Shareholders’ Agreements

What is a Shareholders’ Agreement?

Without wishing to state the obvious, a Shareholders’ Agreement is an agreement between the shareholders in a company. It can be on whatever terms the shareholders choose but generally it will set out rules, policies and procedures for matters such as:

  • the relationship between shareholders,
  • the management of the company,
  • board and shareholders meetings,
  • issuing and selling shares and
  • settling disputes or disagreements between shareholders

Having a Shareholders’ Agreement means that you have an agreed way to run your business together and to deal with future events.

The need for a Shareholders’ Agreement can be easily overlooked at the beginning of a new business relationship, particularly when you start your business with your family, friends, or someone who you have known for a long time. Unfortunately, as time passes and your business grows, disagreements or disputes between you and your fellow shareholders can occur, for example, about paying dividends, issuing new shares, taking new members, or going your separate ways. In such circumstances, pre-agreed ways set out in a Shareholders’ Agreement will help avoid or resolve such issues swiftly.

What is the legal status of a Shareholders’ Agreement?

There is no statutory requirement for a company to have a Shareholders’ Agreement. It is most useful to think of it as a private contract between the shareholders.

A Shareholders’ Agreement will be legally valid if it is formed in compliance with the usual contractual requirements – offer, acceptance, consideration, and an intention to create legal relations between the parties. Once a Shareholders’ Agreement is established the shareholders who have entered into the agreement are obliged to comply with its provisions.

Where a dispute arises between shareholders, the courts enforce the terms of the agreement, apart from those terms that are contrary to the statutory obligations of the company. For example, agreeing not to alter the articles of associations in the future, which is protected by section 21 of the Companies Act 2006 or dismissing a director without the protections afforded by employment law.

What is the relationship between the Articles of Association and Shareholders’ Agreement?

A company’s Articles of Association (“the Articles”) and a Shareholders’ Agreement should be compatible documents. The main difference between the Articles and a Shareholders’ Agreement is that the Articles are required by law and must be published on the Companies House website when a company is formed. They govern the day-to-day management of the company. For example, the classes of shares, the rights to vote, dividend entitlements, appointment/powers/duties of directors, and notice/proceedings at shareholder and director meetings. The Shareholders’ Agreement can cover these issues as well but can go into much more detail and can be kept confidential.

For the governance of a company to be consistent and to avoid conflicts between the two documents, the Articles should be reviewed and amended as required when entering into a Shareholders’ Agreement.

What can you include in a Shareholder’s Agreement?

There is no fixed format for a Shareholders’ Agreement. As mentioned above, a Shareholders’ Agreement can deal with any issues the shareholders want it to. It is usual though, for a Shareholders’ Agreement to cover the following points:

Regulating management of the company

Usually, directors are the ones who run a company day to day. However, shareholders may wish to restrict the discretion of the directors on certain decisions, especially if the directors are not shareholders.

Reserved matters

The Shareholders’ Agreement can set out a list of matters that the company must not carry out, without the prior consent of the shareholders, it can also change the rules concerning what constitutes shareholders’ approval. In the Companies Act 2006 the threshold for passing a Special Resolution is 75% and for an Ordinary Resolution is 51%. These percentages can be changed.

This would ensure that the business is being managed in a way that all of the shareholders agree with. Such provisions are especially useful for minority shareholders in the company.
Having an agreed list of “reserved matters” means that each of the shareholders has an opportunity to veto certain transactions, if they believe those transactions are going to be detrimental to their interests or those of the company.

What issues are considered to be reserve matters is for you as shareholders to decide. Common issues included are the approval of business plans, financing, loan capital, capital expenditure, material contracts, related party transaction, and shareholders’ guarantees of borrowings.

Dividend policy

How dividends are divided among shareholders is one of the most significant issues for shareholders. A Shareholders’ Agreement can outline how dividends are calculated, and when they are distributed to shareholders, for instance, when the company’s performance has reached a certain level.

Transfer of shares

An example of a particularly helpful restriction on the transfer of shares may be when someone who is both a director and a shareholder has decided to leave the company you don’t want them to keep their shares.

A Shareholders’ Agreement can set out a rule that shares must be sold if a director leaves the company and set the terms of any valuation for the company to purchase the shares for a good leaver (e.g. retirement, illness or death) or a bad leaver (e.g. joining another competitor). Generally, good leavers will get more value for their shares than bad leavers.

Additionally, you may wish to spell out pre-transfer requirements in the provision that must be satisfied before shares can be transferred.

Sales of Shares

Without the relevant clause in either the Articles of Association or Shareholders’ Agreement, a shareholder can sell their shares to anyone they want to, whenever they want to. For example, the shareholder, who is in personal financial difficulties, may sell their shares to the highest bidder. This may not be best interests of the company. A Shareholders’ Agreement can outline a rule about when the shares can be sold and set the term of selling shares.

Drag-along / Tag-along rights

Drag-along rights are provisions where a majority shareholder who wants to sell his/her shares to a buyer can compel the remaining minority shareholders to accept an offer to sell their shares to the same buyer. This allows the buyer to purchase the entire company.

Such provisions protect the majority shareholder from losing a chance to sell the company when he/she wishes to do so. It is worth noting that if you are a majority shareholder and want the other shareholders to be “dragged along”, you must offer the minority shareholders the same price, terms and conditions that you have been offered.

Tag-along clauses are designed to protect minority shareholders. Tag-along rights ensure that the minority shareholders will be bought out and get the same terms and conditions of sale as the majority shareholder, if he/she sells their interest in the company.

Pre-emption rights

This provision will protect existing shareholders from the involuntary dilution of their shares in a company. The involuntary dilution may happen when the company issues new shares to take investment from third parties. In such situations, pre-emption rights would allow existing shareholders to be offered new shares first, in proportion to their holdings, before they can be offered to any new buyers.

In the context of an existing shareholder of the company selling their shares, pre-emption rights can be used to protect a “right of first refusal” in favour of the remaining shareholders.

Disputes between shareholders

Regrettably, shareholders do fall out, and disputes can occur. If you would like to read more about Director and Shareholder Disputes please follow the link HERE [to Director and Shareholders disputes page].

These situations can be disastrous for your business, possibly leading to its failure if they are not resolved softly. A Shareholders’ Agreement can lay down specific mechanisms to deal with those disputes. These may include at what stage mediation could be considered, or who an arbitrator may be.

Deadlock resolution

A Deadlock resolution provision in a Shareholders’ Agreement is especially important for companies owned by two people, each holding 50% of the shares and each being a director. Companies established in such terms can often find themselves in deadlock situations, where the only options are Derivative Claims through the Courts or the winding up of the company.

A Shareholders’ Agreement is an opportunity to put in place arrangements to bring a deadlock to an end.

A “Russian Roulette” Clause allows either party to serve a notice that sets a price on the company’s shares and then elects to either buy or sell at that price.

The second party then has a period of time, say 30 days, to serve a counter notice. The counter notice can contain either a counter offer to buy or a counter offer to sell. It is agreed that an unanswered first notice or a counternotice is binding.

Such a clause favours the party with the largest financial resources as a notice to buy must be accepted if the other party cannot raise the funds to buy at that price. The procedure is also based on at least one party being willing to implement the clause.

On the positive side it avoids arguing about valuation and avoids the company being wound up.

A “Texas Shoot Out” Clause

Each party must put in a notice that can offer to buy or sell their shares.

If both parties offer to buy the highest bid wins. If one party offers to buy the other must sell. If no one offers to buy the company is wound up.

Non-compete covenants

This clause is to protect and benefit all the shareholders by preventing any of the owners from using the confidential information of the company to start a competitive business or to contribute to a direct competitor. Shareholders aiming to grow the business by bringing in new partners should use this clause to protect the value they have built in the business and its long-term prospects.