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We strongly recommend that if you have two or more shareholders in your company then you have a Shareholders’ Agreement.
We regularly hear clients concerns about the cost versus benefit of entering into a Shareholders’ Agreement, however, our message is the same – prevention is better than cure. Invest in a Shareholders’ Agreement so that you know that many key issues are regulated by mutual agreement instead of trying to negotiate with someone after the relationship has already broken down, or you are just relying on the provisions of the Companies Act 2006.
If there is an irretrievable break down in the relationship between the shareholders and commercial negotiations fail, the only way in which the situation can be resolved is by an application to the Court for the “just and equitable” winding up of the company. In addition to the legal costs, this can be stressful, and potentially commercially costly, plus there is no guarantee that the Court will make an Order unless there is a good reason to do so. In other words, if there isn’t a Shareholders’ Agreement and there is a dispute between the shareholders, the shareholders are likely to incur significant costs and time in dealing with the dispute.
Outside of the legal provisions set out in statute, the articles of association (Articles), or case law, a shareholder does not have the right to be involved in the day-to-day management of the company, be provided with information or dictate the strategic direction of the company. As a result, shareholders may use a Shareholders’ Agreement to supplement their legal rights, for example, by having an information covenant that allows them to receive monthly management accounts or agree a business plan with the directors.
Although the directors manage the day to day running of a company, the shareholders are the owners of the company. In order to give the shareholders more control over certain decisions, and to also ensure that minority shareholders are protected, a mechanism called shareholder consents are often included.
The Companies Act 2006 provides that the most important decisions affecting a company rest with the shareholders, such as amending the Articles (consent of at least 75% of share), changing the company’s name (must be at least 75%), or disapplying shareholder pre-emption rights, to name a few.
These statutory rights can be reinforced in the Shareholders’ Agreement which can further state what decisions require shareholder consent.
Shareholder consent is often a defined term in the Shareholders’ Agreement, and it is often defined as a percentage, say, 100% of shareholders are needed to consent to certain actions. The decision over the percentage of shareholders which are required for consent is often an issue for serious thought as it can give minority shareholders (or a group of minority shareholders) considerable rights above and beyond their rights preserved under the Companies Act 2006.
Common examples of matters which may require shareholder consent include:
amending the Articles;
changing the company’s name;
selling or disposing of a subsidiary or assets;
altering any share rights;
deviating from an agreed business plan;
the company being wound up;
purchasing assets above, say, £10,000;
borrowing or lending any money;
removing a director appointed by a shareholder;
making a substantial change to the business.
Careful consideration needs to be given to the percentage of shareholder’s which are required for shareholder consent.
This is an often overlooked but important consideration. If there are no relevant provisions in the Shareholders Agreement dealing with the death of a shareholder then a number of problems can arise, such as the remaining shareholders suddenly being faced with a new shareholder who inherited the shares but doesn’t know anything about the business.
The ability to control where the shares go in the event of a shareholder dying can be dealt with in the Shareholders’ Agreement by providing that there are :-
pre-emption rights on the transfer of shares - such that the shares are offered to the existing shareholders pro rata first, or to the company which can buy back the shares. Such provisions will usually set out the price and valuation method for such shares.
a cross-option clause - this is a clause under which the company or each shareholder takes out a life insurance policy on their own life, naming the other shareholders (or the company) as the beneficiary in the event of their death. In the event of the death of a shareholder then the life insurance policy will be triggered and the nominated beneficiary will receive funds to enable it to buy the shares from the deceased shareholder’s estate. The purchase price of the shares is normally specified as market value or the value of the funds received under the insurance policy. The cross option allows the beneficiary to force the personal representative of the deceased shareholder to sell the shares to the beneficiary.
Many private company small businesses set up by 2 founders are attracted to the balance of 50:50 ownership. The protections however need to be balanced by the risk of deadlock.
Clauses can be inserted into a Shareholders’ Agreement that outline what happens in the event of a deadlock and this can include a number of stages such as a first step of discussing the issue, but if it isn’t resolved then there could be mediation (not usually legally binding), and if this fails then referral to an expert (which is usually legally binding).
In the event that there is a deadlock which remains unresolved then the Shareholders’ Agreement could provide that shareholder(s) can buy out the other shareholder(s), however, the issue here will be the value at which the shares are purchased plus which shareholder can buy out the other shareholder. This can be a tricky situation and some novel methods are used to resolve this issue including two of the more commonly used ones “Russian roulette” and “Texas shoot-out”.
Russian roulette - this requires one of the parties in deadlock to serve a notice on the other confirming a price that they value their shares in the company. The other shareholders must then decide whether to either buy the shares at the price stated or sell all of their own shares at the same price.
Texas shoot-out - this provision requires each deadlocked shareholder to provide a sealed bid for the other’s shares to an independent party. The shareholder who has the highest bid must buy the other shareholder out at the bid price.
Both provisions aim to enact a change in share ownership as a way of bypassing the deadlock – if one party is bought out, they can no longer hold up the vote and the company can move forward.
It is also possible to insert a deadlock provision that provides a number of options for dealing with these situations, the benefit being that the size of the dispute can have a corresponding solution rather than resorting to buying out the opposing shareholder every time there is an issue.
Risks associated with deadlock can include :-
Cash flow issues - deadlock can hinder the company's ability to access funds, as banks may be reluctant to lend to a company with internal strife.
Missed opportunities - inability to make timely decisions can lead to missed business opportunities and financial losses.
Loss of trust - prolonged disputes can damage the company's reputation with customers, suppliers, and employees.
Difficulty attracting investors - potential investors may be deterred by the uncertainty and instability caused by the deadlock.
Although Shareholders’ Agreements are tailored to each specific shareholding arrangement, there are a number of clauses typically used in most Shareholders’ Agreements:
Voting Matters - as owners of the company, shareholders usually want a say on the larger decisions concerning it. Such decisions are normally made through ordinary or special resolutions, both of which require certain percentages of shareholder approval to pass. A Shareholders' Agreement can determine what percentage of shareholder consent is required to pass a resolution (provided the percentage is greater than any statutory limit):
Issuing, Transferring and Selling Shares - clauses determining the issuing of further shares or the transferring or selling of existing shares will normally be included. It is within these clauses where share valuations and rights such as the statutory right of pre-emption (the right to purchase or refuse new shares before they are offered elsewhere) will be found. These clauses will normally cover the following:
Pre-emption rights: on the transfer of shares the shares are first offered to other shareholders or they can also be offered to the company (which can buy them back);
Permitted Transfers: this might allow a shareholder to transfer their shares to say their spouse or children usually without the consent of the other shareholders;
Compulsory Transfer: a transfer is normally triggered in certain situations, for example death, physical or mental capacity, of a shareholder or a shareholder leaving employment of the company (see good and bad leaver below).
Dividends - there may be a clause setting out the percentage of company profits to be distributed as dividends to shareholders. There could also be a clause detailing when a company does not have to pay dividends at all (the most likely scenario being that it cannot afford the dividends payments at that time);
Directorship/Employee Rights - there can be clauses concerning the right for specific parties to also be directors and/or employees of the company or the right to nominate a specified number of directors;
Company Financing - there may be clauses setting out how the company is to be funded, such that if further investment or financing is required how this will be achieved, i.e. through bank borrowing, investment from shareholders, and whether there can be security over the company’s assets (or any restrictions on giving security);
“Tag Along” and “Drag Along” - in the event of a proposed sale of shares by a shareholder, the Shareholders’ Agreement can require that either the other shareholders (usually minority shareholders) have to sell their shares as well (drag along) or shareholders can insist that the offer from the buyer is extended to their shares as well (tag along);
Non-Compete and Non- Solicitation - it is common to find clauses that restrict the ability of an outgoing shareholder to either set up a competing business and/or to take employees or customers with them when they leave;
Deadlock - where there is a deadlock between shareholders, or shareholders and directors, the Shareholders’ Agreement can provide a mechanism to solve the deadlock (see “Deadlock: What Options are Available to Shareholders?” below). This should be considered in conjunction with the dispute resolution clauses;
Confidentiality - one of the main reasons for using a Shareholders’ Agreement rather than amending the Articles is often to maintain confidentiality of the contents, there is usually a confidentiality clause requiring the parties to maintain the confidentiality of the contents of the agreement, trade secrets and any other confidential information relating to the company;
Shareholder Departure - it is common to find clauses that outline what happens in the event that a shareholder chooses to leave, is forced to leave, or dies. These clauses will also tend to discuss the procedure concerning that departing shareholders’ shares, who can purchase them, and their value; quorum for a shareholders’ meeting, and when and how notice is to be given regarding the calling of a shareholders meeting;
Dispute Resolution - there will usually be a clause determining the procedure to deal with any disputes that arise between shareholders. We suggest that in the first instance the shareholders consider mediation and thereafter disputes could be referred to an expert to issue a legally binding resolution of the disputed matter, in order to try to preserve the confidentiality of the arrangements. These issues should be considered in conjunction with the Deadlock clauses.
This is not an exhaustive list and each Shareholders’ Agreement can be drafted in a bespoke manner to include or exclude whatever the parties wish. As these are private contracts, they will also usually include other standard contractual clauses such as governing law and jurisdiction, third party rights (or lack of), assignment and variation clauses.
Every private company limited by shares is legally required to have Articles which serve as the company’s rulebook. The Articles together with a Shareholders’ Agreement provide the structure for the management of the company. The Articles are a contract between the company, its directors, and the shareholders, and are often the Model Articles (introduced by the Companies Act 2006) or a version of the Model Articles tailored to the specific requirements of the company. A Shareholders’ Agreement is a private contract between the shareholders but usually the company is also a party to it so that it also binds the company and its directors.
Shareholders need to weigh up the pros and cons of using the Articles or a Shareholders Agreement or both in order to regulate arrangements between themselves, and the company.
If there is a Shareholders’ Agreement, then it will normally state that it takes precedence over any conflicting provisions in the Articles. However, a Shareholders’ Agreement cannot provide for lower standards or thresholds than those set out in the Companies Act 2006 i.e. 75% of shareholders’ votes will be needed to amend the Articles.
For advice on Shareholders’ Agreements, or to have one drafted, reviewed or updated, please contact one of our corporate solicitors for further information.
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