Shareholder agreements

A shareholders’ agreement can be an important way of protecting the rights of different shareholders. An agreement can also be a good way to ensure that shareholders agree on key issues, making it easier to avoid – and if necessary resolve – any future disputes.

Who needs a shareholders' agreement

Many start-up and SME companies are governed by a default company constitution, known as the model articles of association (or ‘model articles’). These default company law rules provide that the directors of a company are responsible for day-to-day management of its business, and make most of the decisions. Unless your company’s articles of association say otherwise, only a few matters (such as changes to the company's share capital, or to its articles) have to be referred back to shareholders for a decision.

The shareholders have relatively few, but important rights to intervene, principal amongst which is the right to appoint and remove directors. But the model articles also allow the directors to appoint further directors at their discretion, without consulting the shareholders.

Between the shareholders themselves, company law rules generally provide that the will of the holders of a majority of the voting rights will prevail. A minority shareholder only has limited power to block shareholder decisions.

Shareholders in some companies will want to vary these default rules. Circumstances in which this commonly happens include:

Jointly-owned companies

Companies are often set up by founders on the understanding that they will have a relationship akin to that of partners in a partnership - an equal say in how the company is run and how it develops, equal access to company information, and an equal share in the company's success.

A shareholders' agreement can be used to provide and protect such equality, and also (if desired) to ensure that all founders are required to approve certain key decisions.

Investors with a minority stake

An outside investor, such as a venture capital firm or a business angel, may be prepared to provide working capital to fund growth in your company in return for a minority shareholding. To protect the returns from, and value of, their investment, they will want more than the usual company law protections for minority shareholders.

A shareholders' agreement (which, in this instance, may be called an investment or subscription agreement instead) can be used to vary the usual rules, to protect the outside investor.

Joint venture companies

Two businesses may set up a company to carry on a joint venture - maybe joint research and development, or a pooling of parts of their production, distribution or administration. Each takes half the share capital in the joint venture company, and each has the right to appoint half the board. They usually want to vary the usual company law rules so that neither investor can make any decision at either shareholder or board level without the consent of the other.

A shareholders' agreement can be used to vary the usual rules, to create the required equality, and to ensure there is a mechanism for resolving situations where the joint venture partners are unable to reach agreement on a decision.

Doing without a shareholders' agreement

Shareholders in a start-up or SME might consider a shareholders' agreement unnecessary - they will rely on the closeness of their relationship with their business partners to solve future problems when they arise. Many also find it embarrassing or uncomfortable to discuss contentious 'what if' or worst case scenarios.

But many of the circumstances catered for in a shareholders' agreement - circumstances that happen all the time - will arise when your business relationship has been strained or destroyed. Anticipating them now can save you significant time and money if they occur.

Without such an agreement in place, you may face disagreements between your shareholders on matters such as:

• when your board should get shareholders’ approval
• whether any important decisions, such as issuing more shares which dilute the power of existing shareholders or purchasing another business, need consent from all or nearly all shareholders
• if any shareholder can transfer their shares as they think fit without first offering them to the other shareholders
• when your business is sold and how you go about this

Your discussions can also highlight areas where your expectations are not as similar to your partners' as you thought. With your legal advisers helping to smooth negotiations, and making sure issues are raised and dealt with constructively, a shareholders' agreement can be a worthwhile investment now, as well as valuable insurance for the future.

What a shareholders' agreement covers

Positive obligations

Some clauses in a shareholders' agreement operate as voting agreements - the parties bind themselves to exercise their votes as shareholders to put into effect their agreed intentions as to how the business will be funded, run and developed. For example, a shareholders' agreement could include provisions regarding:

• the activities the company will carry on, and its intended rate of growth
• the intended exit route and the timescale for achieving it
• the company's dividend policy (ie the proportion of profits to be paid out as dividend and the proportion to be retained to fund the business)
• the composition of the board of directors and senior management team, and their remuneration and other terms of employment
• levels of borrowing
• future funding (eg how much will be needed, the form it will take, how much each of the parties will put in, whether third parties will be allowed in and on what terms)

Rights of veto

Other parts of the agreement often provide that important decisions, whether or not they would ordinarily be taken by the directors or the shareholders, cannot be made unless all shareholders agree to them - so minority shareholders can veto them. Equally, a shareholders’ agreement might also set out that the approval of a specified shareholder or shareholders (often the founders) is required for certain key decisions. The agreement will specify which decisions require such additional approval. Typically, these could include decisions to:

• issue further share capital
• change the company's articles of association
• buy or sell a business, or any asset of more than a certain value
• buy or sell a significant stake in another company
• acquire or dispose of any premises
• appoint or remove a director
• award directors or employees more than a certain level of remuneration, and/or dismiss a director or employee earning more than that remuneration
• borrow above a certain level, or grant security over the company's assets
• incur capital or hire purchase commitments above a certain level
• take out or vary insurance other than for full replacement value
• buy any of the company's shares back from a shareholder
• take action to sell the company
• take action to wind the company up
• prevent favourable contracts or arrangements between the company and its directors or shareholders other than on agreed terms

Issue and transfer of shares

A shareholders' agreement will often make specific provision for the procedure on issue and transfer of shares.

On issue of shares, these provisions must balance the need for the company to be able to issue shares to raise further funds against the danger of a shareholder finding their shareholding has been diluted by an issue to other shareholders.

On a proposed transfer of shares, they must balance the value to shareholders of having a market for their shares if they want to sell them (or if they die and their estate wants to sell them), against the danger of other shareholders building up a larger shareholding than they previously held, or new, 'undesirable' shareholders being admitted.

Options include:

• allowing minority shareholders a complete veto over any issue or transfer of shares
• requiring the company (on an issue) and the owners of the shares (on a transfer) to offer the shares to existing shareholders, pro rata their holdings, before they can be issued or transferred to anyone else, or in any other proportions

If a pro-rata offer must be made, the agreement might also provide a means of valuing the shares - by reference to an expert or arbitrator, or according to some formula in the agreement.

A shareholders’ agreement might also give majority shareholders the right to require minority shareholders to transfer their shares in order to facilitate the sale of the company to a potential buyer (a so-called ‘drag-along’ right).

Rights to appoint directors

Shareholder agreements to protect outside investors may provide that they can appoint a director to the board of your company, to protect their interests. A venture capitalist, for example, may appoint a non-executive director, who takes little part in day-to-day management unless the company is not providing the promised return. A business angel may insist on being appointed to the board in person, and may play an active (and valuable) part.

Equally, you might want to ensure that any board appointment requires the approval of specific shareholders (such as founders), or a specified majority of shareholders.

Dispute resolution

Agreements may contain a mechanism for resolving disputes, such as referral to a third party expert or arbitrator, or a buy-out mechanism whereby one side buys out the shares of the other at a price determined in accordance with the agreement. It can even provide that in the event of an unresolved dispute, the parties agree to vote to wind the company up.

The issue of which party buys out the other, and at what price, can be extremely difficult to negotiate. Agreements can become quite complex. One solution is to say that a shareholder can offer their shares to the others at a price of their choosing:

• if the other shareholders accept, they pay the price that has been set
• if the other side does not accept the offer, they become obliged to sell their shares to the original seller, who is obliged to buy them, at that price. The original seller will not want to set too high a price for their shares, because they may end up having to buy the other party's shares at that price

A mechanism like this stops the seller from setting an unrealistic price, because they may end up having to buy the other party's shares at that price.

Shareholders' agreements, articles of association and other documents

Provisions in a shareholders' agreement could, in many cases, be included in the company's articles of association instead. The key difference between the two is that, if properly drafted, a shareholders' agreement is a confidential document. The articles of association are a public document, available at Companies House for all to see.

There are also technical differences between the two that mean that, very broadly:

• a shareholders' agreement is generally more appropriate if the arrangements you want to set up are personal to individuals involved with the company (or some of them) now

• articles might be more appropriate if you want the arrangements to automatically apply to all shareholders generally, whether current or future

You should remember that your shareholders’ agreement will only apply to those people who are signed-up to it. In particular, future shareholders will only be bound if they sign-up to the terms.

There may be overlap between a shareholders' agreement and, for example, the company's articles of association or service contracts with directors and other staff. For example, a shareholders' agreement and articles of association may both include provisions governing transfers of shares. Service contracts and shareholders' agreements may both contain restrictive covenants prohibiting directors and employees from working for competitors, or disclosing confidential information.

If you are unsure, further legal advice can help you to choose the best place for each provision, and ensure there are no inconsistencies between the various documents. 

Legal advice can also help you to identify whether or not the rights exercisable by the minority shareholder or outside investor might mean they are a Person with Significant Control (PSC). If they are, their particulars must be entered in the company's public PSC register.

Timescales and costs

If you are using your own lawyer to draft the agreement, it can usually be drafted in a few days. However, if there are issues that need to be negotiated, this will affect the length of time that the agreement will take to draft.

The costs for advising on and drafting a shareholders' agreement will vary depending on the complexity of the issues involved and the length of negotiations.

Finally, remember it is important that you always fully understand all the provisions in your shareholders’ agreement and, if in doubt, take legal advice.