Why you need a shareholders’ agreement

Robert Goddard, commercial lawyer at Thackray Williams outlines the reasons why every company should have a shareholders’ agreement

What is a shareholders’ agreement?

A shareholders’ agreement is a contract between the shareholders of a company in which the shareholders agree their rights and obligations. It is easy to assume that nothing will go wrong in the future, and that you and your business partners will be able to resolve any differences if and when they arise. However, even close friends and family members can fall out and the company suffers as a result. “Without the right legal structure to fall back on, if you fall out, you could end up with little or nothing to show for the time and money you have invested in the company. Even worse, you could end up with a costly legal dispute,” says Robert.

Every company has Articles of Association but these are normally basic and very rarely offer a shareholder adequate protection. For example:

• there is usually no provision to prevent a director from being removed by 51 per cent of the shareholders;
• all major executive decisions by the directors are made by a majority. Even though they may be a majority shareholder, as a single director they could be outvoted;
• even if the articles are made to protect shareholders, they can be amended by a 75 per cent majority of the shareholders, in which case they could take any protection away from a minority shareholder in the articles.

How can a shareholders’ agreement help?

A well drafted shareholder agreement can help prevent disputes from arising and, in the event that they do arise, can help provide a swift resolution.

Shareholders that leave

There is no implied right for the existing shareholders to be able to buy the shares of a shareholder that leaves the company and there are often no restrictions on to whom the shares can be sold. The agreement can include provisions requiring any employee shareholders who cease to be employed by the company to offer their shares for sale to the remaining shareholders.

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 one shareholder (or a group of shareholders) buys the shares of the other at a price determined in accordance with the agreement.

Rights of veto

Shareholders who are not directors may want to have the right to veto important decisions about the company and its business. Without a vote on the board or a shareholders’ agreement, they may have little or no say.

The shareholders’ agreement can provide that certain fundamental decisions, whether or not they would ordinarily be taken by the directors or the shareholders, cannot be made unless all shareholders agree to them.

Non-compete provisions

A departing shareholder could use the knowledge, experience and contacts they have acquired from the company to set up a competing business and take the company’s best customers and employees.

To guard against this a shareholders’ agreement can restrict departing shareholders from setting up in competition with the company and poaching customers and employees for a period of time after they have ceased to hold shares in the company (and whilst they hold shares).

Avoiding deadlock

Where a company is owned and jointly managed by any even number of individuals, there is a risk that the company can be deadlocked and it cannot move forward. These scenarios are one of the most common causes of expensive litigation.

A shareholders’ agreement can include deadlock resolution provisions to resolve a deadlock quickly and effectively.

Defining the exit strategy

Buyers of private companies usually want to acquire all of the shares (and not just, say, 85 per cent). However, some of the shareholders may not wish to sell.

Shareholders’ agreements commonly include “drag along rights” entitling a majority shareholder to compel the minority to sell their shares as part of a sale. In addition, minority shareholders often have “tag along” rights which enable them to require that a new buyer also buy their shares, to prevent them being left behind with the new buyer.

In the event of death

Another extremely important consideration is what should happen if one of the shareholders dies? A number of undesirable situations could arise if no agreement is in place. For example, the surviving shareholders may wish to purchase the shares of a deceased shareholder but the executors of that person may not wish to sell them. This leaves open the possibility of the deceased shareholder’s spouse or personal representatives getting involved in the running of the business. Alternatively, the executors of the deceased shareholder’s estate may want to sell the shares to the remaining shareholders, but the remaining shareholders may not be able to afford them.

For more information on how your company might benefit from a shareholder agreement, or to update your current agreement, contact Robert Goddard.

The contents of this article are for the purposes of general awareness only. They do not purport to constitute legal or professional advice. The law may have changed since this article was published. Readers should not act on the basis of the information included and should take appropriate professional advice upon their own particular circumstances.