By Sarah Kerr
While there is no legal requirement for shareholders in a company to enter into a shareholders' agreement, failing to do so can be the commercial equivalent of driving without a seatbelt. Without a shareholders' agreement, shareholders can find themselves embroiled in costly, time-consuming litigation that can seriously undermine the value of their investment.
What is a shareholders' agreement ?
A shareholders' agreement is a written contract between shareholders regulating the operation of the company in which they have invested. It provides shareholders with certainty about their rights and obligations towards each other. Importantly, if properly drafted, shareholders' agreements set out clear rules for how to deal with major change events, such as the introduction of new investors, the exit or death of a shareholder, the sale of all or a substantial part of a company's assets or the listing/initial public offering of a company's shares.
There is no set format for a shareholders' agreement – it can be as long or as short (and as straightforward or as detailed) as shareholders wish.
Why have a shareholders' agreement ?
Detect incompatibility before investing: Negotiating a shareholders' agreement can be an invaluable "mutual due diligence" exercise for potential co-investors. Thrashing out the detail of a shareholders' agreement can force shareholders to turn their minds to possible future events they may not otherwise have paused to consider. As with all commercial (and personal) relationships, it is better to know about the "deal-breakers" at an early stage. Sometimes, issues will emerge during the negotiation process that make it untenable for one or more prospective investors to follow through with their investment in a company. More often than not, though, the negotiation of a shareholders' agreement can be a positive learning experience for all investors and can crystallise and align shareholders' long-term goals for the company concerned.
Address issues at the outset to avoid costly disputes later on: Without a shareholders' agreement, the relationship between shareholders in a company is regulated by various provisions of the Companies Act 1993 and the company's constitution (if it has one). While the Act and a company's constitution go some way to detailing the rights and obligations of shareholders, there are many key matters they overlook. By failing to adequately address the "hard issues" (and even the more mundane operational issues) at the outset of their relationship, shareholders can experience severe financial loss further down the track. This loss can manifest itself in legal fees (if a dispute escalates to litigation) and in a serious diminution in company profits (due to board members and management being distracted from running the company's business). In extreme cases, shareholder disputes can lead to the financial collapse of a company or to a court-ordered liquidation.
Confidentiality: Remember that company constitutions are publicly available documents, accessible to all via the Companies Office website. To keep key commercial terms between shareholders confidential, it pays to record them separately in a shareholders' agreement, instead of including them in a constitution.
Attract funds more easily: If properly drafted, a shareholders' agreement can be a sign of "good housekeeping" that makes a company appear more attractive as a borrower to a bank or other lending institution.
Succession: A shareholders' agreement can give a company a headstart in any sale process, demonstrating to potential purchasers that shareholders "have their house in order" and have definitively agreed amongst themselves procedures for the sale of the company's shares or assets.
Foundation for claim in damages: Breach of a shareholders' agreement by a shareholder can enable non-defaulting shareholders to pursue the defaulting shareholder for damages for breach of contract.
What matters are addressed in a shareholders' agreement?
The content of shareholders' agreements is generally split between operational matters of an administrative nature and provisions specifically designed to address "change events".
Operational matters can include:
- who has the right to appoint directors and how many (including whether a shareholder continues to have the right to appoint a director when that shareholder's shareholding falls below a certain percentage threshold);
- whether the chairperson of the board has a casting vote;
- the quorum for shareholders' meetings and board meetings;
- the company's dividend policy – when will dividends be paid/not paid? how will dividends be calculated (for example, as a percentage of net profits)?;
- director and shareholder approval thresholds for key decisions
- for example, it may be appropriate to require a 90% board
resolution and/or shareholders' resolution (or even a unanimous
board and/or shareholders' resolution) for significant actions
- the entry by the company into contracts committing the company to expenditure in excess of a certain monetary amount;
- the appointment or removal of members of the senior management team;
- the establishment of a share option or similar incentive scheme for company employees or executives;
- a trade sale or listing of the company;
- future funding of the company, including:
- whether funds will be borrowed from banks or other third parties and, if so, whether shareholders will be required to personally guarantee borrowing from third parties;
- whether shareholders will be required to inject further capital or to make shareholder loans to the company;
- whether budgets and business plans are to be prepared and, if so, how frequently, who is to prepare and approve them and to whom are they to be disclosed;
- a robust dispute resolution mechanism designed to avoid situations of deadlock (that can be fatal to a company's continued existence, particularly in a closely-held company where shareholding is split equally and where both shareholders may have equal board representation). Dispute resolution may be by means of referral to a respected independent third party (such as the head of an industry body or professional association), via mediation or, failing success at mediation, via arbitration.
Provisions in shareholders' agreements dealing with "change events" can include:
- pre-emptive rights applying to the transfer of shares,
- whether a selling shareholder's shares must first be offered to all existing shareholders proportionate to their shareholding before being offered to third parties;
- whether a selling shareholder may sell some but not all of its shares;
- how the sale price of shares is determined – who determines the price (the selling shareholder, the board, a third party?) and using what valuation methodology?;
- whether the pre-emptive rights relating to the sale of shares are automatically triggered if a shareholder acts in breach of the shareholders' agreement (so that any defaulting shareholder can be forced to sell its shares);
- stipulating certain "permitted transfers" (for example to family trusts and related corporate entities) that can occur outside the pre-emptive rights regime;
- pre-emptive rights applying to the issue of new shares,
- whether new shares in the company must first be offered to all or only a select pool of existing shareholders proportionate to their current shareholding (as protection from dilution) or whether the board may offer new shares to any party it thinks fit without first offering them to existing shareholders (to encourage the injection of fresh capital);
- whether particular shareholders have veto rights enabling them to block the issue of shares to any prospective new shareholder;
- tag-along rights enabling a minority shareholder to force an exiting majority shareholder to secure the same "exit deal" for the minority shareholder;
- drag-along rights enabling an exiting majority shareholder to force a minority shareholder to sell its shares to a third party buyer who is only willing to purchase 100% of the company's shares and who does not wish to have the minority shareholder as a co-shareholder;
- provisions addressing what happens when a shareholder dies or
becomes mentally incapacitated, including:
- whether the pre-emptive rights relating to the sale of shares are triggered automatically on the death or mental incapacity of a shareholder (so that any mentally incapacitated shareholder or the estate of a deceased shareholder can be forced to sell that shareholder's shares);
- whether shareholders are required to take out trauma and life insurance policies for each other's benefit so that remaining shareholders can afford to purchase shares held by mentally incapacitated or deceased shareholders;
- non-compete provisions preventing an exiting shareholder from being involved in a competing business in a particular geographical region for a prescribed period of time after selling its shares in the company.
We can help
Hesketh Henry's Corporate and Commercial team has extensive experience in drafting and negotiating shareholders' agreements for companies of all types (whether venture capital or private equity investee companies, closely-held/family companies, or companies in which management are to invest). Please call us to discuss your circumstances – we would be delighted to assist.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.