Introductory Guide to Shareholders’ Agreements

October 10 , 2013
October 10 , 2013
October 10 , 2013

Introductory Guide to Shareholders’ Agreements

October 10 , 2013
October 10 , 2013

What is a Shareholders’ Agreement?

We often have clients who tell us that they have started a new business and have been advised by friends / colleagues to enter into a shareholders’ agreement. We are frequently asked why a shareholders’ agreement is needed and the matters covered by the agreement.

To put it simply, a shareholders’ agreement is a private contract that can be entered into by some or all of the shareholders of a company to regulate the affairs between them. It gives rise to contractual obligations between the parties and the usual contractual remedies are available in the event of breach.

The structure and provisions within a shareholders’ agreement can vary depending upon a number of factors, including the nature of the company’s trading activities, its size generally and the number of shareholders. That being said, broadly speaking, there are certain matters which are almost always covered by the shareholders’ agreement and which are often the subject of negotiation between parties. In this blog we will explore 10 common clauses in shareholders’ agreements which will hopefully give you an overview of why the document is needed and areas of contention.

1.    Minority Protection / Reserved Matters

The majority of day to day company decisions are taken by the directors i.e. the officers of the company. However, there are some more important decisions which parties may decide should be only made by the shareholders i.e. the owners of the business.

This is typical in scenarios where the directors are not the same as the shareholders and where there is one or a number of minority shareholders. Given private companies tend to have a small number of shareholders, it is not uncommon for the majority of power (i.e. voting control) to be held by a few individuals. Also, unlike public companies, it is not easy to sell shares in a private company. As such, a dissatisfied minority shareholder is left in a difficult position.

To appease minority shareholders, parties may agree that certain decisions should be “reserved” for shareholder approval and that a higher voting threshold is required (i.e. higher than would be ordinarily required by law). Some of these decisions include:

•    Appointing or removing a director
•    Remuneration for directors or employees over a specified value
•    Bank borrowing above a certain level
•    Capital expenditure over a specified value
•    Buying back shares from a shareholder
•    Issuing further shares

2.    Voting Agreements

A shareholders’ agreement can include clauses which oblige the parties to vote in favour of or against particular resolutions. Examples of the subject matter of voting agreements include:

•    Dividend policy of the company (i.e. the percentage of profits that should be paid out as dividends)
•    The business and activities of the company
•    The rate of growth and expansion of the company
•    Extent of borrowing
•    Terms of employment of the directors and senior staff

The agreement will set out aims and objectives in relation to the specified matters and the shareholders will be contractually bound to vote in compliance with those aims and objectives.

3.    Deadlock

Deadlock clauses determine how conflicts are to be resolved where there is irreconcilable difference between the shareholders. Deadlock is a common situation where there are only two shareholders and each holds 50% of the shares in the company. This is also common in a joint venture scenario.

Approaches that can be taken in the shareholders’ agreement towards deadlock include:

•    Russian roulette: this requires one of the shareholders in the deadlock to serve the other with notice to either buy the other’s shares or offer to sell his own shares to the other party.

•    Texas shoot-out: under this approach each party must make a sealed bid to purchase the other party’s shares, which are then presented to a neutral third. Whoever has placed the higher bid ‘wins’ the right to purchase the other party’s shares.

•    Deterrence approach: this approach requires one party to either buy the other party’s shares at 125% of the market value or sell its own shares to the other party at 75% of the market value.

4.    Transfer and Issue of Shares

Shareholders’ agreements can give the shareholders a right to veto the issue or transfer of shares, specify the percentage of positive votes required for the issue or transfer of shares or provide existing shareholders with the right of first refusal.

The right of first refusal means that existing shareholders must be given the opportunity to buy the shares before they are sold to anyone else. In such a case the shares are usually offered in proportion to the shareholders’ current holdings. The agreement should also set out the procedures for calculating the price of the shares, the length of time the right of first refusal will last and the period within which the shares must be paid for.

5.    Option Events

Shareholders’ agreements often set out events that will trigger the option for shareholders to purchase the holding of another shareholder. Common option events include the bankruptcy, insolvency, death or incapacity of a shareholder. Without such a provision, the shares could end up in the hands of a competitor or a beneficiary who lacks the desired level experience or shared vision of the company.

The agreement must make provision for the shares to remain with the current shareholders of the company but without beneficiaries of the deceased losing out on inheritance from their loved ones. This can be achieved through cross-option agreements and obtaining life assurance policies. Each shareholder will enter into a cross-option agreement to purchase the shares if a trigger event occurs. The shareholders will often each obtain a life assurance policy to the value of his shares in the company which will then be paid out to the remaining shareholders in the event of his death. This ensures that the shareholders will have sufficient funds to pay for the deceased’s shares.

6.    Drag-along

A drag-along right provides a majority shareholder who wishes to sell his shares with the right to force minority shareholders to join the transaction. The rationale behind such a provision is that external investors may only wish to acquire a company if they can purchase all of the shares.

Majority shareholders may feel that it is unfair for them to be denied the opportunity to exit the company because those with small holdings do not wish to sell their shares. The existence of a drag-along right is also attractive to those considering purchasing a majority shareholding in the company, as selling the shares in the future will be easier.

7.    Tag-along

Tag-along rights provide minority shareholders with the right to join a transaction where a majority shareholder seeks to sell his stake in the company. This is to protect minority shareholders from being left with a majority co-shareholder that they do not know or trust.

8.    Protecting the competitive interests of the company

Clauses protecting the competitive interest of the company can be very important, particularly in exclusive and niche business areas. Such clauses can include restrictions on shareholders soliciting employees of the company and being involving in competing businesses. It may also include restrictions on dealings with key suppliers and customers of the company.

Individuals should think carefully about the scope of the business carried on by the company and the extent to which shareholders should be prevented from engaging in competitive activities.

9.    Dispute Resolution

Shareholders’ agreements should contain detailed dispute resolution mechanisms. This ensures that in the event of a dispute, the issue can be resolved swiftly and with minimum disruption to the business.

Although the law provides remedies where shareholders have been prejudiced by the actions of directors, disputes between shareholders are not dealt with in great detail. This is because shares are personal assets belonging to an individual. As such, it is important that provisions are drafted to deal with disputes. To avoid making an application to Court, parties often decide that arbitration or mediation is a sensible approach to dealing with disputes.

10.    Information/Confidentiality

The agreement will usually impose a duty of confidentiality on shareholders as to the shareholders’ agreement and any confidential information held about the company.

Company Commercial Department

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Sean MacEntee


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