How to negotiate better shareholder agreements

BlueChilli controversy: what founders need to know about negotiating shareholder agreements

Australian incubator BlueChilli is at the centre of controversy regarding alleged ‘one-sided’ shareholder agreements and failing to deliver on their promises.

While BlueChilli CEO Sebastien Eckersley-Maslin has yet to comment on the allegations, the article sparked some discussion in the CeBIT office: what do start-ups need to be aware of before signing shareholder agreements with incubators or investors? How much room for negotiations do start-up founders have when it comes to shaping the terms of the agreement?

We had the chance to catch up with Kurt Falkenstein, Founder and Australian Partner of start-up law firm General Standards to find out more.

CeBIT 365: The news article cited BlueChilli’s shareholder terms as ‘extremely one-sided’. What should start-up founders watch out for before they sign any formal agreements?

Falkenstein: The first thing I’d like to point out here is that it is very unlikely that a legal document such as a shareholder agreement is completely one-sided. It’s usually only for very critical business decisions that the investor or a particular shareholder wants the final say. It is up to the founder to assess how the person will handle this responsibility before any agreements are signed.

To give you an example, venture capital funds have obligations to their own investors and are therefore bound to act reasonably, and so they will be more likely to balance their needs with the needs of the business founder. At the end of the day both sides want to see the business flourish. If you’re receiving investment from a wealthy individual, they can make decisions much more independently. When it comes to negative controls, the individual investor is likely to be more emotional than a VC fund, so founders need to be able to fully trust the relationship before they give one or more shareholders any negative controls.

At the end of the day you have to accept though that when you take someone’s money to grow your business they will want some level of protection. Otherwise they are exposing themselves to significant risk. As a start-up founder, you need to fully understand how much protection your investors would have and what impact that will have on business decisions.

The important thing to remember is that you do want to offer protection, not give away control. For instance giving shareholders a liquidation preference is sensible. This means that they can get their money back out if the business is sold for less than the value at which they invested. This is different to giving an investor the right to say “yes or no” to sell the company. That is handing over control.

CeBIT 365: Could the recent controversy be the result of a lack of legal advice before the agreements were signed?

Falkenstein: Absolutely, I would actually put it down to that. The terms that caused the controversy are completely standard in the VC industry. I assume that there was a lack of understanding about what the terms mean. This should have been explained to start-up founders by their lawyer.

In my experience though, people have a low stamina for the transaction. They don’t like to negotiate the terms. What also often happens is that only the positive terms are discussed and the negative controls only enter the scene when you receive a long form legal document to sign.

I’d advise start-up founders to be proactive and ask for this as early as possible in the piece to give you the ability to seek counsel and fully understand what you are signing.

The single most important thing to negotiate in shareholder agreements is how decisions are being made. Do directors or shareholders have the final say? This is important because at the end of the day shareholders can’t be sued for making bad decisions. Directors have much more overall responsibility.

CeBIT 365: In your experience, how negotiable are incubator shareholder terms compared to other forms of start-up investment?

Falkenstein: In general, incubator terms are not very negotiable because they have a portfolio they deliver and they try to keep things as consistent as possible.

In our experience, incubators are very interested in making their legal documents better though. They don’t succeed by making life hard for their start-ups.

We also find that too many companies are advised to defer negotiations because the shareholder agreement will need to be renegotiated when the next round of capital is raised. This means people often don’t think and simply accept the terms. This can end up costing them more than double the legal costs than investing in getting a great long-term shareholder agreement at the outset.

And this is not something that just happens to founders!

A prominent Australian VC firm made the assumption that a change in shareholder agreement would happen when a new investor came onboard. However, this never eventuated and they had to renegotiate terms to increase their required controls. It’s always better to negotiate before signing legally binding agreements than trying to correct the course after the fact.

CeBIT 365: Are different funding and incubator models more suitable for different entrepreneur personalities?

Falkenstein: Yes, absolutely. To start with incubator is an incredibly broad term.

BlueChilli and the York Butter Factory are both “incubators” but are completely different. For founders this means that you have to have a crystal clear understanding of what your business needs most urgently. What are the services that you are getting from an incubator? Is this really what you need? An incubator that provides cash won’t give you enough money to break even, just to get you started. You need to ask yourself what needs to happen to get you to the next stage and consider if this is the right model.

CeBIT 365:
The news article cited that founders were having issues obtaining access to their source code. What advice would you give to other founders to avoid this kind of situation?

Falkenstein: The progressive transfer of technical ownership should be documented in agreements. It’s a vital element of the business’ IP and needs to be protected.

CeBIT 365
: What is the worst mistake you have seen start-up founders make when they signed a shareholder agreement?

Falkenstein: The worst mistake I have seen is taking money before an agreement has been signed. All that means is that you are borrowing money that an investor can ask back for at any time. If you’ve spent the money you can be bankrupt in an instant. If someone buys shares, they can’t simply ask you for a refund.

Kurt_Falkenstein.jpgAbout Kurt Falkenstein

Kurt Falkenstein is the Founder and Australian Partner of start-up law firm General Standards. He started company in 2011 to help start-ups access affordable high quality legal services. General Standards has advised over 1,000 start-ups across Australia, the UK and USA.


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