Shareholders agreements are an integral part of governing how businesses are run and what happens if things go wrong. In a way, they can be looked at as a business form of a prenup agreement. A prenup is intended to provide contractual protection for couples if their relationship breaks down and, in the same way, a shareholders agreement can do likewise in a business relationship – ‘what happens if we fall out and decide to go our separate ways?’
However, a shareholders agreement also goes further as it also seeks to provide a framework for how the business is run and how decisions are made on a day to day basis, as well as governing how to manage a breakdown in the relationship should that arise. Shareholders agreements may also involve a number of shareholders being party to it, rather than just two, bringing different dynamics at play to those in a bilateral relationship.
Why have a shareholders agreement?
In business things go wrong and people fall out. Without a shareholders agreement to manage that, things may get nasty fairly quickly. Without one you will be left in a situation where you have no reference point or agreement between the parties as to how you are going to manage the business and how parties may exit the business, which may create problems further down the line.
Shareholders agreement often put restrictions on who you, or your fellow shareholders, are able to transfer shares to. Without such restrictions, a shareholder can in theory transfer shares to whomever they like, including to a person whom the other shareholders may not necessarily approve of.
A shareholders agreement avoids these issues as everybody knows the rules.
Shareholders agreements also govern how business decisions are made. There is a distinction to be drawn between those who are shareholders and those who are directors of a company. Only those who are directors have management responsibilities for the company as a matter of company law. So, in the absence of a shareholders agreement, those people who are shareholders but not directors are not in a position to influence board decisions relating to the business. If shareholders want a say in certain decisions, or a right to veto certain key decisions, then this can be provided for in a shareholders agreement. The shareholders agreement can also set out provisions regulating the board of directors and how decisions are made by the board, for example majority or unanimous.
Other provisions often included in shareholders agreements include non-compete restrictions and obligations of confidentiality – although similar provisions are typically included in employment contracts for those shareholders who are also employees of the company.
What happens if the parties can’t agree?
If the shareholders or directors cannot agree on something this is often referred to as a “deadlock”, and the shareholders agreement can set out an agreed deadlock resolution procedure. For example, this can be asking a third party independent expert to resolve the matter or a reference to mediation. Depending upon the dynamic, and if the business cannot function whilst in deadlock, then the agreement may include provision for one party buying out the other. If there is a 50/50 split then you could have a sealed bids approach, where the highest bid buys out the other shareholder, or another approach, such as one party making an offer to give the other party the right to buy or sell at that offer price.
Some businesses may take the view that it is difficult at the outset to regulate a resolution procedure for all disputes and which may not be foreseen at the time of entering into the agreement. Some disputes may be minor, some may be more significant, and there is a school of thought that if there is no provision made in the agreement to resolve a deadlock then it forces the parties to agree their own resolution at the time. A dispute resolution procedure can add some certainty and clarity, but this also needs to be balanced with the need for flexibility.
Ownership of shares
Many shareholders want to restrict who their business partners sell their shares to and a shareholders agreement can govern this. There could be a rule that you can’t transfer your shares without the other shareholders’ consent. Alternatively, there could be a right of first refusal, allowing the other shareholders to buy the shares before they are offered to a third party. There can also be provision made for certain transfers to be exempt from these restrictions, such as transfers to family members or, for corporate shareholders, to related group companies.
Regulating share ownership can be more complicated in the case of shareholders who are also employees of the company but whose employment then ceases. For example, if you bring somebody in and incentivise them with 10% of the shares and they then leave, what should happen to their shares? It is common for a shareholders agreement to set out leaver provisions governing whether departing employees should be entitled to keep their shares or whether they have to sell them and, if so, at what price. A key factor here is whether the employee shareholder is a “good leaver” or a “bad leaver”, as different approaches may apply. For example, if somebody is made redundant through no fault of their own, they can be treated as a good leaver and should be able either to keep their shares or sell them at market value. A bad leaver could be somebody who is dismissed for gross misconduct, for example, and they may be required to transfer their shares at a much lower or nominal value.
Drag rights and tag rights
In a situation where there is a majority shareholder and there is a third party that wants to buy the whole company, then a drag right can come into play if included within the shareholders agreement. If the minority shareholders do not want to sell, which may then frustrate a sale of the whole company, then the use of a drag right by a majority shareholder can require the minority to sell at the same price. That is one of the risks of being a minority shareholder.
On the flip side if a majority shareholder was selling their shares and the minority shareholders wanted to sell as well, they may be granted ‘tag rights’ to be able to tag along to the deal and also sell their shares to the buyer.
Articles of association or shareholders agreements?
Many of the issues referred to above can, alternatively, be provided for in the company’s articles of association rather than in a shareholders’ agreement. However, there are a couple of key distinctions between the two. The articles of association of a company are in the public domain, whereas a shareholders agreement is a private contract which can be kept that way. In addition, as a matter of company law, articles of association can be amended with 75% shareholder consent whereas changing a shareholders agreement would typically require the agreement of all parties to it which helps to protect minority shareholders.
Some businesses may find shareholders agreements to be too prescriptive, in particular in the early stages when the company or the relationship is still quite new. However, my advice would be not to leave this too late – a shareholders agreement can provide a clear framework for all parties to work to, can provide protections for shareholders and can seek to avoid a messy divorce which might otherwise arise further down the line.