Shareholders' agreements: an expense too far?

Incorporating a company is relatively quick, cheap and easy to do, but putting a shareholders’ agreement in place with your fellow shareholders can seem expensive and time consuming. Is it something that needs to be done early on in the lifecycle of a company or can it be put off until later?

A shareholders' agreement is a contract entered into between a company and some or all of its shareholders. It can deal with all aspects of the relationship between the parties, including the personal rights and obligations of the shareholders. Together with the company’s articles of association a shareholders’ agreement creates internal “rules” by which a company is governed.

The main reason to put a shareholders’ agreement in place early on in the lifecycle of a company is that it is generally much quicker, cheaper and easier to do so than trying to negotiate a settlement in the event that a dispute arises and no agreement is in place to determine how such dispute will be resolved.

Founders of new companies all too often “park” the issue of the shareholders’ agreement fully intending to deal with it at a later date when they have more time and money. The problem with taking this approach is that foundersoften find they actually have less time to deal with matters such as shareholders’ agreements as their business grows and/or the shareholders’ agreement gets forgotten about as they devote their time and attention to making the business a success. In addition, their personal plans and expectations may diverge over time, making it harder to agree the terms of the shareholders’ agreement later on in the lifecycle of the company.

It is good practice for a company to adopt new articles of association when a shareholders’ agreement is put in place so that the articles are consistent with the terms of the shareholders’ agreement. In addition, certain matters such as issues and transfers of shares, board and shareholder meetings and so onare best dealt with in the company’s articles of association instead of/as well as the shareholders’ agreement, because unlike shareholders’ agreements, which are only binding on those shareholders that are parties to the agreement, the articles of association are automatically binding on all shareholders. Therefore, in this article references to shareholders’ agreements include the company’s articles of association where appropriate.

Examples of areas in which disputes commonly arise and the provisions of shareholders’ agreements that are intended to deal with such matters are set out below.

Management

The directors of a company are responsible for the management of itsbusiness and are generally entitled to exercise all the powers of the company. Although directors are subject to statutory duties, including the duty to act in good faith in the best interests of the company, as a general rule theyare not required at law to consult the shareholders about decisions relating tothe management of the company and its business. Where all the shareholders are also directors this may not be an issue. However, shareholders who are not directors may nevertheless want to be consulted about and/or have the right to veto important decisions about the company and its business.

Shareholders’ agreements usually include provisions reserving decisions about certain matters relating to the management of the company and its business to the shareholders. For example, it is common for the directors to be required to obtain the consent of some or all of the shareholders before committing the company in relation to such matters as issuing new shares, selling material assets of the business and appointing new directors. In the event that the directors act in breach of the shareholders’ agreement, the underlying act will remain binding on the company, but the shareholders may have a claim for damages for breach of contract against both the company and any shareholder who was involved in perpetrating the breach (e.g. a shareholder who is also a director).

Departing Shareholder

The shareholders of a company may have agreed that one or more of their number will “earn” their shares in the company by working as employees of the company (whether for a fixed period or indefinitely) and the success of the business may depend on such shareholders fulfilling their obligations. In the event that an employee shareholder changes his mind and resigns, he will not automatically be required to offer his shares in the company for sale to the remaining shareholders and will therefore benefit from a windfall attributable to the value created by his fellow shareholders (whether by investment or hard work).

Shareholders’ agreements sometimes include provisions requiring any employee shareholders who cease to be employed by the company to offer their shares for sale to the remaining shareholders. The price at which the shares must be offered for sale (whether market value or at a discount) usually depends on whether the departing employee shareholder is a good leaver or a bad leaver. For example, a shareholder may be a bad leaver where he has resigned within a minimum period of time after being issued shares or he has been dismissed in circumstances in which he is guilty of fraud, dishonesty or gross negligence.

Shareholders may also be concerned about departing employee shareholders using the knowledge, experience and contacts they have acquired during their employment with the company to set up competing businesses and poach the company’s customers and employees. For this reason, shareholders agreements usually include a number of restrictive covenants which seek to restrict departing employee shareholders (or even all shareholders) from setting up in competition with the company and poaching customers and employees for a period of time after they have ceased to hold shares in the company.

Exit

Shareholders often have different ideas about what their business is worth and when is the best time to sell, and they may disagree about the timing and/or the terms of any proposed sale. However, purchasers of private companies usually want to acquire the entire issued share capital free of any minority interests and, for this reason, shareholders’ agreements commonly include drag along rights entitling the majority shareholder(s) to compel the minority to sell their shares in the company to any proposed purchaser of the shares of the majority shareholder(s).

Drag-along rights are usually accompanied by tag along rights which entitle the minority shareholder(s) to require the majorityto ensure that any proposed purchaser of the shares of the majority also purchases the shares of the minority shareholder(s) on the same terms.

Deadlock

Where a company is owned in equal shares and jointly managed by two individuals, there is a risk that deadlock may arise at both board and at shareholder level. For example, one party may wish to take the business in a new direction or seek investment from a third party while the other wants to carry on business as usual.

Deadlock can be disruptive and damaging for any business, but is particular risky for new businesses which are often working to tight deadlines and budgets. If not resolved quickly, deadlock may result in the failure of the business. In addition, unless one party has acted in breach of contract or duty the parties may not have recourse to the courts to settle the dispute. In any event litigation is usually expensive and time consuming and may damage the company’s reputation and the goodwill of the business. It is therefore important that there is a mechanism in place to resolve any deadlock as quickly and as privately as possible.

Shareholders’ agreements sometimes include deadlock resolution provisions which require the parties to use commercially reasonable efforts to resolve any deadlock in accordance with an agreed procedure and timetable and, in the event that the deadlock cannot be resolved by negotiation within the agreed timetable, provide a mechanism for the compulsory purchase by one party of the other party’s shares in the company.

Matthew Cunningham is a solicitor at Waterfront Solicitors.