Five key things to include in a shareholders' agreement

It has been said that too much agreement kills a chat. But when it comes to shareholders, the existence of a shareholders’ agreement will almost certainly improve a chat.

As its name suggests, a shareholders’ agreement is a document that governs the relationship between multiple shareholders of a company and sits alongside the company’s articles of association.

All shareholders should enter into the shareholders’ agreement and be bound by its terms. If the company takes in new shareholders, the new shareholders should be required to enter into a deed of adherence, confirming that they will be subject to the provisions of the shareholders’ agreement.

Shareholders’ agreements have many provisions that govern the basic mechanics of a company, such as how board and shareholder meetings are called, how notice is given and what constitutes a meeting quorum. However, many fail to include key provisions which are important for the success of a company and the protection for the shareholders.

Here then are FIVE KEY THINGS TO INCLUDE IN A SHAREHOLDERS’ AGREEMENT that are often overlooked.

1.  SHARE TRANSFER PROVISIONS

When a shareholder wishes to sell their shares, this can be an unsettling time for the remaining shareholders as it can sometimes cause a shift in the business. The purpose of a share transfer clause is to govern this process and give rights to the remaining shareholders. Pre-emption provisions can be included so that the selling shareholder must first offer their shares to the existing shareholders at an agreed price or fair value. Share transfer provisions can also give the company itself the option of buying-back the shares, thereby increasing the existing shareholders’ holdings pro rata, subject to certain restrictions.

Shareholders’ agreements often also include compulsory transfer clauses which force the transfer of shares, conditional on certain occurrences, also known as events of default. Events of default can result in the shareholder becoming a ‘good leaver’ or a ‘bad leaver’, which should be defined in the shareholders’ agreement. Whatever the leaver is classified as will dictate the price they receive for the shares.

Examples of a bad leaver include where the shareholder in question has acted to the detriment of the company, has breached material terms of the shareholders’ agreement, has committed an offence of fraud or dishonesty, or becomes bankrupt or insolvent.

Being a good leaver typically means that the shareholder in question is transferring their shares, arising from a situation in which they are not at fault in any way, such as death, loss of mental capacity or retirement.

The impact of which leaver category a party falls into is highlighted when considering the price at which they can sell their shares. A bad leaver may be restricted to selling their shares for nominal value or less than market value, whereas a good leaver is able to sell their shares at market value.

2.  DRAG & TAG RIGHTS

Drag along rights and tag along rights are designed to provide protection to both the majority and minority shareholders of a company, by working in a similar way in the event of a potential sale.

Drag along rights provide that if shareholders holding a specified majority of the shares or voting rights in the company wish to sell their shares, and the buyer requires the entire issued share capital of the company, the minority shareholders can be ‘dragged along’ and forced to sell their shares at the same price per share as the majority.

Similarly, tag along rights provide that if the specified majority are selling their shares and the minority shareholders also wishes to sell theirs, they are entitled to ‘tag along’ at the same price per share as the majority.

3.  DEADLOCK PROVISIONS

A deadlock can occur at board level or at shareholder level. If there is no majority between the board of directors in relation to a board decision, this is deadlock. Similarly, if there is no majority of the shareholders (who hold voting rights) in relation to a shareholder resolution, this is also deadlock.

A deadlock at board level may affect the day to day running of the business, whilst a deadlock at shareholder level may mean that key decisions for the business are unable to be made. Both deadlock scenarios can therefore have profound impact.

On some boards, the chair is given a casting vote which can prevent deadlock. But this option is not available at a shareholder level which means that 50:50 shareholder companies can run into problems.

Deadlock resolution provisions are important as they aim to solve seemingly irreconcilable conflicts, allowing the business to operate normally. The provisions may require the parties to negotiate in good faith but, failing this, can include options such as mediation or arbitration, or failing this, a buyout. Buyout provisions can be structured as a ‘Texas Shootout’ (whereby offers are made by each shareholder to buy the other out with the highest bid winning) or as a ‘Russian Roulette’ (whereby one shareholder can offer to buy the other out at a specific price, and then the other can enter a counter-offer until a conclusion is reached).

Whilst these provisions can be helpful, their main value is in incentivising both parties to negotiate and reach an agreed position for the benefit of the business as a whole.

4.  RESERVED MATTERS

Most day-to-day decisions of a company are made by the directors, sometimes via board meetings. Some of the more significant decisions, such as selling the company, always require shareholder approval. But the shareholders may also want to maintain greater control over the directors by reserving the right to approve certain other matters. A reserved matters schedule in a shareholders’ agreement can set out the decisions that either require unanimous consent from the voting shareholders, or consent of an agreed percentage of the voting shareholders. This schedule should always be tailored to the individual company because decisions that are unimportant to some businesses, might be of utmost importance to others.

Shareholders can negotiate this schedule between themselves, depending on their business and its needs. However, the most common things to cover are matters such as the right to alter the company’s articles of association, increasing or reducing the amount of the company’s issued share capital, altering the name of the company, issuing any loan capital in the company, changing the nature of the company’s business and making capital expenditure above certain financial limits.

5.  DIVIDEND POLICY

This provision stipulates the amount of dividends to be paid out to shareholders annually, usually based on a percentage of the company’s annual profits, unless otherwise agreed. The advantage of having this documented is that no shareholder will take a dividend if it is not in accordance with the shareholders’ agreement (or otherwise agreed), as they will be in breach of the agreement and potentially subject to a compulsory transfer of their shares. This promotes transparency between the shareholders and the business, allowing for a positive working environment.

In essence, because shareholders’ agreements provide comfort and protection for the shareholders of a company and pre-planned solutions to many of the issues that arise between them, they generally facilitate a smoother and more streamlined business - and yes, a more relaxed chat around the boardroom table.

For further information, please contact Mollie Williams.