If your company has two or more shareholders, then it is important to have a shareholders’ agreement. This type of agreement gives your company the best start possible as it gets everyone to focus and reach agreement on how the business will be run and helps ensure a clear plan to deal with any issues that arise.
In this article, we will be going over the different aspects a shareholders’ agreement covers, what circumstances it takes into account, and why you should get one for your company.
What is a shareholders agreement?
A shareholders’ agreement is a contract between the owners of a company that outlines their rights and responsibilities. The agreement also outlines what will happen if an owner wants to sell their shares or if the company is dissolved. This document will typically provide for, among other things, how the company is to be managed, how profits will be shared, how disputes will be handled, and what information about the business the shareholders are entitled to.
What should a shareholders’ agreement cover?
A shareholders’ agreement should cover the expectations, obligations and rights of shareholders in the company. This includes, but is not limited to, the following:
How directors in the company will be appointed or removed
The default method of appointment of directors of the company is by a simple majority of the shareholders. If you have two or more shareholders then you may want to ensure that each shareholder or group of shareholders has a right to appoint or remove their own director, even if they don’t own a majority of the shares. A shareholders’ agreement can set out agreed rules for how many directors there will be, and how they will be appointed or removed.
How the business will be funded
Businesses and companies can be funded in a number of ways, but shareholders will often contribute the initial start up funding, either as a loan or in exchange for equity in the company. The shareholders’ agreement will set out the terms of any shareholder loans or the percentage of ownership received for capital contributions, and also set out an agreed process if any future shareholder funds are required. This can include specifying if the proportions of shareholding need to remain the same, and equal funding needs to be contributed from all shareholders.
How profits will be distributed to shareholders
A policy on when profits will be paid to shareholders should be set out in the shareholders’ agreement. The key elements of such a policy may include: (i) when profits should be retained in the business to fund future growth; (ii) whether the shareholders should receive regular drawings in anticipation of profits during the financial year; (iii) the manner of payment (e.g., pro rata to all shareholders or in accordance with an agreed formula); and (iv) any other relevant preferences or restrictions.
How will disputes and issues be resolved
Disputes and issues between shareholders are likely to arise from time to time. The shareholders’ agreement should therefore provide for a mechanism to resolve such disputes in an orderly and efficient manner. Without such a provision, the parties would have to resort to court proceedings, which can be costly and time-consuming. The most common mechanisms for resolving shareholder disputes are mediation and arbitration, and if the dispute can’t be resolved, a process for one party to buy out the other. The agreement may also state that as a last resort the company would need to be placed into liquidation. Identifying which type of dispute resolution mechanism your company will be employing is key information that every shareholder should consider and reach agreement on.
Whether shareholders will work in the business and on what terms
Arguments between shareholders can often arise if they have different expectations about how much time each will spend working in the business, or if they feel their fellow shareholders aren’t pulling their weight. A well drafted shareholders’ agreement will ensure that these expectations are clearly set out from the beginning and include consequences should a shareholder fail to meet the agreed requirements. When shareholders will be contributing differing amounts of time or expertise to the company, a common solution is for the company to employ the shareholders or engage them as independent contractors, rather than to simply share profits. There are pros and cons of structuring payment for shareholders’ work in this way, and the tax treatment of each option should be considered. We recommend that you agree on these fundamental matters at the start of your business and record it in your shareholders’ agreement, which should set out the roles and responsibilities of working directors and shareholders and the method of remuneration.
How decisions and spending limits will be determined
The shareholders’ agreement can outline what types of expenses are permissible, as well as how much money can be spent on each category of expense without needing board of director approval. It can also provide guidelines for monitoring and approving expenses and set out when decisions on expenditure need to be agreed to by the shareholders, rather than simply approved by the directors. The agreement should specify how decisions will be made for spending at both director and shareholder levels (i.e., majority vs unanimous decision). Shareholders should have a robust discussion before agreeing on approval thresholds for expenditure, as the aim is to balance the need for protection and control vs flexibility and ensuring that an excessive administrative burden is not placed on the company.
When a shareholder passes away or suffers a permanent injury
In the event that a shareholder passes away or suffers a permanent injury, the shareholders’ agreement may provide for a process by which their shares are bought out or transferred to another party, and whether the other shareholders have the first option to purchase the shares. The agreement may also include a requirement that insurance is purchased to enable the deceased shareholder’s shares to be purchased from the shareholder’s estate by the company or the other shareholders. If the shareholder holds a key role within the company which they are no longer able to fulfil due to illness or incapacity, the shareholders’ agreement may specify a period after which an exit and mandatory sale of their shares must occur. In some cases, the shareholders’ agreement may also provide for measures such as assigning voting rights to another party so that necessary decisions of the company can continue to be made. This helps to ensure that the company can continue to function smoothly despite the loss or incapacity of a shareholder.
When a shareholder wants to exit the business
When a shareholder wants to exit the business, the other shareholders may be very concerned that they will end up in business with someone they don’t know and whose values they don’t align with. Most shareholders’ agreements will include provisions requiring the exiting shareholder to offer their shares to the other shareholders first before selling their shares to anyone else (often referred to as pre-emptive rights). To avoid disputes at this stage we recommend that the agreement sets out a clear process and timeframe for exercising pre-emptive rights and setting the value of the shares. Some shareholder agreements will require that a third party buyer of an exiting shareholder’s shares must be approved by the continuing shareholders. When a majority shareholder wants to sell their shares to a third party, the agreement may specify that the minority shareholder(s) must sell their shares also if the third party wants to buy the whole company (drag along rights) or that the minority shareholders can insist that their shares be bought on the same basis (tag along rights). Another consideration is whether to include a restraint of trade provision in relation to any key shareholders who might be integral to the company, as their exit could cause serious risk if the shareholder sets up a competing business.
When shareholders need to approve significant decisions
Shareholders will usually want to ensure that their consent is needed before any significant decisions are made about the company’s future. The shareholders’ agreement should set out what decisions the shareholders need to consent to unanimously, or by a super majority such as 75% or 80%. Examples of such significant decisions include when the company is going to borrow over a certain amount, give security over the company’s assets for borrowing, sell part or all of the company, purchase an asset worth over a certain amount, or water down the shareholding by issuing more shares.
What information and reports shareholders have access to
Shareholders’ agreements should specify what information and reports the shareholders have the right to receive. This could include annual financial statements, budgets, monthly management accounts and performance data, comparative reports for previous periods, as well as copies of board minutes and resolutions. Typically the agreement will also include a confidentiality requirement limiting the right to use or disclose the information that is provided to the shareholders.
Should you get a shareholders’ agreement?
Having a shareholders’ agreement in place means that if disputes arise or a shareholder wants to exit there is a clear road map to deal with the situation, which will save you a lot of angst (and the cost of litigation). Our clients find that by working through the process of agreeing on the terms of a shareholders’ agreement, the shareholders consider and discuss together a lot of potential issues that they may not have thought about previously. This means there are less likely to be misunderstandings between the shareholders and it sets the company up for success.
If you need help with drafting your own shareholders’ agreement for your company or business, you can consult our experts here at Carlile Dowling. Our team includes commercial law experts as well as conveyancers and property lawyers and has provided trusted legal advice for more than 130 years. Get in touch today by calling 06 835 7394 or contact us online.
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