The Rights of Employees as Shareholders in a Startup
Shriram Bhashyam | November 18, 2015
As with citizenship, in employment, it's important to understand your rights. In the startup world, employees have rights not only as employees, but also as shareholders, since they are typically paid in equity as well as cash. Further, much of an employee's net worth can be tied up in company stock, so it's all the more important to understand the rights that inhere to stock ownership. In this post, we discuss the general rights of employees as shareholders in the companies they work for.
Most startups that have received VC funding are corporations, typically organized under the laws of Delaware. So let's deal with Delaware law, the most developed corporate law in the US.
Common stock holders generally have the following rights under Delaware law:
- Voting rights
- Information rights
- Monetization rights
- Direct and derivative rights to sue
There are also a host of rights for minority classes of stock holders against majority holders, which are beyond the scope of this post.
By default, each share of common stock has one vote, although other formulations are allowed. For example, since Google did it, it's become vogue for founders and other execs to have a separate class of common stock that has superior voting rights (usually 10 votes per share). It's a way for founders to retain control even after IPO.
Common stockholders have the right to vote on major matters, such as mergers/acquisitions, plans to dissolve/wind up the company, and amendments to the certificate of incorporation ("COI"). For startups, the thing to note is that founders, early employees, and other shareholders may be subject to "drag-along rights", which are rights of the company's investors that compel the shareholder to vote in favor of a merger or other liquidity event.
The other interesting point is with amendments to the COI. Common stock holders, as a class, have a right to vote on amendments to the COI that, among other things, adversely impact their powers or preferences, or that increase or decrease the number of authorized shares in the class. In startup world, this latter right implicates a vote on VC financing. This is because VC financing means the issuance of preferred stock, which usually involves increasing the number of authorized shares of common stock. In practice, a vote of a majority of common stockholders is on an as-converted basis (i.e., assuming conversion of preferred to common), would be required, decreasing the voting power of employees and founders vis-a-vis VCs.
Under Delaware law, a common stockholder has the right to inspect and make copies of the corporation's stock ledger, a list of stock holders, and its books and records. However, such a demand must be for a "proper purpose", which means a purposes reasonably related to the person's interest as a stock holder. (Note: What purposes are "reasonably related" are the subject of a separate inquiry that's beyond the scope of this answer, that I'm happy to answer separately). As a rule of thumb, if the stockholder seeks to see a list of stockholders, the burden of proof lies with the company to show an improper purpose. If the stockholder seeks to inspect books and records, the burden of proof lies with the stockholder to show proper purpose.
Monetization rights are rights to proceeds in respect of the shares, such as those from dividends, merger, acquisition/sale, or dissolution. Common stockholders in startups typically do not receive dividends, although the preferred stockholders (i.e., VCs) sometimes do, with the caveat that I don't really know what happens at biotech firms, where dividends from IP licensing are possible. Monetization rights are weakened by the VC's liquidation preference. In a liquidity event, the VC has a right to get back a certain multiple of their investment (market rate is 1x as of this writing) or convert to common and take their proceeds as a common stockholder. If they elect the former, the VC gets paid out before common stockholders, meaning that the monetization rights can be hollow in practice. See these blog posts for more on how liquidation preference can go wrong for common stockholders.
Direct and derivative rights to sue
A common stockholder can sue the corporation directly based on contractual or legal rights (e.g., alleged violation voting or dividend rights).
Derivative rights allow the stockholder to sue a third party (typically an insider, such as management or the directors) on behalf of the corporation. This right basically allows a shareholder to initiate a suit when management has failed to do so.
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