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What is a Shareholders Agreement?

Shareholders agreement

A shareholders agreement is a legally binding contract between a company’s shareholders that sets out their rights and obligations within the partnership. This document governs the internal operations and shareholding relationships within a privately held corporation to align key issues upfront.

It is recommended that all companies formed via a partnership, that have founders, investors and owners, operate within the terms of a shareholders agreement. It aims to set out means of navigating points of conflicts, disputes or change proactively and consistently.

Read on for more information on a shareholders agreement including the pros and cons, and some simple tips for creating an effective contract for your business.

What Does a Shareholders Agreement Entail?

A shareholders agreement details the rights, responsibilities and duties of a company’s shareholders and directors. It records internal procedures governing operations that shareholders commit to abide by through contractual consent when signing the document.

These agreements play a supplementary role to a company’s articles of association or incorporation by clarifying processes between owners. Articles focus on external formalities like company purpose, asset distribution, amendments to authorised capital, director liability and decision thresholds legally requiring certain voting margins.

In contrast, shareholders’ agreements concentrate on internal relationships between actual owners and management personnel in areas the articles leave flexibility around based on “subject to a shareholders agreement” provisions.

For most small private companies, partners simply rely on standard model articles as their constitution rather than undergoing tailor-made changes, hence necessitating an additional pact spelling out unaddressed issues affecting them personally in the articles.

Common elements covered by a shareholder agreement include:

Ownership & Control

  • Share transfers – rights of first refusal, permitted buyers, transfers triggering provisions
  • New share issues diluting ownership – pre-emptive provisions, anti-dilution mechanisms, mandatory offers to existing owners first
  • Voting procedures and rights attached to different shared class structures
  • Director appointment processes – board composition and size, independent director quotas
  • Management roles – separation of Chairman and CEO
  • Deadlock-breaking mechanisms

Rules Governing Operations

  • Dividend policies – distribution thresholds, pay-out ratios
  • Salaries and benefits – caps, reviews, exceptions or adjustments
  • Related party transactions oversight restricting conflicts of interest
  • Financial reporting requirements – audits, information access

Investor Exit Strategies

  • Triggers initiating stake sales like poor performance or misconduct
  • Vesting schedules for share-based employee incentive schemes
  • Pathways for buyback, drag along rights, tag along rights, liquidation preference stacks

Dispute Resolution

  • Mediation and arbitration clauses
  • Option for “shotgun buyout” mechanism – one shareholder names a sale price for the company, and the other can decide to buy them out at that price or sell their stake instead at the named valuation

So in summary, shareholders agreements establish the rules and procedures for navigating a whole host of complex situations that can impact company owners during the lifecycle of the business and the tenure of the owners and investors within it.

From start-up to exit, the goal of the agreement is to align incentives between founders, management, employees and investors early on before complicated situations may arise. It forms a key part of corporate governance, establishing best practices, and checks.

What are the Key Purposes of a Shareholder’s Agreement?

The main objective served by a shareholders agreement is to provide structure to the management of rules and procedures that will likely impact shareholders during their tenure with the company. This includes:

1. Setting Shareholder Expectations

Openly setting out the expectations between owners early on in the working relationship to minimise conflicts further down the line when the business starts to grow. It designates the rules that govern operations, transfers, and dividends. This helps to ensure that everyone involved is on the same page from the start.

2. Clarifying Ownership Rights

Transparent ownership terms assist businesses in securing external investment. A shareholders agreement will include a valuable roadmap as to how external investment is managed which can give new investors to the business a sense of security that there is an established process in place.

3. Restricting Share Transfers

Rules around changes in ownership act as insurance policies around retaining control or monitoring the type of buyer that can purchase shares in the business. Clauses such as the rights of first refusal, vetting, and approvals on external share transfers can avoid partnership conflicts.

4. Pre-Emptive Rights on New Shares

Anti-dilution provisions require new share offerings to be offered in the first insurance to existing investors in proportion to their current share percentage. This helps to avoid business ownership being diluted by external parties or for new investors to take majority control when this isn’t wanted.

  1. Management Accountability

A shareholder agreement offers accountability for management teams. By detailing reporting requirements, sharing management and participation status for the duration of their ownership tenure, they can ensure that they deliver against the agreed objectives set.

In summary, shareholders agreements provide stability to founders and shareholders throughout a private company’s lifecycle. This document can offer security for majority owners while reassuring minority investors by establishing a shared vision and repeatable decision-making processes in the form of a guidebook to reference during complicated company milestones such as new investments or acquisitions.

What Gets Covered in A Shareholders Agreement?

While shareholder agreements differ based on specific company requirements and investor negotiating leverage, several themes would feature in most:

Corporate Governance

  • Board composition – quota of founder, investor and independent directors
  • Designating key consent rights needing majority or unanimous approval thresholds beyond ordinary resolutions
  • Shareholder reservation of rights – vetoing significant decisions like major contracts, expenditures, related party pay, appointment/removal of key employees

Ownership Terms

  • Structure – separate classes carrying different rights like liquidation preference stacks, dividend entitlements, voting power
  • Permitted transfer restrictions – rights of first refusal, deemed offer provisions, mandatory escrow periods, permitted transferees
  • New issue criteria – pre-emptive rights, anti-dilution protections, valuation methodologies

Exit Provisions

  • Vesting schedules for share-based employee incentives if applicable
  • Pathways facilitating exit – drag along rights, tag along rights, liquidation preferences, redemption rights

Financial Policies

  • Accounting standards adherence
  • Auditor selection criteria
  • Transparency commitments like the annual state of the company report to shareholders
  • Oversight on contracts beyond certain threshold by value

Dispute Resolution

  • Internal escalation procedures via boards before external mediation
  • Clear arbitration guidelines

General Terms

  • Confidentiality around proprietary company information
  • Opt out or opt-in for individual sections rather than wholesale acceptance
  • Rules amending provisions – voting margins, adherence to amendments by incoming shareholders

What are the Pros and Cons of a Shareholder’s Agreement?

Advantages of Shareholders Agreements

Align Incentives Between Stakeholders

By preventing unregulated actions or input, a shareholder ensures that established procedures are followed at key business milestones.

Clarify Control Arrangements Upfront

Avoids struggles down the line once external investors come on board by clearly defining the rights attached to founder vs outside share categories early on in the business administration process.

Smooth Leadership Transitions

Succession planning is a key area that is set out to help ensure that when one shareholder leaves, this is done in a controlled manner that doesn’t leave the business in a difficult position.

Attract Investment

Shareholder agreements demonstrate that the business is committed to good governance and minimising investor risk. This transparency helps to build confidence for external investors.

Establish Ground Rules

The document functions as a rulebook for dispute resolution on issues like independent valuations for share transactions. This can help to prevent long, drawn-out conflicts and arguments.

Flexibility To Update Easily

Shareholder agreements may need to be updated to reflect the changing needs of the business. Clauses that permit this can be added to allow for the refinement of the original agreement.

Drawbacks of Shareholders Agreements

Difficult To Negotiate Initially

When multiple parties are involved in business ownership, it can be difficult to manage the expectations of everyone. This means that it can initially be a difficult document to negotiate to start with, but the security the agreement affords is worth the initial difficult conversations.

Risk of Rigidity

Excessively strict clauses could impair the business’s ability to respond in an agile way to upcoming market opportunities. It’s important therefore to strike the right balance between control and freedom.

Silent Partners Can Feel Sidelined

Strict board control quotas could disenfranchise passive investors who are focused solely on returns rather than active involvement.

Administration burdens 

Rigorous meeting and reporting procedures can become burdensome with increased shareholders down the line.

False Sense of Security

Despite extensive legislation, shareholder contracts can only go so far in conflict resolution. Business owners will still need to be able to work together day-to-day for the benefit of the business which may mean personal differences need to be put aside.

While shareholder agreements have some potential drawbacks like difficult initial negotiations and administrative burdens, their advantages often outweigh these concerns. By establishing ground rules and clarifying control arrangements upfront, shareholder agreements help align stakeholder incentives, attract investment, enable smooth leadership transitions, and provide a framework for updating policies as the business evolves.

Though not a cure-all, thoughtful shareholder agreements create transparency and processes to resolve disputes, supporting good governance and shareholder confidence. Ultimately, the security and stability a well-crafted shareholder agreement affords make it an important tool for businesses with multiple owners.

Who Should Be Involved in Formulating a Shareholders Agreement?

The people that need to be involved in the creation of a shareholders agreement are; founders & major shareholders, legal representatives, accountants, external investors and key employees.

The ideal scenario when forming this document is to get buy-in and input from all affected parties from the start. Doing this ensures that each party’s interests are considered whilst remaining legally compliant.

The founders and major shareholders should lead the process and negotiations that are held. Ultimately, it’s their vision for the company that shapes the need for wider investment and shareholders.

High-level managers and board directors should ensure the agreement allows for company government and succession planning. Corporate lawyers are essential in the process to ensure that terms are clear, cover the rights and responsibilities of shareholders, and are legally binding.

If any external investors hold a stake in the business at the time of the agreement being drawn up, they should also be consulted. Similarly, if employees have stock options and incentives, they may also need to be involved.

Tips To Create An Effective Shareholders Agreement

Not all shareholder agreements are equal. To get the most effective version, business leaders should:

Involve Experts Early

Seek legal counsel’s guidance on the framework and key considerations before starting discussions. An independent lens helps prevent overlooking crucial principles and diffuses tension.

Build in Flexibility

Avoid overly prescriptive clauses dictating decision thresholds that could inhibit governance as the company evolves. Reasonable flexibility facilitates smooth adaptation over time.

Map Clear Exit Strategies

Outline orderly provisions guiding dissolution or share transfer scenarios for all shareholders. Whether due to performance, retirement or misconduct – clear transitions enable stability.

Address Disputes Upfront

Tackle thorny issues like independent valuations and share transfer payments early. Instituting mediation guidelines creates important backstops before relationships fray.

Review and Refine Regularly

Incorporate periodic reviews into the agreement to confirm continued relevance amid operational growth and market shifts that alter equations between shareholders.

The most sustainable shareholder agreements balance the comprehensive coverage of potential issues that can arise, with adaptability for unforeseeable future developments. They are living documents that are open to continuous refinement to ensure that they reflect the changing business vision and direction.

Key Takeaways On Shareholder Agreements

  • Shareholders agreements govern internal company operations between founders, management and shareholders.
  • They codify rights, terms of participation, and rules on issues directly affecting owners like leadership decisions.
  • Agreements outline equitable processes to facilitate smooth investor entry and eventual exits.
  • They identify classes of shares with different privileges to establish fair authority distribution.
  • Shareholders’ agreements are secondary to articles of incorporation, which cover external company purposes and dissolution.
  • They are recommended for private companies as extra protection beyond articles alone.
  • Flexibility is crucial to maintain fairness amid evolving dynamics between shareholders over growth phases.

In summary, carefully constructed shareholder agreements are prudent insurance policies that help to mitigate foreseeable friction between startup owners. They are not fool-proof though, and just like any insurance policy, prevention is always better than cure. With this in mind, be sure to build business partnerships on strong relationships and communication channels, not just contractual requirements.

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