If there is a disagreement between the owners of a business and one of them comes to us for advice, the first question we are normally going to ask is: do you have a shareholders agreement?
This article explains why.
Why have a shareholders agreement?
When founders set up a business there is usually significant amounts of positive energy brought to the new project, not to mention many establishment tasks to perform. In the rush to start trading the founders will often not give detailed consideration to matters such as how decisions regarding the business will be made, how disputes will be resolved and what processes need to be followed if one of more person involved wants to sell out of the business.
Unfortunately, companies whose management is overseen by a handful of individuals are fertile ground for power struggles, particularly when the businesses they run start to become successful. Therefore, from an operational perspective a shareholders agreement is strongly recommended for companies with more than one shareholder.
And generally speaking, it’s best to get it documented when everyone’s full of that positive energy we mentioned – at the start!
What is a shareholders agreement?
In its most rudimentary form a shareholders agreement is a contract executed by members (shareholders) of a company setting out their rights, interests and powers. It offers transparency and order between the shareholders of the company, its board of directors and employees and aims to negate any disputes that may arise between these parties, or at least provide a mechanism to resolve them.
A company constitution, in contrast, is concerned with the fundamental mechanics of a company as may be specified in the Corporations Act. For example, the different types of shares, the number and appointment of directors, and the conducting and giving notice of meetings.
Shareholders agreements are bespoke to each company’s business. While there may be an overlap of content in a company constitution and a shareholders agreement, most shareholders agreements will contain a provision that its terms prevail over those of the constitution in the event of inconsistency.
What should a shareholders agreement cover?
Because shareholders agreements are unique to each company, the type of decisions and manner in which they are made should be linked to the business.
In a construction context, the agreement may cover the types of projects a company intends to undertake and the procedures for obtaining approval from shareholders or directors. For example, it could specify that the company must obtain the unanimous approval of the shareholders in a general meeting if it wishes to proceed with projects over $50 million or with design and construct contracts, as opposed to construct contracts.
Other examples of decisions that could be delegated to the shareholders for their approval are:
- disposal of the company’s assets;
- granting of loans or security over a company’s assets;
- expansion or diversification of the company; or
- issuing shares to anyone other than a current shareholder.
There may also be different approval thresholds under the agreement. Decisions may require a majority resolution (51% of votes in agreement), a special resolution (which could, for example, be defined as 75% of votes in agreement), or a unanimous resolution.
Key issues that should be addressed in a shareholders agreement
When drafting a shareholders agreement you should consider how parties’ rights and interests may lead to future disputes.
If a shareholder company has a nominee director in a joint venture there may be a duty to act in the interest of both the shareholder and the joint venture. For this reason it is common to see provisions in shareholders agreements stating that directors who are appointed by individual shareholders are entitled to vote and make decisions for the benefit of their appointing shareholder.
Deadlock can arise when shareholders with equal powers are unable to agree on an issue, which then prevents a company from passing a resolution.
While it’s tempting to believe that “we’ll sort it out” would do the trick, shareholders should take the time to consider mechanisms for avoiding deadlock. This might include rotating the chairperson having a “casting vote”, disputes being referred to an independent third party, and if there is a major deadlock preventing operations, even options for one shareholder to buy the other out.
It is common for shareholders agreements to contain a provision restraining a shareholder from competing with the company both while they hold shares and for a period after they have sold their shares. Restrictions can apply to ownership of an interest in, or employment by, a competing business, and to solicitation of customers, employees or suppliers away from the company.
The starting point for interpreting such restraint provisions is that they are void by virtue of being a restriction on an individual’s right to earn income.
However, if it can be shown that a restraint protects a legitimate interest, such as the valuable good will of a business, and is reasonable in relation to the duration and scope of this protection, it will be enforceable. Moreover, a shareholder who has sold their shares will have received valuable consideration in return for the agreement to be restrained after leaving a company, which increases the enforceability of a restraint.
Drag along / tag along
Drag along and tag along clauses concern the rights of shareholders to sell shares to third parties.
A drag along clause gives a shareholder (usually holding a majority of shares) the right to force other shareholders (usually holding a minority of shares) to sell their shares to a bona fide third-party purchaser.
A tag along clause gives shareholders (usually holding a minority of shares) the right to require a bona fide third-party purchaser to extend an offer to purchase the shares of another shareholder (usually holding a majority of shares) to all shareholders.
The rights under such clauses are often linked to percentage shareholdings, with such percentages negotiated at the time of drafting the shareholders agreement.
Buy sell provisions
A buy sell provision is critical for the continued operation of a company where shareholders (or their key individuals) are heavily involved in the day-to-day management of its business.
A buy sell provision can be triggered where a shareholder, or their related key person, dies, suffers a total or permanent disability or some form of trauma that prevents their continued contribution to the business.
Typically, these provisions are structured as a ‘put option’ granted to the shareholder who suffers the triggering event and a ‘call option’ granted to the remaining shareholders for the sale/purchase of the sufferer’s shareholding.
In addition to the buy sell provision we strongly recommend that the shareholders take out, and regularly update, appropriate insurances so that in a triggering event it is the insurance proceeds that pay for the sufferer’s shareholding.
These provisions can prevent not only financial heartache for remaining shareholders but also the unwanted intervention in the business of a sufferer’s inexperienced and/or uninterested family members.
Five considerations when drafting a shareholders agreement
- Understand the needs of your business
Having a good understanding of the capacity of your business will enable a shareholders agreement to reflect both the goals and boundaries of a company’s operations.
- Preserve your interests
From the perspective of a shareholder, there are certain mechanisms that can be included to preserve personal views. In some agreements, by a shareholder ensuring that they have majority voting rights, they ensure they retain control in the agreement.
If you are not able to obtain the majority voting right you can still seek to ensure that key decisions require unanimous approval.
- Avoid deadlock
The potential for deadlock is dependent upon the number of shares that each party holds and the voting rights attached to each share.
If there is any danger of deadlock (eg by two similarly contributing shareholders with one share each) it is important to be able to quickly deal with these situations to continue with the operations and decision-making of the company.
- Specify what powers should be delegated
Although it’s important to protect your interests, it’s also necessary to consider the efficient function of company operations. If every decision required unanimous approval from 7 people, that could create significant operational challenges.
Delegating certain powers to particular directors or other officers of the company can allow for the smooth operation of projects, approval of variations or the entering of minor subcontracts.
- Have an exit strategy
An effective shareholders agreements should provide for a smooth transition in the event you want to sell or forfeit a shareholder’s interests. It’s worth thinking about the circumstances in which a shareholder may sell shares, to whom the shares may be sold and at what value.
Implementing a shareholders agreement can not only minimise costs, but also prevent paralysing issues such as deadlock from arising further into a company’s development.
We therefore strongly recommend that company founders enter into a shareholders agreement at the start of their business journey.
Batch Mewing would like to acknowledge the contributions of our law clerk, Marquessa O’Leary, to the production of this article.