Shareholders’ agreements – minimise the chances of future disputes

A shareholders’ agreement is a private document outlining how a limited company will 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. On the other hand, shareholders’ agreements are governed principally by contract law and can, therefore, provide more flexibility.

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

Using a shareholders’ agreement, parties can agree how they want various aspects of the company to operate, provided the terms do not conflict with mandatory company law or other legal obligations.

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 suitable provisions, shareholders may have less control over who joins the board and how appointments are made.

The agreement cannot remove directors’ statutory duties under the Companies Act, but it can set out additional rules between the shareholders about board appointments and decision-making.

How the company is financed

If shareholders are expected to contribute future funding, a fair method can be agreed upon and set out in the agreement.

This section may also include what business bank facilities the company uses, who its auditors are where applicable, and any procedures in place to approve capital expenditure over a certain amount.

Dividend payments

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

However, any dividend must still comply with company law, including the requirement that it is paid from profits available for distribution.

Voting decisions

When more than one shareholder owns a company, they need to establish how decisions will be made.

Often, shareholders’ agreements clarify how significant company decisions are made, with many people choosing to implement a percentage-based approval system.

These are often known as reserved matters and might include taking on substantial borrowing, issuing new shares, buying or selling a major asset, changing the nature of the business or entering into an unusually large contract.

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 can 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 is particularly important where conflicts arise between two equal shareholders and neither has enough voting power to force a decision through.

There are several ways to resolve this type of dispute:

• Russian roulette – one shareholder offers either to buy the other’s shares or sell their own shares at the same stated price.
• Texas Shoot Out – both shareholders make sealed bids to purchase the other’s shares, usually via a neutral third party.
• Deterrence Approach – one buys the other’s shares at an agreed premium to market value, or sells their own shares at an agreed discount.

Other variations of these deadlock solutions exist, including ‘Mexican Shoot Out’ and combinations of several mechanisms.

These provisions can have major financial consequences, so deadlock clauses should be drafted carefully and with professional legal advice.

Confidentiality

The company’s shareholders can agree to keep confidential information they know about the business and restrict how that information may be used or disclosed.

How the directors are paid

Given that it is common for company directors to also be shareholders, it may be prudent for their remuneration arrangements to be addressed in the agreement, together with an agreed process for reviewing them at certain intervals.

This can safeguard shareholders against directors being over-generous when setting their own remuneration.

Non-competition

How shareholders behave can significantly impact the company’s success. A shareholders’ agreement may therefore contain restrictions preventing shareholders from competing with the business, including for a certain period after they sell their shareholdings.

Given that shareholders typically have extensive knowledge of the company and its employees, a further clause can prevent them from poaching staff or customers during their time as shareholders and for a prescribed period afterwards.

However, restrictive covenants such as non-compete and non-solicitation clauses need to be reasonable in their scope, duration and geographical reach if they are to be enforceable.

Share transfer restrictions

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

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

These are often referred to as pre-emption rights. See our guide to pre-emption rights for limited companies.

Alternatively, clauses may be used to prevent a share transfer unless it is approved by the other shareholders.

While this isn’t appropriate for all businesses, a shareholders’ agreement can regulate the transfer of shares in numerous ways.

You may also want to address succession planning issues – what happens to someone’s shares if they die, become seriously ill, leave the business or become bankrupt? If a shareholder leaves voluntarily, the agreement should work alongside the company’s rules for transferring shares.

A well-drafted agreement may provide for compulsory transfers in certain situations and specify how the shares will be valued.

‘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 can require the remaining shareholders to sell their shares on the same basis.

On the other hand, tag-along provisions can protect minority shareholders by giving them the right to participate in a sale on the same terms as the majority shareholders.

What happens when a new shareholder joins?

A shareholders’ agreement only binds the people who are parties to it.

If somebody later acquires shares in the company, they will not automatically become a party to the existing shareholders’ agreement merely because they have become a shareholder.

For this reason, agreements commonly require new shareholders to sign a deed of adherence, under which they agree to be bound by the existing agreement.

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.

Under Section 21 of the Companies Act 2006, a company’s Articles of Association can normally be amended by special resolution, requiring at least 75% of the votes cast.

A shareholders’ agreement can provide additional protection because its own amendment clause can require a higher level of consent, including unanimous agreement between the parties.

However, it is not automatically the case that every shareholders’ agreement requires 100% consent to change. This depends on the terms of the particular agreement.

Due to this, a minority shareholder can sometimes retain greater protection if a shareholders’ agreement is in place.

Whilst shareholders’ agreements are often favoured by minority shareholders, they generally benefit any type of shareholder.

A shareholders’ agreement can offer additional protection to individual shareholders and the company as a whole by setting out their responsibilities and limiting their actions in certain situations.

Shareholders’ agreement or Articles of Association?

The two documents perform different roles and are often used together.

The Articles of Association form part of the company’s constitution and bind the company and its members. They are filed at Companies House and are publicly available.

A shareholders’ agreement is a private contract between the parties who sign it. It can contain commercially sensitive arrangements which shareholders may not want to place on the public record.

It is therefore important that the Articles and shareholders’ agreement are drafted so that they work together rather than contradicting each other.

See our guide to the Articles and Memorandum of Association for more information.

Do you need a solicitor to prepare a shareholders’ agreement?

There is no legal requirement to use a solicitor, but this is one area where professional advice can be particularly valuable.

A shareholders’ agreement may need to deal with voting control, minority protection, share valuation, compulsory transfers, restrictive covenants, deadlock and what happens when a shareholder dies or leaves the business.

A poorly drafted clause may not work as intended when it is eventually needed – which is often when the shareholders are already in dispute.