Shareholder agreements

Who needs a shareholders’ agreement

Company law rules generally provide that the directors of a company are responsible for day-to-day management of its business, and make most of the decisions. Only a few matters (such as changes to the company’s share capital, or to its articles) have to be referred back to shareholders for a decision. The shareholders have important, but only relatively few, rights to intervene otherwise, principal amongst which is the right to appoint and remove directors.

As between the shareholders themselves, company law rules generally provide that the will of the holders of a majority of the voting rights will prevail. A minority shareholder only has limited power to block shareholder decisions.

Shareholders in some companies will want to vary these usual rules. Circumstances in which this commonly happens are:

Quasi-partnerships

Companies are often set up on the understanding that, irrespective of their shareholdings, the shareholders will have a relationship akin to that of partners in a partnership – an equal say in how the company is run and how it develops, equal access to company information, and an equal share in the company’s success. Lawyers often call companies like this ‘quasi-partnerships’.

A shareholders’ agreement can be used to vary the usual company law rules, to provide equality.

Outside investors with a minority stake

An outside investor, such as a venture capital firm or a business angel, may be prepared to provide working capital to fund growth in your company in return for a minority shareholding. To protect the returns from, and value of, his investment, he will want more than the usual company law protections for minority shareholders.

A shareholders’ agreement (which, in this instance, may be called an investment, or subscription, agreement instead) can be used to vary the usual rules, to protect the outside investor.

Joint venture companies

Two businesses may set up a company to carry on a joint venture – maybe joint research and development, or a pooling of parts of their production, distribution or administration. Each takes half the share capital in the joint venture company, and each has the right to appoint half the board. They usually want to vary the usual company law rules so that neither investor can make any decision at either shareholder or board level without the consent of the other.

A shareholders’ agreement can be used to vary the usual rules, to create the required deadlock 

Doing without a shareholders’ agreement

Shareholders in a quasi-partnership often consider a shareholders’ agreement unnecessary – they will rely on the closeness of their relationship with their business partners to solve future problems when they arise. Many also find it embarrassing or uncomfortable to discuss contentious ‘what if’ or worst case scenarios.

But many of the circumstances catered for in a shareholders’ agreement – circumstances that happen all the time – will arise when your business relationship has been strained or destroyed, so anticipating them now can save you significant time and money if they occur. Your discussions can also highlight areas where your expectations are not as similar to your partners’ as you thought. With your legal advisers helping to smooth negotiations, and making sure issues are raised and dealt with constructively, a shareholders’ agreement can be a worthwhile investment now, as well as valuable insurance for the future.

What a shareholders’ agreement covers

Positive obligations

Many clauses in a shareholders’ agreement operate as voting agreements – the parties bind themselves to exercise their votes as shareholders to put into effect their agreed intentions as to how the business will be funded, run and developed. For example: 

• The activities the company will carry on, and its intended rate of growth.
• The intended exit route and the timescale for achieving it.
• The company’s dividend policy (ie the proportion of profits to be paid out as dividend and the proportion to be retained to fund the business).
• The composition of the board of directors and senior management team, and their remuneration and other terms of employment.
• Levels of borrowing.
• Future funding (eg how much will be needed, the form it will take, how much each of the parties will put in, whether third parties will be allowed in and on what terms.)

Rights of veto

Other parts of the agreement often provide that important decisions, whether or not they would ordinarily be taken by the directors or the shareholders, cannot be made unless all shareholders agree to them – so minority shareholders can veto them. Typically, these include decisions to:

• Issue further share capital.
• Change the company’s articles of association.
• Buy or sell a business, or any asset of more than a certain value.
• Buy or sell a significant stake in another company.
• Acquire or dispose of any premises.
• Appoint or remove a director.
• Award directors or employees more than a certain level of remuneration, and/or dismiss a director or employee earning more than that remuneration.
• Borrow above a certain level, or grant security over the company’s assets.
• Incur capital or hire purchase commitments above a certain level.
• Take out or vary insurance other than for full replacement value.
• Buy any of the company’s shares back from a shareholder.
• Take action to wind the company up.
• Prevent favourable contracts or arrangements between the company and its directors or shareholders other than on agreed terms. 

Issue and transfer of shares

A shareholders’ agreement will often make specific provision for the procedure on issue and transfer of shares. On issue of shares, these provisions must balance the need for the company to be able to issue shares to raise further funds against the danger of a shareholder finding his shareholding has been diluted by an issue to other shareholders. 

On a proposed transfer of shares, they must balance the value to shareholders of having a market for their shares if they want to sell them (or if they die and their estate wants to sell them), against the danger of other shareholders building up a larger shareholding than they previously held, or new, ‘undesirable’ shareholders being admitted.

Options include:

• Allowing minority shareholders a complete veto over any issue or transfer of shares.
• Requiring the company (on an issue) and the owners of the shares (on a transfer) to offer the shares to existing shareholders, pro rata their holdings, before they can be issued or transferred to anyone else, or in any other proportions. 

If a pro-rata offer must be made, the agreement needs to provide a means of valuing the shares – by reference to an expert or arbitrator, or according to some formula in the agreement. 

Rights to appoint directors

Shareholder agreements to protect outside investors may provide that they can appoint a director to the board of your company, to protect their interests. A venture capitalist, for example, may appoint a non-executive director, who takes little part in day-to-day management unless the company is not providing the promised return. A business angel may insist on being appointed to the board in person, and may play an active (and valuable) part. 

Dispute resolution

Agreements may contain a mechanism for resolving disputes, such as referral to a third party expert or arbitrator, or a buy-out mechanism whereby, if a dispute occurs, one side buys out the shares of the other at a price determined in accordance with the agreement. It can even provide that, in the event of an unresolved dispute the parties agree to vote to wind the company up. 

The issue of which party buys out the other, and at what price, can be extremely difficult to negotiate. Agreements can become quite complex. One solution, for example, is to say that one shareholder can offer his shares to the others at a price of his choosing. If they accept, they pay the price he has set. To stop him from setting an unrealistic price, the agreement also provides that, if the other side does not accept his offer, they become obliged to sell their shares to him, and he to buy them, at that price. He will not want to set too high a price for his shares, because he may end up having to buy their shares at that price himself! 

Shareholders’ agreements, articles of association and other documents

Provisions in a shareholders’ agreement could, in many cases, be included in the company’s articles of association instead. There are technical differences between the two that mean that, very broadly, a shareholders’ agreement is appropriate if the arrangements you want to set up are for individuals involved with the company (or some of them) now. Articles are appropriate if you want the arrangements to apply to future shareholders too. 

One key difference between the two is that, if properly drafted, a shareholders’ agreement is a confidential document, whereas the articles of association are a public document, available at Companies House for all to see. 

There may be overlap between a shareholders’ agreement and, for example, the company’s articles of association or service contracts with directors and other staff. For example, a shareholders’ agreement and articles of association may both include provisions governing transfers of shares, and service contracts and shareholders’ agreements may both contain restrictive covenants prohibiting directors and employees from working for competitors, or disclosing confidential information. 

Your legal adviser will tell you the best place for each provision, and ensure there are no inconsistencies between the various documents. 

Timescales and costs

Once you have an idea of what points and issues you would like your shareholders' agreement to address, the agreement can be drafted in a few days.  However, if there are issues which need to be negotiated, this will affect the length of time that the agreement will take to draft.

The costs for advising on and drafting a shareholders agreement will vary depending on the complexity of the issues involved and the length of negotiations.

Finally, remember it is important that you always take legal advice.