The inventors’ shareholders’ agreement

The inventors' shareholders' agreement is a tool that helps establish the rules for working together within a company. The term shareholders' agreement refers to the internal commitment among partners to define, according to each one's interests, the rights and obligations they will have in a current or future company.

The loneliness of inventors in the process of creating an innovative product, building the team, and the lack of financial resources are the main reasons that drive entrepreneurs to seek partners along the way.

Is it bad to have business partners?

The presence of partners is very beneficial, as long as they play a clear role in the development of the project. Including partners in an innovation project can bring valuable tools that accelerate the innovation process and the product’s launch to market.

On the other hand, most inventors, in the very early stages of their projects, bring in partners who, instead of contributing to development, end up being an obstacle to the project’s future.

The loneliness inventors experience is, without a doubt, the main factor that leads them to make mistakes. As a result, inventors tend to undervalue their ideas and, simply because they feel alone in the process, give away shares of their project’s future profits without having a clear understanding of what the new partners will actually contribute.

Therefore, if developing an innovative project truly requires resources or skills you don’t have, bringing partners on board might be a very good solution.

Differences between partners and employees

The partners in an innovative project are the owners of the current or future company. They acquire ownership rights over the idea, the patents, and of course, the future profits that may be generated.

On the other hand, managers or employees are the people involved in carrying out day-to-day tasks. They take responsibility for meeting essential goals and clearly add value to the development of the project.

It is very true that, in the early stages of a project’s development, partners (owners) often take on the role of employees or managers handling key tasks. This duality of roles is not a mistake, as long as there is a clear understanding of one’s position as a partner and the distinction between that and the responsibilities tied to a managerial role.

In our experience working with inventors, one of the most common sources of dissatisfaction and conflict between partners is related to the inventor’s perception of the lack of availability and commitment from some of the partners who join them on the journey.

In most cases, these problems become a real obstacle for the projects, and without a doubt, situations like these can be avoided with a shareholders' agreement.

The right time to sign the inventors' shareholders' agreement

The best time to establish the terms of collaboration in an innovative project is at the moment of joining. Whether they are close family members, friends, or unknown investors, not signing a shareholders' agreement is a serious mistake.

Objectives of the inventors' shareholders' agreement

The inventors' shareholders' agreement is not a tool for threats or establishing hierarchies. The shareholders' agreement is a tool whose main objectives are:

To define each partner’s interests.
To create conditions that make the governance system viable.
To prevent partner relationships from hindering the development of the project.
To establish rules of collaboration: rights and duties.
To establish how partners will be compensated.
To define conditions between current partners and facilitate the entry of new ones in the future.

Common clauses in the inventors’ shareholders’ agreement

Below, we will review some of the most common clauses in the inventors' shareholders' agreement. It is important to note that these agreements do not only regulate the relationship between the original owners of the idea or founders. These clauses are often also applicable to define the rules of collaboration between the entrepreneurs (founders) and investor partners. The shareholders' agreement will only be valid if signed by 100% of the partners. Therefore, any new members joining the ownership in the future must agree to this agreement.

Drag-along clauses in the shareholders’ agreement

The Drag-Along Clause: its specific purpose is to ensure that, in the event one of the partners (typically the main one) receives an offer to purchase the company or the patent, the rest of the partners are required to sell their shares as well, and cannot block the sale of the company.

For example, if Juan has created a company to commercially exploit his patent, the first thing he must do is formally transfer either the exploitation rights or the ownership of the patent itself (depending on the negotiation). Based on this premise, Juan could attract investors interested in multiplying their money through the increased value of the company responsible for selling this innovative product.

So, it’s clear that Juan’s interests and those of his private investors are aligned—everyone wants to make money from a potential sale of the company, if that happens. In this regard, Juan should agree in advance on the minimum value for which he would be willing to sell his company, whose main asset is the patent.

If the time comes when the investors or Juan himself find a buyer for the company, as long as the previously agreed minimum conditions are met, they may not oppose the sale transaction.

In reality, this type of clause is included in shareholders' agreements to prevent the interests of any of the parties from being negatively affected along the way.

Tag-along clauses in the shareholders’ agreement

The Tag-Along Clause: its purpose is to ensure that, if one of the partners receives an offer to buy their shares (not the company itself), the other partners can request that the buyer also acquires their shares under the same conditions. Typically, these situations end up blocking the transaction, since the buyer is often only interested in acquiring shares from one specific partner. For this reason, the clause establishes that the shares must be purchased proportionally from all partners.

Let’s continue using Juan as an example.

Let’s imagine that Juan, the founder, owner of the patent and main partner in the company responsible for commercially exploiting the product, decides—for whatever reason—to sell his share of the company. Moreover, Juan manages to find a buyer for it.

Without a shareholders' agreement, Juan could sell his share, profit from his invention, and leave the company—and the partners who trusted him—adrift like a ship without a captain.

To avoid this type of situation, a protective clause is included that, based on the minimum conditions established in the shareholders' agreement, allows the remaining partners—who are not involved in managing the sale—to demand that the new buyer acquires all the shares, or alternatively, a package of shares made up of contributions from all partners, not just Juan, who in this case is the one seeking to exit the project.

Shareholders’ agreement clauses for attracting talent

We are aware that, in order to develop an innovation project, you will most likely need, in addition to investors, professional profiles to support you during specific stages. For example: engineers for product development, lawyers for patent protection, sales experts, among others.

A very common situation among inventors is recognizing these needs but lacking the financial resources to hire such professionals and fairly compensate them for the significant value they bring to the project.

In such frequent scenarios, inventors often decide to turn certain employees into partners, compensating them with ownership shares. In other words, making them partners.

There are three common methods or clauses in the shareholders' agreement to carry out these processes in a safe and structured way.

Vesting Clause. Gradual acquisition system.

Let’s imagine that Juan needs an industrial design engineer, an expert in innovative product development. This is the profile that will help Juan develop different versions of his product and will be responsible for the management of technical projects.

In a less advisable scenario, Juan could transfer part of the project's ownership to the engineer. In this case, without setting goals or conditions. The transferred ownership would be final—it belongs to the engineer, whether they fulfill their responsibilities or not.

Precisely to avoid this type of conflict—so common in inventor-led projects—the clause is applied that outlines the conditions for transferring ownership, the goals that determine such transfers, the portions of ownership to be transferred, and most importantly, the timing at which these transfers become effective.

In this way, Juan can ensure that the engineer gradually acquires the committed ownership shares as they meet the agreed-upon objectives within the timeline established according to the project’s real needs.

Phantom shares clause

The shares, equity, or ownership interests to be transferred in a company are like a type of title—essentially, a form of property. These titles carry both a “political right” and an “economic right.”

For example, among the political rights associated with the ownership granted to the engineer—following the previous example—are: participation in shareholders' meetings, the obligation to share critical information, the ability to take part in establishing or electing the company’s governing bodies, among others. In contrast, the economic right refers exclusively to the ability to generate financial income from transactions involving these ownership titles.

The good news is that there is a way to transfer part of the project’s ownership without assigning political rights in the process. In other words, Juan could grant part of the ownership to the industrial engineer by transferring only the economic rights of the shares offered. In the future, if profits (dividends) are to be distributed among the owners, or in the event of a potential sale of the company, the industrial engineer would receive the corresponding share based on their ownership. Meanwhile, the political rights of those shares could remain in Juan’s hands during the product development phase.

Stock Options.

Through the Stock Options method, key employees—such as the industrial engineer in Juan’s company—are given the opportunity to purchase part of the ownership at a price significantly lower than its potential market value.

Of course, it is essential to define in the shareholders' agreement—beforehand and between founders and investors—the optimal conditions for using these ownership shares, the minimum prices, and, most importantly, the maximum amount of ownership that could be sold under these terms.

Failing to properly define and outline the tools or methods through which talent can be attracted using company ownership as a form of compensation may negatively impact the development of the project. In most cases, it is the founders or entrepreneurs who end up in a worse position. Since this strategy is not established in advance, they are often the ones who have to sell part of their own ownership in order to avoid placing the burden on investors—an unfair situation overall.

Defining the governance systems of an inventors' company

As you know, a company’s structure is made up of its owners and employees. However, there is one figure we haven’t considered yet, and it is essential for the project to move forward without major conflicts.

The governance of the company

Most inventors believe that by holding 51% of the company’s ownership, they have full control over it. However, as you can see, the inventors' shareholders' agreement can establish rules that may alter this assumption. It's important to note that holding 51% of a company, when there is a well-structured shareholders' agreement in place, rarely guarantees that level of control.

The governing body of a company can be structured in different ways, and the shareholders' agreement can also include modifications regarding the scope or autonomy of this body.

What is certainly true is that the company’s administrators—the ones who make up the governance structure—will be ultimately responsible for its operation, for better or for worse.

There are three common forms of governance in inventor-led companies:

Sole Administrator: In this case, all responsibility is transferred to the administrator. The appointed person is in charge of the entire operation of the company and is the only individual with authority over bank accounts and other critical aspects. This governance model is typically used when all partners who hold ownership in the company have full trust in the administrator. It’s important to understand that the administrator does not necessarily have to be the founder or inventor.

Do you remember the movie about Steve Jobs when the investors removed him from the company’s leadership? Steve Jobs was still a shareholder of Apple, but he could no longer manage the company.

Joint Administrators: In our opinion, this governance model is not very efficient. By definition, individuals who serve as joint administrators share all rights and responsibilities. The main limitation we see is the high level of dependency it creates for the company’s daily operations. Imagine needing the presence of all joint administrators just to open a bank account. However, in situations where there is a lack of trust, this may be the most effective governance system.

Board of Directors: Without a doubt, this is the most common governance structure in inventor-led companies. It is a slightly more complex structure that, by design, includes at least one Chief Executive Officer or Chairman of the Board, a Secretary, and may include board members with voting rights in the company’s most important decisions. It is a flexible model, as the CEO can handle the company’s day-to-day operations, while major decisions must be approved by the board.

It is true that we are required to define the governance system that prevails in the company and to identify its key members and their roles. That’s right—we have this obligation with public authorities. If a problem arises, they will know who to contact.

The governing body has clear responsibilities defined by law. So, why talk about governance within the framework of the shareholders' agreement?

Well, within the shareholders' agreement, we can customize the scope and functioning of the governance structure—without violating legal regulations.

One very relevant point—at least according to our experience—has to do with the system used to determine the company’s value at any given time, the definition of objectives, budgets, and so on.

The topic of valuation methods and systems for updating company value could easily be the subject of its own post—or even an entire book.

As you may have read earlier, the shareholders' agreement defines critical situations related to the buying and selling of company ownership—such as tag-along and drag-along clauses.

In any of these circumstances, the most important aspect is to define the method for updating the company’s value, as well as the situations that arise from or are related to that value. This is a critical issue, as it determines the potential real return for both the founders and the investors.

Restrictions on the transfer of company ownership

When you're alone on the journey, you can sell or transfer ownership—or part of it—without much difficulty. However, in the world of inventions, when companies have clearly defined roles such as founders and private investors, the situation changes completely.

Founders are usually fully involved in the day-to-day operations of the company. Their monthly compensation is often far from what they expect as a return on their invention. On the other hand, investors are highly concerned with maintaining rights that allow them to limit actions related to the buying and selling of company ownership.

Let’s use another scenario involving our friend Juan.

Let’s imagine that Juan has invented a special device for sanitizing razor blades. A unique product on the market, protected by a patent and commercialized through a company for which he has raised funding from private investors, using the patent rights to sell the product.

Well, despite the growth of Juan’s company during the first three years, his energy has begun to wear down. Personal issues and situations have arisen that demand much more of his time and resources.

In the midst of this storm, Juan receives an offer for funding from a very special partner—a razor blade manufacturer with a large industrial operation and strong sales capacity for its products.

At first glance, it seems like the perfect partner.

However, the vision and return on investment goals previously agreed upon with the investors are compromised by this deal. With the entry of this new partner, the investors would be diluted, and they suspect that the company’s valuation—which ultimately defines the profitability of their ownership stake—may not grow sufficiently as a result of the operation. Let’s imagine that the investors believe the entry of this new partner would cause the company to be perceived in the market as “the little sibling of...” and, as a result, other major players in the industry would likely rule out future business opportunities.

This scenario may be very convenient for Juan, but it doesn’t necessarily benefit the other partners. For this reason, limitation clauses are quite common in this type of inventors' shareholders' agreements.

Dividend distribution rules or limitations

Without a doubt, limitations on dividend distribution are often a source of conflict or dissatisfaction. That’s why it is so important to address this matter from the very beginning.

Let’s imagine that Juan’s company is generating very attractive profits. Juan has built up a significant amount of cash thanks to his excellent management. However, let’s not forget that Juan holds 51% ownership in this example. Typically, founders retain the majority of ownership for a long time.

According to standard dividend distribution rules, the amount of money to be distributed would be defined, and each partner would receive a sum based on their ownership percentage.

Juan will be very happy—he’ll receive the largest share of the distribution. On the other hand, the investors might feel that their portion does not truly compensate for the risk they’ve taken with their investment. Therefore, they may prefer that the available cash be used to accelerate growth, launch new versions of the product, and so on.

Investors understand that Juan should earn more—that’s not the issue. The real concern is that distributing dividends can create a significant obstacle to the growth of the company’s value, which is ultimately the figure that determines the return for the investors, including Juan as part of the ownership.

There are other important elements within the inventors' shareholders' agreement—clauses that help balance power and real opportunities for founders and entrepreneurs. Not all shareholders' agreements should be the same; they must be customized according to each specific situation, the types of partners involved, and their respective interests.

If you’d like to learn more about this topic, or if you prefer personalized guidance, we’d be happy to help. Remember that at Let’s Prototype we don’t charge inventors for the advice or information we provide. It’s our way of giving back to the inventor community for everything it gives us. Our true mission is to take part in the development of products that have real potential to become successful businesses.

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