What is a shareholders’ agreement?
A shareholders’ agreement is a contract between one or more shareholders of a company. Often, it will establish rights and obligations of shareholders, rules regarding how shares can be transfers, and establish the management of the company.
Why shareholder’s Agreements?
While the startup may begin with high spirits and bold plans, there is a possibility that founders of startups my fall apart. One function of a well-drafted shareholders’ agreement is outline contingency plans for potential fall-outs. Other common reasons to draft shareholders’ agreements include:
- “My investors wish to manage the company. But I don’t want to lose control.”
- “My co-founder and I fell out. I don’t want him/ her to set up a company to compete with my company.”
- “My co-founder wants to sell out to an investor, but I don’t.”
- “What can I do if I have disputes over day-to-day management with the other co-founders?”
Key Provisions to include in a Shareholders’ Agreement
- Shareholders’ Agreement and Employment Contracts [
- Share Transfer and Liquidity
- Shareholders’ Disputes
Most management decisions of the company are decided by the collectively by a simple majority vote by the board of directors. Therefore, shareholders may want to have the right to appoint or nominate directors. One way to do this is for shareholders to state in the shareholders’ agreement the power of each shareholder to nominate directors.
In addition, the shareholders’ agreement may wish to have certain important matters (such as dissolving the company, entering into high- value transactions, creating mortgages, etc.) to requiring unanimous consent of the directors. Alternatively, the shareholders’ agreement may stipulate that only shareholders have the right to make these decisions.
A well-drafted shareholders’ agreement can therefore stipulate who can appoint directors and well as what powers directors can exercise.
2. Shareholders’ Agreements and Employment Contracts
It is common in startups that shareholders are also employees of the company and will have an employment contract with the company. These employment contracts may have restrictive covenants, such as clauses requiring an employee to maintain confidentiality and preventing the employee from setting up a competing business nearby or poaching customers.
A shareholders’ agreement can specify that if the employment contract is breached, the breaching employee would have to sell their shares at a reduced price.
3. Share Transfer and Liquidity
Founders of startups often have to work with different parties, such as angel investors and venture capitalists. Over time, some members of the startup may also want to leave and others may want to join in. Therefore, founders of the startup may want to restrict who can be a shareholder of the company. One way to accomplish this is to draft a shareholder’s agreement requiring approval from the directors before shares can be sold to third parties.
At the same time, this may have an impact on the liquidity of the shares: if there are too many restrictions on the sale of shares, it may become difficult to find a third party to purchase the shares. These are some of the ways different shareholder agreements try to overcome this problem.
Pre-emption in share allotment This clause states that if the company decides to issue more shares, shareholders with pre-emption rights have priority to buy shares before they can be offered to the open market. This is to ensure that existing shareholders rights are not diluted.
Right of First Refusal This clause requires a shareholder that wishes to sell his shares to an investor to first offer them to the existing shareholders. If no existing shareholders exercise the right to purchase, the shareholder becomes free to sell his/ her shares to the investor.
Piggyback/ Tag Along Clause This clause states that if a majority shareholder wants to sell his shares to a third party, the minority shareholders can decide to “tag along” with the majority shareholder and sell out to this third party on the same terms and conditions.
Drag Along Clause Sometimes, the majority shareholders want to sell the entire company to a buyer but does not have the consent of minority shareholders. A drag- along clause allows the majority shareholder to force all other shareholders to sell their shares to the buyer.
4. Shareholders Disputes
Funding Disputes A growing business will require access to equity and debt financing. A shareholders’ agreement may specify requirements for shareholders to inject capital by purchasing shares or acting as a guarantor for the company. It may specify consequences if shareholders are unwilling to do so, such as allowing other shareholders the right to purchase the defaulting shareholder’s shares at a reduced price.
Other Shareholders Disputes and Deadlock
Shareholders may not always agree on the running of a business, and the consequences of a shareholder’s dispute can be huge. For example, when the director nominated by the disagreeing shareholders refuse to attend board meetings, the company’s business will risk being put at a halt (a deadlock).
A well-drafted shareholders’ agreement may consider the following mechanisms to address these deadlock situations.
The clause would require shareholders to make genuine efforts to resolve their differences. It may require shareholders to attend mediations or arbitration when disputes arise.
If the dispute cannot be amicably resolved, shareholders may want to sell their shares and exit the company. These clauses would govern the valuation method and the manner of buying-out the shares of the exiting shareholder by an existing shareholder.
As a last resort, parties may consider winding-up and deregistering the company. However, often this will lead to the shareholders receiving very little or nothing at all, as the company will first be required to pay all its debts before shareholders can receive their share. Furthermore, the proceeds of winding-up the company will often be less than selling a running company to a third party.
A properly drafted shareholders’ agreement can often save time, costs and distress. Aside from the resources above, there are plenty of sample shareholders’ agreement online. However, you should note that there is no such thing as a one-size-fits-all shareholders’ agreement. Always consider the above issues and tailor the agreement to the needs of the company and individual shareholders.