What is a shareholder’s agreement and why do you need one?
You have started a company with someone you know and trust. You agree on the business plan. You agree on who will do what. So, do you need a shareholder’s agreement? The answer is yes!
Not because we expect the relationship to fail, but because businesses change. People change. Money gets tight. New opportunities arise. Life happens. One shareholder may want or need to leave, while another wants to keep going.
A well drafted Shareholders Agreement sets out what is to happen in these situations and assists in negating or minimising disputes.
What is a shareholder’s agreement?
A shareholder’s agreement is an agreement between shareholders of a company that details how the shareholders will deal with different situations and how certain aspects of the company will be governed, including dispute resolution.
It can address matters that are not covered, or are not covered in enough detail, by the Corporations Act 2001 (Cth) (the Act), the replaceable rules or the company’s constitution.
A shareholder’s agreement is not compulsory under the Act. However, that does not mean it is unnecessary. The value is in replacing disputes with agreed rules before a problem arises which is unquantifiable.
Is a shareholder’s agreement the same as a company constitution?
No. They can overlap, but they do different things.
The Act contains mandatory rules and a set of replaceable rules for company governance.
A constitution governs the company’s internal management and has statutory contractual effect between the company, its members and its officers under the Act.
A shareholder’s agreement is a separate contract between the people and/or the entities who sign it.
The above documents should be prepared to work together. If the constitution and shareholders agreement point in different directions, uncertainty and disputes can follow. Usually the constitution will prevail.
It is important to note that a shareholder’s agreement cannot contract out of the law or excuse directors from their legal duties.
Why is a Shareholders Agreement needed?
When a company has more than one shareholder, the real question is not whether disagreement is possible. It is what will happen when the shareholders disagree, want different things or can no longer work together. Here are some things to consider when deciding if and why you need a shareholder’s agreement:
1. Having a Shareholder’s Agreement makes the decision making clear
Who controls the day-to-day business? What decisions can directors make? What major decisions need shareholder approval? Does approval require a simple majority, a special majority or unanimous consent?
The agreement can address reserved matters such as substantial debt, issuing new shares, changing the business, selling major assets, entering related party transactions or declaring dividends, purchasing property and borrowing money.
The clarity provided by the agreement helps prevent one person from making a decision that may not benefit all.
2. A Shareholder’s agreement protects both majority and minority shareholders
A majority shareholder may expect to control most decisions. A minority shareholder may want protection against being ignored or locked into a company with no practical exit.
The agreement can balance those interests through information rights, reserved matters, pre-emptive rights, broad representation, consent thresholds and protection around new share issues.
Although the Act provides remedies for oppressive or unfairly prejudicial conduct, Court proceedings are rarely the outcome a businessowner wants. Agreed protections can reduce the chance of a dispute reaching litigation at Court and costly litigation.
3. A Shareholder’s Agreement can control who can become a shareholder
Without an agreed transfer process, a shareholder can sell their shares to whomever they choose. This could become problematic. Say for example, the company runs a business. Do the shareholders want someone as a shareholder who has no idea how that business is to run, or the intricacies of it? That has the potential to destroy the business.
A shareholder’s agreement can include:
a) Pre-emptive rights or a right of first refusal for the other shareholders;
b) The right for remaining shareholders to approve new shareholders;
c) Restrictions on transfers for competitors or unsuitable buyers;
d) Tag along rights protecting minority shareholders if the majority sells; and
e) Drag along rights allowing an approved sale of the whole company to proceed.
Transfer clauses need careful drafting and should align with the constitution and the terms of issue of the shares.
4. A Shareholder’s agreement provides an exit plan
What happens if a shareholder wants to retire, stop working in the business, becomes seriously ill, dies, is made bankrupt or breaches the agreement?
The agreement can create buy-out processes, identify triggering events and set a valuation method. It can also distinguish between a shareholder who leaves in agreed circumstances and one who leaves after serious misconduct or breach.
Without workable and practical exit mechanisms, shareholders can remain financially and legally connected long after the working relationship has ended and often in costly dispute.
5. Shareholder Agreements deal with deadlocks before the company freezes
A 50/50 company can reach a point where neither side has enough votes to move forward. Even companies with different ownership percentages can deadlock where important decisions require unanimous approval.
A deadlock clause might require negotiation, mediation, referral to an independent adviser, a buy-sell processes or, as a last resort, a sale or winding up process.
The right mechanism depends on the shareholders, their finances and the type of business and what the shareholders seek to achieve with the shareholders agreement.
6. Shareholder Agreements set expectations about funding and returns
Will the business be funded by share capital, shareholder loans, external borrowing or a combination? Must shareholders contribute more money when requested? What happens if one can contribute and another cannot? What gets paid first, dividends or shareholder loans?
The agreement can establish a funding process and the consequences of not participating. It can also record the shareholders approach to reinvesting profits, paying dividends and repaying shareholder loans, subject to the Act and Directors Duties.
7. Shareholder Agreements protect business information and value
Shareholders may have access to confidential information, customer relationships, pricing, strategy and intellectual; property.
A shareholder’s agreement may include confidentiality, non-solicitation and carefully drafted restraint provisions. It should also identify who owns existing and future intellectual property. In this manner, a shareholder cannot leave and compete against the company.
It is important to note however, that it is not a substitute for appropriate employment, contractor, intellectual property assignment or confidentiality documents. These agreements should be checked as part of the same legal structure.
What clauses are usually included in a Shareholder Agreement?
No two companies are identical, but a shareholder’s agreement commonly deals with:
The company’s purpose, business plan and governance structure.
Appointment, removal and powers of directors.
Which shareholders will hold which roles in the business and how their salaries will be set.
Board and shareholder meetings, voting and reserved matters.
Access to financial information and reporting.
Funding including shareholder loans and when they are repaid.
New share issues.
Dividend policy or principles for distributing profits.
Restrictions and procedures for transferring shares.
Tag along and drag-along rights.
Death, disability, insolvency, retirement and other exit events.
Valuation and payment terms for share buyout.
Deadlock and dispute resolution procedures.
Confidentiality, intellectual property and restraints.
Breach, termination and how new shareholders become bond
When transactions require a unanimous resolution.
The above is just a starting point. The drafting must reflect how the business actually operates and what its objective is.
When should Shareholder agreements be prepared?
Ideally, a shareholder agreement should be put in place before the company begins trading. At this stage, shareholders are most aligned in their expectations and objectives, and there are usually fewer entrenched positions or potential areas of dispute. So, discussing issues that may potentially become contentious is done with a rational mind.
That said, it is never too late to put a shareholder agreement in place. If your company is already operating without one, we still strongly recommend adopting one.
Likewise, if you already have a shareholder agreement, it is worth reviewing whether it remains fit for purpose as your business evolves. You should consider putting in place or updating a shareholder agreement if:
A founder, investor or employee shareholder is joining;
The ownership percentages or share holdings are changing;
The business is raising capital or taking on substantial debt;
A shareholders role in the business is changing;
The company is growing beyond informal decision making;
Do I need a shareholders agreement in place?
For a company with two or more shareholders, a properly prepared agreement is invaluable. As discussed above, it could save thousands of dollars if shareholders do fall into dispute down the track. It gives the shareholders a structure for decisions, funding, transfers, and managing disputes. It protects relationships by reducing the number of important questions being left to memory or assumptions. The objectives of the company are documented and can be revisited even years later. Furthermore, if a disagreement does occur, it provides a starting point for resolving it without immediately turning to litigation.
Do you need a shareholder agreement? Wollerman Shacklock provide are your trusted Melbourne Business Lawyers who will review your ownership structure, identify the issues that matter to your business and prepare a Shareholder’s Agreement that works with your company constitution and other key documents. Contact us on (03) 9707 1155 or admin@wslegal.com.au to arrange your shareholders agreement.