Gone are the days of a simple handshake symbolising an agreement. As our laws and markets have become more complex so too have our documents. Understanding what your documents mean is a crucial part of being in control of your company. And for investors - understanding what your rights and responsibilities are can give you the confidence (or the warning signs) that influence your choice to invest in a company. Vesting and drag-along agreements are vital components to your shareholders agreement and outline when you actually ‘own’ your shares and under what conditions you may be forced to sell them. Today, we outline them both for you.
Vesting
Vesting is an important way of retaining shareholders over time, giving you the opportunity to fundraise with greater security. Put simply, shares that you buy you only get to ‘own’ after a period of time. The shares are often lumped into separate stages: say after one year you may own 20% of your shares and after another year you get another 20%. Shares that you own are vested shares. Shares that you have bought but do not yet ‘own’ are unvested shares. Essentially, those unvested shares are reserved for you, but you cannot yet control what you do with them. Vested shares belong entirely to the shareholder, and can be sold at their will. Unvested shares still technically belong to the shareholder, but cannot be acted on until the set period of time has elapsed. Shareholders are incentivised to keep their unvested shares, as if they forfeit them, they must sell them back to the company at their nominal value, which leaves them unable to profit. Vesting therefore operates as a safety net for employees or shareholders leaving the company, which is a security mechanism for periods of growth.
Vesting is important symbolically as well as financially, for two main reasons:
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It shows commitment to the company. When a founder is willing to vest shares, it indicates they are committed to the startup’s success, which in turn can be a mechanism to get more investors on board.
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It builds loyalty. Keeping employees and shareholders involved in your startup long term is not only a positive indicator to prospective investors, but also demonstrates loyalty to those who have stuck around through the early stages of growth.
Drag-Along Agreements
The words ‘drag-along’ paint a harsh picture of shareholders being forced into undesirable positions within the company, but despite its name, the drag-along agreement is key to future-proofing your startup. If a large investor or bidder comes along and offers to buy out the entire company, the majority shareholders (those who hold more than 50% of the shares), can control what options the minority shareholders have. If those majority shareholders agree to sell their shares, the minority shareholders are ‘dragged along’ with that decision and must also sell their shares to the incoming bidder. There are typically measures to safeguard these minority shareholders, such as ensuring that their shares are sold on the same terms as the majority shareholders.
Having this agreement ensures that a life-changing opportunity of a new investor is not obstructed by too many moving parts - such as a large number of minority shareholders who pose a small but annoying resistance to the sale of a company. In a worst case scenario, just one reluctant minority shareholder could jeopardise a major offer from a third party looking to buy the entire company.
Understanding how your shares and company works is integral to its success. Above all, ensuring transparency in how shareholder rights are communicated to all parties could save you a lot of time when a big opportunity comes knocking.
For a deeper dive into drag-along rights and their counterpart, tag-along rights, see our dedicated post on drag-along and tag-along rights. If you’re thinking about founder vesting, our guide to vesting schedules explained covers the standard structures for Australian startups. Learn more about our venture capital and fundraising practice.
