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Working with others can create a range of problems and disputes over time. Whether it’s a friend, family member, or a third-party investor, it’s easy to presume that things will run smoothly. However, complications can naturally arise and it’s vital to be prepared. This is where a shareholders’ agreement can help.
But while things can always go wrong, they can also go well. In either case, a shareholders’ agreement can be a useful tool. It is a pre-agreed contract between all or individual shareholders that governs how business decisions are made, disagreements resolved, and relationships managed.
In this article, we will explain what a shareholders’ agreement is and the 7 key reasons why having one is important. We’ll also highlight how it’s different from your articles of association and how to change your provisions or add someone to the contract.
What is a shareholders’ agreement?
As the name suggests, a shareholders’ agreement is a contract between a company’s shareholders. It can involve all or some shareholders – majority or minority.
It is legally binding and commonly used in addition to a company’s articles of association. There are no set rules regarding how many or which provisions the contract should cover, but it is common for its aim to include the following:
- Outline and protect the rights of each shareholder
- Manage shareholders’ relationships and define how disagreements between them should be resolved
- Define dividend provisions as well as share transfers and valuations
- Establish shareholders’ roles in how the company will be run and important decisions made
Why you need a shareholders’ agreement
You may choose to draft shareholders’ agreements for a number of reasons, such as:
1. To govern your business
The fundamental purpose of a shareholders’ agreement is to regulate business relationships. Whether you go into business with someone you know, or a third-party investor, it’s vital to protect each party’s and the company’s best interests.
However, this can be tricky to manage personally. So, a pre-established agreement is a practical way of regulating the terms and functionality of your professional affairs.
The agreement may also be used to establish shareholders’ roles and obligations under certain circumstances that cannot be managed by directors. For example, if the company wishes to take out a loan over a certain amount, the agreement may indicate that shareholders’ approval is required above the borrowing cap.
It’s worth considering a shareholders’ agreement to set out the rules on how the business is governed and the roles that the owners play within it.
2. To safeguard minority shareholders
Another reason is to preserve the rights of the existing minority shareholders. One way this can be done is through the use of pre-emption rights. This means that before shares are transferred or new ones are issued, they are first offered to shareholders with pre-emption rights.
Only if and when refused can they be presented to other shareholders. Pre-emption rights ensure that the minority shareholders’ ownership is not unfairly diluted by other shareholders.
The agreement can also set out the regulations regarding the sale and transfer of minority shares and how they should be valued. This can be achieved via what are known as ‘tag-along rights’. This concerns the sale of a majority shareholding, which gives a minority shareholder the right to sell their shares on the same terms.
When negotiating tag-along rights, you should determine whether they apply to the sale of all, any, or specific majority shares. Doing so can present a beneficial exit strategy for a minority shareholder. Not only does it offer financial and legal protection, but it also means that they are not left behind with a new, unfamiliar investor.
If such rules are not already outlined in your articles of association, a shareholders’ agreement is a helpful solution to shield minority stakeholders.
3. To give control to majority shareholders
Majority shareholders can also benefit from a shareholders’ agreement. For instance, should you wish to sell your company, but struggle to reach an amicable decision with a minority shareholder, the agreement can be used to enforce drag-along rights.
Drag-along rights are the opposite of tag-along rights, as they don’t give the minority shareholder any flexibility. Instead, the majority shareholder has the authority to override conflicting votes, and essentially has the final say. When acted upon, drag-along rights force minority shareholders to sell their shares when majority shareholdings are sold.
There are 3 key advantages of using drag-along provisions. Firstly, they protect the majority stake in the company. So, if another owner holds back a beneficial company change, they put the majority shareholder in control.
Secondly, they can be used to improve the marketability of your company. If you find a buyer who wants complete business control, the absence of minority shares could make it a more attractive, easier, and quicker sale.
Finally, drag-along rights may increase your share valuation if you choose to sell your majority shareholdings. The terms could allow for the value of minority shares to match that of the majority shares (or a minimum price), thus boosting the total cost to the new investor.
4. To control who owns the company
A shareholders’ agreement may be used to present more control over how your company’s shares are transferred, if this is not already settled in your articles of association. This could be applied in the event of bankruptcy, the death of a shareholder, or simply the sale of existing shares for personal gain.
You may choose to set straightforward provisions for such situations, whereby shares cannot be transferred unless approved by the other shareholders. Alternatively, you could apply more specific provisions, such as shares may only be transferred to certain persons or types of persons.
Additionally, this is another instance where pre-emption rights might be useful. This element of regulation over the handling of shares is particularly useful for start-ups and small companies. In this vulnerable stage of growing your business, it can give you more control over how your company’s ownership structure operates, who retains ownership, and who invests in your business.
5. To set specific rules and restrictions
As well as being prepared for various situations, you may also wish to use a shareholders’ agreement to restrict certain arrangements, should they arise. This could concern:
- The company being sold
- The company dissolving
- Shareholders buying each other out
- Shareholders investing in a competing business
- Shareholders exiting the company
- Shareholders exiting on bad terms
- Who may or may not acquire shares in the company
- How shareholders’ power, duties, and liabilities are affected by these
Let’s say that an existing shareholder chooses to leave the company and sell their shares. You may want to apply a non-compete clause to the agreement, that prevents them from creating or joining a competing company or sector for a certain amount of time.
Issuing specific limitations is a helpful and powerful way of protecting your business and its growth, as well as any sensitive company information that you wish to keep private.
6. To manage disputes
It’s common for business associates to fall out. This can happen for several reasons, such as a breakdown in trust, tension during company struggles, unfair treatment, or having different goals.
These situations can be especially intensified if you go into business with a friend or family member. It can make these obstacles more difficult to overcome due to a conflict of interest and the personal emotions involved.
But whether it’s someone you know and trust or a third-party investor, there are always unforeseen challenges that could come up in the future. So, it’s often easier to prepare for potential clashes with a formal document.
Without a shareholders’ agreement to govern how disputes should be controlled, you may struggle to find a suitable solution at the time. Having pre-agreed rules that suit all parties is a time and cost-effective way of eliminating disagreements quickly and efficiently, whilst protecting the interest of all those involved.
But what if there is no resolution and you reach a deadlock? This can cause a lot of additional complications, especially if there are only 2 shareholders or they have a personal relationship. Your agreement should set out the provisions for a worst-case scenario. Typically, one shareholder is removed to break the deadlock.
7. Generate stability and privacy
Finally, a shareholders’ agreement can be used to demonstrate stability and administer a sense of privacy.
Having this contract in place shows that you plan for contingencies, that you don’t put your company at risk, and that you work swiftly and efficiently in the interest of the business.
Furthermore, displaying this sense of responsibility and consideration can be especially helpful when seeking new funding; it shows lenders that your company is risk-averse and trustworthy.
Finally, a shareholders’ agreement is a private contract that does not need to be filed at Companies House. It can, therefore, be used for confidentiality purposes, keeping certain information about the internal workings of your company and business relationships off the public register.
Shareholders’ agreements vs. Articles of Association
Both of these documents will often cover similar areas and overlap each other. For example, they both outline stakeholders’ rights, the distribution of dividends, and the rules regarding communication and decision-making.
However, they have their key differences. As mentioned above, a shareholders’ agreement is a private contract. It is an optional course of action, however, if exercised, it is legally binding. Also, it is specifically designed to manage business governance and relationships.
In contrast, articles of association are a statutory requirement when forming a limited company. It is a legal document between a company and its members – and between members themselves – that determines the key rules about how the company is run.
While your articles outline stakeholders’ rights, they also include more general information such as how to make someone a director and how to bring in new shareholders, for example.
Both documents are part of your constitution and are typically used in conjunction with each other. They can also both be amended at a later date. To change your articles, you need to pass a ‘special resolution’.
This is where a general shareholder meeting takes place to cast votes on a significant business matter. Unless you are a public limited company, it can also be carried out in written form. Special resolutions are governed by section 283 of the Companies Act 2006 and require a majority vote of 75% or more to pass.
Changing a shareholders’ agreement
Similar to your articles, a shareholders’ agreement can also be changed if necessary. If new shareholders join, existing ones leave, or someone wants to renegotiate terms, for example, it can be updated or a new one issued. In either case, all relevant parties must agree to the new conditions.
If you are making a few minor changes, you can amend an existing agreement via a deed of variation. However, if there are extensive and complex changes, it is often simpler to issue a new document.
How to add a new party
A deed of adherence is used as a supporting document that confirms a new party to an existing shareholders’ agreement, and that they shall be subject to it. It is a relatively simple document that requires brief background information, explaining the subscription of the new shareholder and the terms that they are thereby accepting.
It must be signed by all the shareholders of the existing shareholders’ agreement and the new shareholders. Witness’s signatures may also be required.
Rather than drafting an entirely new contract, a deed of adherence simply acknowledges the person being added and the conditions under which they are joining. To make sure that your deed of adherence is drafted correctly, we recommend seeking professional advice.
Drafting a shareholders’ agreement
Like your articles of association, there are no specific provisions that must be included in a shareholders’ agreement. It is entirely dependent on the needs of the company and its owners.
However, the two items that are recommended to cover are disputes and deadlocks. These are the worst-case scenarios that your board should be prepared for, with comprehensive terms on how they are to be managed and resolved. By planning ahead for these specific circumstances, you can save valuable time and effort, and ensure that conflicts are dealt with swiftly, efficiently, and fairly.
Additionally, there is no specific timing or deadline for drafting a shareholders’ agreement. It is not part of the incorporation process, although it is generally advised to action as soon as possible.
A shareholders’ agreement is a useful mechanism for governing your business and the relationships between its owners. One of its primary benefits is to set the provisions for settling worst-case scenarios. But it’s also a powerful and advantageous instrument that preserves the company’s and its owners’ best interests.
We hope this guide has been helpful in understanding shareholders’ agreements and why they’re important. If you have any questions or comments, please post them below or get in touch with our team.