You may be wondering - what is a shareholders’ agreement and why do I need one? When you incorporate a company, the standard model articles of association do not include any protective provisions for shareholders. Therefore, you will need a separate shareholders’ agreement if you want to provide further detail to govern the relationship between shareholders and the company.
When starting a business it can be tempting not to worry about shareholders’ agreements, especially if the company is very small at the outset. However, even if there are only two shareholders/co-founders involved at the outset, it is still important to get this agreement in place early on. As time goes by, circumstances may change that affect the position of shareholders within the company and unexpected tensions could arise. Writing up a shareholders agreement from the start will ensure everyone’s interests are suitably protected.
Below is a more detailed explanation of what a shareholders’ agreement is and why you need one.
Defining decision making powers
In a limited company, one ordinary share generally carries the right to one vote. Therefore, when it comes to voting, majority shareholders will automatically have far greater control than minority shareholders. And if there is a shareholder who owns 75% or more of the company, they would have the power to override the wishes of the other shareholders, and make fundamental changes such as approving the adoption of new articles of association.
For minority shareholders, a shareholders’ agreement will protect your decision-making power, typically by setting out a list of veto rights which prevent certain actions from being taken without the approval of the minority shareholders. Some shareholders may have a particular interest in certain decisions that are important to them, and may want to be able to have a greater influence in these areas of the business.
Limiting the power of the directors
Where some shareholders are company directors and others are not, this can create an imbalance of power. Directors have influence over almost all of the day-to-day decision making in a business, with many key decisions made at board level. Shareholders who are not directors may wish to maintain some decision-making power and limit the control of the directors.
A shareholders’ agreement can regulate the balance of power between shareholders and put some restrictions in place. It could determine which matters can be agreed solely by directors, and require other decisions to be approved by shareholders. This may include any changes to the nature of the business, entering into large contracts or taking on any additional borrowing, or decisions such as hiring new employees.
Protecting both minority and majority shareholders
Without a shareholders’ agreement, a minority shareholder’s position can be very exposed. Decisions made by majority shareholders may not be in the best interest of the minority shareholders, potentially reducing the value of their shares. For this reason a shareholders’ agreement is an essential protection for their interests. The shareholders’ agreement may provide minority shareholders with a say in any matters that could devalue their shares. It may also include a dividends policy detailing how profits will be shared, to guarantee a return on shareholders’ investments.
Majority shareholders generally benefit from a far stronger position than minority shareholders when it comes to key decision making. However, a shareholder’s agreement protects the interests of the majority shareholders too.
Some agreements include a drag along clause which affords the majority shareholder protection over their investment, should they wish to sell. Typically a third party buyer will want to purchase 100% of the shares of a company, in order to gain full control. If any minority shareholders are refusing to sell, this could jeopardize a sale for the majority shareholder. A drag along clause would therefore oblige the minority shareholders to sell their shares as part of the agreement. From the minority shareholders’ perspective, they are guaranteed the same terms for their shares as the majority shareholder has agreed. Drag along clauses are typically included in a company’s articles of association, but there may be reasons why the parties want to include this in the shareholders’ agreement instead.
Determining the issue and transfer of shares
A shareholders’ agreement will typically define provisions for how new shares can be issued or existing shares transferred. The issue of new shares – for example to raise funds for the company – could adversely affect shareholders, since it could dilute the value of their existing shares, so provisions governing how this process can take place should be set out in advance.
Similarly, with the transfer of shares, provisions in an agreement can protect the interest of other shareholders. Whether a shareholder wishes to sell their shares, or in unforeseen circumstances – such as the death of a shareholder – the process for transfer of shares should be set out from the start. This will typically involve a ‘pre-emption’ position whereby shareholders cannot transfer their shares to third parties without first offering them to the other shareholders, who effectively have rights of first refusal. A Shareholders’ agreement can further determine a process for the compulsory transfer of shares when a shareholder exits the company.
Providing stability
The existence of a shareholders’ agreement generally demonstrates stability within the company, making it more attractive to creditors or financiers. Since the decision making procedures are determined in advance, the risk of dispute about the control of the company is greatly reduced. Disputes down the line could be costly, both in terms of legal fees and potential damage to the company through lack of cohesive leadership. So a shareholders’ agreement is an essential element to a stable company.
The contents of this article do not constitute legal advice and are provided for general information purposes only.
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