Shareholder Agreements

If you are going to operate your business through a company structure, with at least one other co-owner, you need to put a Shareholder Agreement in place to protect the rights of all of you. Whilst, the agreement can be entered at any time, it is best to execute it at the time that the company is incorporated. Many good businesses have been destroyed by the breakdown in relationship between the owners, where there was no Shareholder Agreement to set out the rights and obligations of the owners. Each party assumed that they had the same view of how the business was going to be run as all of the other owners. But, if that agreement is not put in writing, the owners are only guessing what the others think.

1. Why do I need a Shareholder Agreement?

A Shareholder Agreement sets out in writing how the company is run and the rights and obligations of each of the owners. Arguably, the most important amongst the rights is how each of the owners will be compensated for their efforts. Go to this link to read more about the benefits of operating your business through a company.

The danger of not putting a Shareholder Agreement in place, is that unforeseen disputes can occur, which can cost the owners a significant amount of money and ultimately the destruction on the business.

2. Form of Shareholder Agreement

A Shareholder Agreement is a contract between the owners of a company. The agreement sets out the rights and responsibilities of each of the shareholders.

Shareholder Agreements can vary significantly in form. However, they usually cover the following issues:

· what types of shares will be issued and the number that will be held by each of the shareholders — different classes of shares will have different rights and rules;

· how decisions are to be made, including the level of support certain topics must achieve before such a decision can be passed;

· how dividends are to be paid to the shareholders;

· how new shareholders may join the company and be issued with shares;

· the manner in which shareholders may leave the company, including who they can sell their shares to;

· the circumstances in which a shareholder can be forced out of the company, including poor behaviour, they commit a crime or they are declared bankrupt;

· what happens if a shareholder leaves or is forced out of the company or if they die;

· how money may be raised; and

· “drag along” and “tag along” rights (which are explained below).

3. Decision making

Careful consideration should be given to how decisions in the business are to be made. A Shareholder Agreement should set out what voting rights each director and shareholder has at a meeting, and the required votes needed to approve a resolution.

Generally, most decisions are made by a majority (over 50%), with only certain key decisions usually requiring 75% or 100% votes, such as raising money, issuing new shares or selling the business.

4. Termination of a Shareholder Agreement

The Shareholders Agreement should include specific clauses explaining how the agreement may be terminated. Agreements usually have terms that allow for termination in the following circumstances:

· by agreement between the shareholders;

· if the company ceases to trade and is wound up;

· if all of the shares are transferred to a single shareholder; and

· if the company undertakes an initial public offering (IPO).

In any event, even if the Shareholder Agreement does not specifically explain how and when it may be terminated, the owners may agree with each other to do so under the usual operation of contract law.

4. Dealing with disputes between shareholders

The Shareholder Agreement should set out the process that is to apply to deal with disputes between the owners. What those processes should be is a matter for the shareholders to determine.

A process that is included in many Shareholder Agreements requires the owners in dispute to initially set out their dispute in writing and then hold a meeting to discuss it. If the dispute cannot be resolved within a certain timeframe, owners can use other methods such as mediation or arbitration.

A common method of resolving a deadlock in a Shareholder Agreement is a “shotgun clause”, which entitles one or more of the owners to buy out the other at an agreed price. It should be noted, however, that it also entitles the other owners to buy them out if they don’t agree to it. This allows one party to exit and the other to move forward with the business and breaking the deadlock.

The main thing to avoid is the ability (or necessity) of an owner starting court proceedings. This can take many years and cost many multiples of what the dispute is about, or the underlying value of the company, which can have a disastrous effect on the company and all of the owners.

4. “Drag along” and “tag along”

These provisions are designed to protect the interests of the owners with a minority of shares (less than 50%) if an owner with a majority of shares (more than 50%) intends to sell their shares.

“Drag along” allows the owner with a majority of shares to force the other owners to sell their shares, for example in a takeover offer. In that case a person looking to buy the entire company agrees with the owner with a majority of shares to sell. In this situation, the owner with a majority of shares to “drag along” the remaining owners and require them to sell their shares so the third party can buy the entire company. However, to protect the minority shareholders, the drag along provision will usually require that those owners are able to sell the shares on the same terms and conditions as the owner with a majority of shares.

A tag along provision operates in reverse. Usually under a Shareholder Agreement when a shareholder wishes to sell their shares, the owner has to provide notice to the other owners to allow them to buy the shares. This requirement is usually contained within a “first right of refusal” clause. But, if the owner with a majority of shares wants to sell shares to a third party, and does not provide notice to the other owners, the tag along provision will enable them to tag along with the owner with a majority of shares and sell their shares for the same price and on the same terms and conditions.

It is really important to put in place a Shareholder Agreement to avoid disputes and save money. Owners should consider seeking advice at the time of incorporation to put a Shareholder Agreement into place that works for the circumstances of their particular business.