Ben and Thomas went to school together. They have known each other for 20 years. They opened a construction company together which now has a turnover of £10 million per annum. They have equal shares in the company. So far so good.
They are now in dispute and at complete loggerheads, the company is suffering as they can’t agree on anything. The employees are leaving because they feel like the ship is sinking, goodwill is diminishing. Ben wants to buy Thomas out but Thomas is refusing because they can’t agree the price of the shares.
What is the problem? They didn’t think it was worth entering into a shareholders agreement when they started the business because they were such good friends and wanted to save costs.
What does a shareholders agreement do?
A shareholders agreement is a private binding contract which provides the foundation for the corporate governance of your company. It outlines what the shareholders of the company can and cannot do. It also sets out each of the shareholders rights and obligations and their roles in running the company. It provides mechanisms for preventing and resolving disputes.
What could a shareholders agreement cover?
- How the company will be funded.
- How responsibilities will be divided between the shareholders and directors.
- A framework for the ownership, structure and management of the business – including a shareholders right to appoint directors, confidentiality, restraints of trade and dividend distribution.
- How the board of directors operate, including how and when it meets and the level of majority to pass a particular resolution.
- What decisions require an ordinary resolution and which require a special resolution.
- The proposed direction the company will go in and how you intend to run it.
- How shareholders may buy or sell shares.
- Restrictions on the transfer of shares.
- Anti-dilution and pre-emptive rights provisions.
- What will happen if the relationship between the parties ends – including a resolution process that provides an agreed framework that can be implemented if issues arise.
- Provisions for unwinding and deadlock – Russian roulette clauses.
- What happens if one of the shareholders dies.
What happens if a shareholder breaches the agreement?
A shareholder can bring a cause of action against another shareholder if they materially breach one of their obligations under the agreement. Here it is important that you take the time to list all the circumstances that you will consider to be a material breach. Examples could include: a shareholder committing fraud, failing to provide agreed capital or failure to comply with the provisions of the agreement.
The agreement can also include a provision that if the material breach is not remedied the shareholder in breach must transfer their shares, have their voting rights suspended or pay compensation to other shareholders.
What happens if you want to dispose of your shares to a third party?
A shareholders agreement should set out provisions relating to the sale of the shares to third parties, these may include that the seller must obtain written consent from the other shareholders or anti-dilution and pre-emptive rights provisions.
What are anti-dilution and pre-emptive rights provisions?
Existing shareholders will want a provision that the company cannot issue new shares which will have the effect of diluting their shareholding and their percentage of ownership of the company. Such a provision could provide that the company must also offer to sell new shares to each of the existing shareholders to ensure that their shareholding carries the same percentage of ownership.
Pre-emptive rights provisions give existing shareholders the right to purchase any shares before they are sold to third parties.
What happens if there are new shareholders either by issuance or purchase?
If the company issues new shares or one of its shareholders transfers its shares to another party then it will need to have the new shareholders enter into a Deed of Adherence in which the new shareholder either assumes all the rights and obligations of shareholders of the same class or assume the rights and obligations of the transferring shareholder. In the second scenario, on execution the transferor will be released from its obligations under the agreement.
If the new shareholder does not agree to enter into the existing shareholders agreement, if for example they are injecting disproportionate amounts of capital into the company, the parties will need to negotiate a new shareholders agreement.
What are drag along and tag along provisions?
Drag along relates to a situation where the majority shareholder wants to sell their shares to a third party. It allows them to force the other minority shareholders to sell their shares at the same time for the same price and terms. This will make the shares far more attractive to a prospective purchaser.
Tag along gives the minority shareholders a right to tag along with the majority shareholders deal and sell their shares at the same price and terms. This is a great tool for the minority shareholders to ensure that their interests are not devalued if the prospective purchaser buys a controlling interest.
What happens if the shareholders no longer want to be in business together or an exit event happens?
The shareholders agreement should include provision for what happens when an exit event occurs, for example, if the companies’ shares are listed or if the company is sold. It will regulate how the price of the shares will then be determined and how one or more of the shareholders can exit the company. It could trigger a pre-determined buy out mechanism or a mechanism for dispute resolution in the event of a disagreement between the parties.
Can a generic shareholders agreement be used?
Of course the provisions outlined above are not the only provisions you can include. Clauses can be drafted to cover nearly any situation you envisage or scenario that concerns you. Shareholders agreements should not be generic and a properly drafted agreement should be customised for your particular business and for the age and standing of the parties.
If Ben and Thomas had covered all of the above points in a shareholders agreement, the company could have continued along on an even keel despite their personal issues. The initial cost of setting up a shareholders agreement is small compared to the costs of a dispute – litigious or otherwise – including loss of good will, employees and the toll that the stress of a dispute takes.