What is a shareholders’ agreement?

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A shareholders’ agreement is a private document which outlines how a limited company is to be run. It is designed to protect all parties, particularly minority shareholders, and to restrain the power of the directors.

Governed by company law, a company’s Articles of Association must meet certain requirements. Shareholders’ agreements, on the other hand, are governed by contract law and can, therefore, provide more flexibility.

Although these two documents could theoretically cover the same topics, such as the rights and responsibilities of shareholders, there are certain benefits of having this information recorded in a shareholders’ agreement, rather than in the Articles.

By using a shareholders’ agreement, parties can create terms which allow them to operate in any way they see fit, providing it is within the scope of the law.

Furthermore, shareholders’ agreements are not made available to the public and, unlike Articles of Association, they do not need to be submitted to Companies House. If shareholders wish to keep some of the company’s arrangements private, they may choose to record these particular terms in the shareholders’ agreement.

What should a shareholders’ agreement contain?

Although there is no fixed format for a shareholders’ agreement, they will often cover the following broad points:

Business of the company

This outlines what the company does, the scope of its current operations, and plans for the future.

Company directors’ appointments

How directors are to be appointed and removed. Without this clause, the shareholders would not be able to prevent the current directors from installing friends, family or other people who may not necessarily be appointed on merit.

How the company is financed

If shareholders are expected to contribute future funding, a fair determination can be agreed upon and set out in the agreement. This section will also include what business bank facilities the company use, who its auditors are, and details any procedures in place to agree capital expenditure over a certain amount.

Dividend payments

The agreement can specify when and how dividends can be made to shareholders. You may want to put in place restrictions on how often they are made, and if they should only be declared if the company’s performance has reached a certain level.

Voting decisions

When more than one shareholder owns a company, they need to establish how decisions will be made. Often, shareholders’ agreements are used to clarify how significant company decisions are made, with many people choosing to implement a percentage based approval system.

Using a shareholders’ agreement to set out what constitutes a ‘significant decision’ and what percentage of approval is required can help to ensure that disagreements and disputes don’t arise during the course of business and can, therefore, prevent unnecessary expenditure in the future.

Dispute resolution

However well intentioned a company’s shareholders are when they set up a business, disputes inevitably arise. If disputes become serious, you need to have a comprehensive resolution process in place, which may involve using external mediation services, or even the option of shareholders buying each other out of the business altogether.

Deadlock provisions

This occurs where conflicts arise between the only two equal shareholders of a company. There are several ways to resolve this type of dispute – Russian roulette (one party buys the other’s shares), Texas Shoot Out (both shareholders make a sealed bid to purchase the other’s shares – via a neutral third party), or Deterrence Approach (one buys the other’s shares at 125% of the market value, or sells their own shares to the other for 75% of the market value).

There are other variations of these deadlock solutions, including ‘Mexican Shoot Out’ (a type of Dutch auction), or a multi-choice combination of several of the above options.

Confidentiality

The company’s shareholders agree to keep any information they know about the business confidential.

How the directors are paid

Given that it is common for company directors also to be shareholders, it is prudent for their salaries to be set out in the agreement, together with an agreed process to review their remuneration at certain intervals. This safeguards the shareholders from directors who may be over-generous in setting their own salaries.

Non-competition

How shareholders behave can have a significant impact on the success of the company. By including a non-competition clause, for example, shareholders are prevented from working with rival companies – including for a certain period after they sell their shareholdings.

Given that shareholders will typically have great knowledge of the company and its employees, a further clause can prevent them from poaching staff during their time as shareholders, and a prescribed duration beyond.

Share transfer restrictions

While shareholders may not be thinking about potentially selling their shares when the business is created, this is something which should be addressed in the agreement.

Many business owners choose to add a clause which requires one shareholder to offer other shareholders the ‘right of first refusal’, if they plan to transfer their shares, for example.

Alternatively, clauses may be used to prevent a share transfer, unless it is approved by all shareholders. While this isn’t appropriate for all types of businesses, there are numerous ways in which the transfer of shares can be regulated by a shareholders’ agreement.

You may also want to address succession planning issues – what happens to someone’s shares if they die?

‘Drag and Tag’ Provisions

If a certain number (typically a majority) of shareholders wish to sell the company at some time in the future, ‘drag along’ provisions will force all of the remaining shareholders to offload their shares on the same basis.

On the other hand, if a company is taken over, ‘tag along’ provisions will ensure that minority shareholders receive the same terms upon a sale as all other shareholders.

How important is a shareholders’ agreement?

Although companies aren’t required to have a shareholders’ agreement, it’s often advisable. Even relatively small companies can run into problems if the rights of shareholders aren’t clarified.

One shareholder could suffer significant financial harm as a result of another shareholder’s actions, for example, but a formal shareholders’ agreement could prevent potentially harmful conduct from being carried out.

Minority shareholders, in particular, can benefit from having a shareholders’ agreement in place.

Currently, only 75% of shareholder approval is required to amend the company’s Articles of Association but 100% is required to alter a shareholders’ agreement. Due to this, a minority shareholder could be said to retain more control if a shareholders’ agreement is in place.

Whilst shareholders’ agreements are often favoured by minority shareholders, they generally benefit any type of shareholder. By setting out the responsibilities of shareholders and limiting their actions in certain types of situations, a shareholders’ agreement can offer additional protection to individual shareholders and the company as a whole.

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