It’s a sad fact of business life that fall-outs among founders are common. Think Steve Jobs at Apple, for example. When you start out and things are on the up and up, underlying differences between founders can be masked as you all work hard to keep the company growing. However, if business slows or a major milestone is on the horizon — a need for new funding, for example — differences between the founders’ approach to the business can come to the fore, sometimes with unfortunate consequences.
Let’s say one of you wants to move on to another venture or has had enough of entrepreneurship and would like to cash out and get a job. How can you each protect your position and move on without a costly and energy-draining dispute about what your shares are worth?
One way of accomplishing this goal is to put in place a shareholders’ agreement right at the beginning. In this article, we explore why a shareholders' agreement is a good idea, what a shareholders' agreement should contain and the process for getting one in place.
- What is a shareholders’ agreement?
- What is the purpose of a shareholders’ agreement?
- What can I include in a shareholders’ agreement?
- Does a shareholders’ agreement override articles of association?
- How do you draft a shareholders’ agreement?
What is a shareholders’ agreement?
A shareholders’ agreement is a contract between the shareholders of a company that works together with the company’s Articles of Association and the general law to determine the rights and duties of shareholders.
When you set up your company, it will issue shares to the founders and first investors. These shares represent the relative contribution each investor has made in the company. For a limited company that’s issued ordinary shares, each share comes with the right to a single vote on company affairs.
So, let’s say you’ve set up a company to develop a gaming app, and that company has been established with 100 ordinary shares. Adam has a strategic vision for the niche the game will fill, Beth has the tech savvy to write the code and develop the app, and Chris is putting up funds to get the business off the ground and pay expenses. You may decide that you want the company ownership to be split 33.3/33.3/33.3 amongst you.
When it comes to shareholder voting, none of you will have a majority of voting rights, so you’ll need to work together to administer the company’s administrative affairs.
It’s important to note the difference between the powers of shareholders and directors when it comes to running the business. Being a shareholder doesn’t automatically give someone the right to make day-to-day decisions, for example, what goods and services the company will provide, whether the company buys property or borrows money – these decisions are taken by the board of directors.
Often this isn’t an issue, since the shareholders and directors are the same people. But, once a company grows, this can create problems. Let’s say Adam and Beth are the people on the ground running the show, and Chris just wants to be a passive investor. Chris might, nevertheless, like an oversight on what Adam and Beth are up to, and the right to veto certain key decisions such as taking on debt or issuing new shares that could affect the value of his shareholding. In this case, you’ll need a shareholders’ agreement. A shareholders’ agreement is, in effect, all about control.
What is the purpose of a shareholders’ agreement?
A shareholders’ agreement is a contract in which the parties agree to use their votes in a certain way to regulate the way a company is run and give a degree of control to shareholders who might otherwise be put at a disadvantage.
Here are some examples of the purpose to which a shareholders’ agreement could be put:
- Shareholders who are not directors of the company may want a say in decision making. They may have made a large investment in the company and want to protect that investment as much as possible by having a say
- Very small companies, for example those with only two shareholders who are also directors, may want to ensure that decisions of the company are only taken by unanimous vote and decide in advance what happens if that’s not the case. Without a shareholders’ agreement, if the shareholders/directors disagree and hold 50/50 shares, the company is ‘deadlocked’ and can’t make a decision
- Minority shareholders who, ordinarily, would not have much (or any) say in the way the company is run may nevertheless want the right to veto certain decisions of the board (for example, major changes of business direction, company mergers or acquisition or sale of company property)
- The agreement will also control the way (and the price at which) shares can be issued, sold or transferred
- It will also ensure that company business is kept confidential and restrict leavers’ ability to set up competing businesses
So, the purpose of a shareholders agreement is to distribute control more fairly between a company’s owners, each of whom may have made different contributions to the company.
- Modify the decision-making ability of directors and shareholders
- Protect the rights of minority shareholders who otherwise might have little power over the running of the business
- Avoid disputes between shareholders escalating because there is already an agreement in place that regulates what to do in the case of a disagreement
- Put in place a process to follow when a shareholder wants to sell their shares or dies
Access legal support from just £140 per hour
Need legal support with your shareholders agreement? Our team of specialist corporate solicitors can help you draft one.
What can I include in a shareholders’ agreement?
A shareholders’ agreement can be whatever the parties want it to be. Typically, however, it contains clauses dealing with the following issues:
Decision-making and the board of directors
Because shareholders generally have little say in the running of a company unless they are directors, there’s the potential for differences of opinion between themselves and the board. If shareholders wish to be more involved in the company’s business, a shareholders’ agreement can, for example, give them the right to veto certain decisions, participate in discussions relating to major issues such as business strategy, acquisitions and disposals, financing etc, and enable them to receive regular updates on business matters like the right to receive copies of the business plan. The shareholders’ agreement may also dictate how and when directors’ and shareholder meetings take place, quorum and voting arrangements.
Another area where shareholders commonly want some control is over the appointment and dismissal of directors, and directors’ pay and benefits, particularly since this can affect the amount of profit that can be distributed to members as dividends. The agreement may therefore deal with how and when dividends will be paid.
A shareholders’ agreement will usually contain provisions that deal with what happens if a shareholder dies, becomes bankrupt or retires from the business, including a pricing mechanism so that a fair sale price can be agreed for their shares. In addition, there will be restrictions on whom a shareholder can transfer their shares to – generally, small companies don’t want third parties becoming involved in the business by way of a share transfer. If a shareholder wishes to sell, this may only be with director approval; alternatively the other shareholders may be given the right of first refusal over the shares being sold. It will usually also cover what happens if new shares are issued, as this can dilute the value of the existing shareholders’ holdings.
It may also contain ‘drag’ or ‘tag’ along clauses that force a shareholder to sell their shares if the majority agree to sell the business, or conversely that enable a shareholder to sell along with the majority at the price agreed.
Shareholders have no obligation to provide financing to the company beyond the price they pay for their shares. However, especially if a company is a start-up, a shareholders’ agreement can sometimes provide that the shareholders be invited to participate in the financing of the company, for example as working capital.
Particularly if a company is owned 50/50, a shareholders’ agreement may contain provisions dealing with how disputes are resolved, and if they are unable to be settled amicably, how, for example, a shareholder may exit the company.
Confidentiality and restrictive covenants
A shareholders agreement will usually contain provisions requiring directors and shareholders keep confidential all matters relating to company business. In addition, it may contain provisions preventing shareholders starting competing businesses or dealing with customers of the company.
Does a shareholders’ agreement override articles of association?
No, a shareholders’ agreement will not override the Articles – if there is a conflict, then the articles will prevail. However, it is possible to provide in the shareholders’ agreement that should a conflict arise, then the shareholders and directors will act together to change the Articles so that they agree with the provisions of the shareholders’ agreement.
The best way to avoid a conflict is to seek legal advice from an experienced corporate solicitor when drafting your shareholders’ agreement so that the Articles can be changed at the same time as the shareholders’ agreement is signed, if this is necessary.
How do you draft a shareholders’ agreement?
The best way to draft a shareholders’ agreement is to ask a lawyer to draft this for you, as they will ask specific questions designed to help you work through different options, depending on your particular circumstances.
For more answers to commonly asked questions and advice on shareholders’ agreements, deadlock and company disputes, consult our corporate solicitors. Get in touch on 0800 689 1700, email us at email@example.com or fill out the short form below with your enquiry.