few months. The longer you wait, the harder it becomes to negotiate terms because power dynamics change, contributions become unequal, and people become attached to their equity. If you're already operating without a shareholder agreement, create one now—it's never too late, and the cost of not having one far exceeds the cost of creating one.

Expect the negotiation to take time. Even among friends, discussing vesting, decision-making, and departure scenarios requires difficult conversations. Use these conversations to surface disagreements and expectations early, when they can be resolved through negotiation rather than litigation. If you can't agree on shareholder agreement terms, you probably shouldn't be co-founders.

The Bottom Line

A shareholder agreement is essential for any multi-founder startup. It prevents co-founder disputes by establishing clear rules for equity vesting, decision-making, transfers, and departures. The cost of creating a shareholder agreement ($2,000-$5,000 with a lawyer, or $59-$199 with a template) is trivial compared to the cost of co-founder disputes, which can destroy your company. Invest in a solid shareholder agreement early, when everyone is still getting along, and you'll avoid the most common cause of startup failure after running out of money.