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Why do you need a shareholder agreement?

Many start-up businesses, in our experience, think that putting in place an agreement between the founder shareholders is not a top priority when they are in the initial stages of setting up and running a company. This could not be further from the truth. Think of it as the corporate equivalent of a pre-nuptial agreement. If things start to go wrong or the parties start disagreeing, then it may be too late to get all the shareholders to agree how the company should be run; there has already a breakdown of trust.

Having a Shareholders’ Agreement is really important at an early stage after setting up your company and is a cost-effective way to ensure clarity and avoid disputes later. It makes sure that all the shareholders are “on the same page” about how the company will be run from the start.

What to include in a Shareholders’ agreement?

With many small businesses there are often just two or a small number of shareholders and those shareholders are often friends, family, partners, colleagues or well-known business contracts. And because they have always got on well on a personal level, the temptation is to believe that going into business won’t impact those strong and established relationships or trust and they could never disagree and not be able to resolve matters. Sadly, too often that is not the case and things change over time.

A Shareholders’ Agreement (which might be referred to as an Investment Agreement or Shareholder and Subscription Agreement if you are investing in a company as a passive shareholder who does not have day to day involvement with a company). In that situation, without the proper protection of Shareholders’ Agreement (by whatever name) your investment is extremely risky, because unless you are a majority shareholder which may give you some protection under the Companies Act and are able to control the board of directors, you probably will not receive regular monthly or quarterly updates about how the company is performing and you may not be involved in decision making at board and shareholder levels.

Minority shareholder protection

One key feature of a shareholders’ agreement is that it can be drafted to protect the rights of minority shareholders and the investment value of their shareholding. Without an agreement, majority shareholders may force issues that are not in the minority shareholders’ interests. Once in place a shareholders’ agreement can only be amended with the agreement of all of the shareholders whereas the company’s articles of association can be changed by a 75% majority meaning that a shareholders’ agreement provides better protection for minority shareholders.

Shareholders’ agreements can contain any arrangement agreed between the shareholders and can vary what would otherwise be the legal position without it. Therefore, an agreement can govern the basis for decision making, to restrict the power of the directors where necessary and to provide protection for the parties involved in the ownership of the company against the actions of the others, whether minority, majority or equal shareholders. Without a shareholders’ agreement a company is subject to control in accordance with company law meaning the voice of the minority shareholders is not always heard.

Rights of veto

Shareholders’ agreements reduce the potential for conflict between shareholders and help the company to be run smoothly with rights and responsibilities of the shareholders clearly set out. There is clarity and certainty as to what can or cannot be done and decisions are taken by consensus in accordance with the provisions of the agreement. The agreement will often provide that certain important decisions cannot be made unless all shareholders (or a certain percentage) agree to them – so minority shareholders can veto them. These typically include decisions to issue further share capital and making changes to the company’s articles of association. A shareholders’ agreement minimises any potential for disputes between shareholders by making it clear how certain decisions are made and also by providing a framework and procedures for dispute resolution.

Key things to consider and usually include in a shareholders’ agreement

Each agreement is different but core issues to consider include:

• Who will be the directors and do any shareholders/investors have a right to be or appoint or remove directors? – how many directors need to be present for a board meeting to be quorate (i.e. able to vote on decisions)?
• What matters can the board of directors decide on and what matters are reserved for decision by the shareholders?
• What will be the “Reserved Matters” that all or substantially all (typically between 75-100%) of the shareholders have to agree to? – these might include changing the name or nature of the business, altering the constitution or share rights, winding up the company, buying or selling assets above a certain value, forming subsidiaries, taking on loans, giving guarantees, entering into contracts of certain values or types, starting legal disputes.
• Minority shareholder protection – if there are minority shareholders, should they be protected, if at all. (Needless to say, if you are a minority shareholder you are likely to say “of course” and may want the right to veto certain actions of the company).
• Will the shareholders work in the company and, if they leave, will they have to sell their shares? – if they do sell their shares and leave, are they prevented from competing with the company and poaching customers/clients and staff?
• IP – do all the shareholders even those who are not employees agree to transfer any intellectual property rights they create when working for the company to the company?
• What happens if a shareholder wants to sell shares? – does he/she have to offer them first to the other shareholders and, if so, are there permitted exemptions (e.g. to family members, family trusts and group companies) where this is not the case?
• Compulsory transfer events – what happens if someone dies, becomes bankrupt, acts in a way that is detrimental to the company or breaches the Shareholders’ Agreement?
• What should the share price be on a sale of the shares in the company? – is this to be agreed or determined by an independent valuer and on what basis? Typically, it will be a fair value valuation on a compulsory transfer and there should a discount be applied if the shareholder who has breached the Shareholders’ Agreement or is a departing employee who is regarded as a “bad leaver” (as defined in the Shareholders’ Agreement).
• Drag and tag rights – can shareholders block the sale of the company? Can shareholders be compelled to sell if a majority agree a sale so the minority can be “dragged” into a sale on the same terms as the majority shareholders? Alternatively, if the majority shareholders are selling, can the minority shareholders require the majority to insist that their shares are bought too.
• Pre-emption rights if new shares are to be issued – do the existing shareholders have the right to take part so as not to be diluted. Are other classes of shares such as preference shares allowed to be issued in future?
• Confidentiality – in terms of protecting the business and assets of the company.
• Deadlock – if shareholdings are on a 50:50 basis (fairly typical for corporate joint ventures) this can create a deadlock. If the deadlock relates to a vital decision on the company’s future, this can hugely impact and damage the business as well as create great friction. A Shareholder Agreement can provide for what will happen in the event of a deadlock situation – will one party buy the other out? On what basis – highest offer or something else.
• Shareholder and/or director disputes – where disputes arise, setting out a clear process and potential outcomes to avoid expensive and risky court disputes.