If You Have M&A in View, Review Founder Shares and Shareholders' Agreements Early
Hello, I'm Noriaki Asato, Representative Attorney at LegalAgent.
In startup M&A negotiations, I sometimes come across cases where issues relating to founder shares or shareholders' agreements surface close to the final agreement stage and the process stalls. Examples include a co-founder who has already left the company but continues to hold a large number of shares, a shareholders' agreement from a previous funding round that was never updated, preferred share distribution terms so convoluted that estimating the sale proceeds takes time, and no decided approach to handling stock options. Starting to sort these out late in negotiations can cost time and negotiation expenses.
Acquirers examine not only the business but also the shareholder structure, contractual relationships, the founders' level of involvement and the ownership of intellectual property rights in detail. If you envision M&A as a future exit strategy, it is important to review your capital policy and shareholders' agreements from an early stage.
Reconciling the Shareholder Register with the Cap Table
First, reconcile the entries for issued shares in the cap table with the shareholder register. In fundraising practice, while investor presentation materials and internal spreadsheets are updated as needed, reconciliation with the shareholder register under the Companies Act, the commercial registration and each investment agreement is handled separately, and there are cases where the records do not match.
In M&A due diligence, the buyer confirms, on the basis of objective documents, who holds how many shares of what class and how transfer restrictions and prior consent rights are set. If there are discrepancies between the cap table and the company's official records at this point, they become a factor that holds up the entire verification process. The history of past share transfers is checked against the entries in the shareholder register. It is also important to track stock options and stock acquisition rights such as J-KISS individually through the stock acquisition rights register and the like, and to manage them separately so that unexercised rights are not confused with issued shares or the shares in the shareholder register.
Handling the Shares of Departed Founders and the Accumulating Risk of Shareholders' Agreements
A common source of disputes over founder shares is the treatment of shares held by founders who have already left the company. There are cases where a founder who was allocated a substantial percentage of shares early on departs and remains a major shareholder without any involvement in management or the business.
Such a shareholder structure becomes a major obstacle not only to subsequent fundraising but also when executing an M&A transaction. From the buyer's perspective, there is concern about uncertainty: whether the departed founder will cooperate in the sale process, agree to give representations and warranties, and promptly give the consents that are conditions precedent to closing. If the buyback of shares, voting agreements and confirmation of confidentiality obligations were not addressed at the time of departure, the sale negotiations themselves may run into difficulty. One approach is to provide for the treatment of shares upon departure or breach of obligations in a founders' agreement or shareholders' agreement, but compulsory share transfers and the setting of buyback prices need to be designed carefully in light of the Companies Act, valuation for tax purposes and the constraints of investment agreements.
It is also worth noting that investment agreements, shareholders' agreements and memoranda pile up with each fundraising round. As the series progress, clauses such as investors' consent rights, information rights, drag-along rights and preemptive rights are added layer upon layer. If the order of precedence with past contractual arrangements is left unclear when a new agreement is signed, the scope of consent matters may differ from investor to investor, or the distribution order under the deemed liquidation clause may conflict with the terms of the class shares in the articles of incorporation, and the company ends up scrambling to coordinate among existing shareholders.
Designing Drag-Along Clauses, Preferred Shares and Deemed Liquidation
For M&A to proceed smoothly, it is necessary to confirm in advance the design of the drag-along clause. This is a clause under which, for a sale transaction approved by the shareholders or others specified in the agreement, the other shareholders can be required to cooperate in the sale on the agreed terms. It sets out how to respond if some shareholders object.
However, the mere existence of the clause does not mean you are always safe. Conditions such as who has the power to trigger it, what threshold of approval is needed to trigger it, whether the covered transactions are limited to share transfers or also include reorganizations such as mergers, and how far the founders are bound differ greatly depending on how the actual contract clause is drafted. In particular, provisions that uniformly impose heavy representations and warranties or indemnification obligations toward the buyer on minority shareholders tend to provoke strong resistance in practice, so consider clauses that preserve the effectiveness of cooperation in the sale without imposing excessive liability.
The treatment of preferred shares and deemed liquidation clauses is also an important issue directly linked to the distribution of sale proceeds. The liquidation preference for residual assets, whether the shares are participating or non-participating, and the distribution order under the contractual deemed liquidation clause are determined individually according to the transaction scheme chosen and the content of the contract clauses. The economic consideration received by stock option holders is likewise determined individually by the terms of issue of the stock acquisition rights and the conditions for their treatment in an M&A transaction. For the buyer, it is important that not only the total acquisition price but also the allocation to each shareholder is clear, so it is essential to confirm in advance that there is no conflict between the terms of the class shares in the articles of incorporation and the distribution agreement in the investment agreement.
Handling Stock Options and Checking Related Parties and IP
The approach to handling unexercised stock options is also an important consideration for completing a sale. Whether the buyer takes over the rights, whether holders exercise them before the transaction and sell the resulting shares, or whether the rights are extinguished with cash compensation depends on differences in the transaction method, such as a share transfer or a reorganization, and on what the terms of issue provide. If the terms of issue do not adequately provide for the procedures for exercise or extinguishment, obtaining the necessary consents from rights holders and negotiating conditions may take time.
Furthermore, the rights relationships between the founders personally and the company are also subject to review. Points include whether key domains and trademarks used by the company are registered in a founder's personal name, whether the company holds the rights to its source code or has obtained the necessary licenses, and whether transactions with founders' affiliated companies or personal loans remain outstanding. If the ownership of intellectual property rights in technology that a departed founder was involved in is left unclear, the buyer may regard it as a risk to business operations, which could lead to a revision of the acquisition terms or the abandonment of the transaction.
Legal Structure and Preparation with M&A in View
To help M&A proceed smoothly, here are the practical matters you should check when opportunities such as fundraising or reorganizations arise.
- Whether the shareholder register, cap table, commercial registration, articles of incorporation and terms of issue of shares are consistent
- Whether the number of shares held and the terms of class shares are clear for founders, departed founders, officers, employees and each investor
- Whether it is clear which past shareholders' agreements and memoranda will survive and which will be terminated or amended
- Whether arrangements for the buyback of shares, voting agreements and confidentiality upon a founder's departure are in place
- Whether the triggering requirements, approval threshold, covered transactions and minority shareholders' liability under the drag-along clause are effective
- Whether rights of first refusal, tag-along rights, preemptive rights and prior consent rights are designed so as not to obstruct M&A negotiations
- Whether a distribution simulation has been carried out based on the liquidation preference of preferred shares and the deemed liquidation clause
- Whether the treatment in an M&A transaction of unexercised rights such as stock options and J-KISS is clear in their terms of issue
- Whether there are deficiencies in transactions with founders and affiliated companies, personal guarantees, or the ownership of domains and trademarks
- Whether supporting documents that can be promptly disclosed in the buyer's due diligence have been organized
When advancing preparations, practical explanations such as Legal DD to Prepare Before Becoming a Seller, which explains the practical steps from the seller's side, What Is Legal Due Diligence? Purpose, Process, Required Documents and Fees, which covers the overall flow of the review, and M&A Attorney Fees and Estimate Items, which summarizes the breakdown of professional fees, will also be helpful.
Because coordinating with shareholders and investors can take time, proceed with these checks before concrete sale negotiations begin. At LegalAgent, through collaboration between generative AI and attorneys well versed in corporate law, we support the optimization of capital policy, the reorganization of shareholders' agreements and pre-M&A reviews. For building a legal structure with future business sales or organizational expansion in view, you can consult us through the following.
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