30 Jan 2023
23 Jul 2020
A company is the most common form to run a business. A corporate structure offers huge advantages, such as identity, limited liability, more opportunities for financing, continuity in the event of transfers, the flexibility of share rights, established laws, etc. If you are running a business with other partners through a company, a Shareholder's Agreement is crucial to avoid any misunderstanding and ambiguities.
A Shareholders Agreement is an agreement between the shareholders of a company:
A Shareholder Agreement normally includes terms addressing key management issues beyond those provided by statute and corporate law. However, these agreement terms are not intended to govern the day-to-day operations of the shareholders’ business.
Dispute between shareholders is one of the most common causes of business failures. According to a report of the Law Commission, litigation costs could exceed by as much as 10 times the amount under dispute by the shareholders. In a company limited by shares, preparing a Shareholders Agreement is the best way to avoid disputes by stating clearly the rights and obligations of the shareholders.
A shareholders agreement is especially important for minority shareholders since the protections of minority interests under the constitutions, articles of association and bye-laws of the company are rather limited. Nor would it be safe to simply rely on the common law action of oppression against the minority to enforce your shareholder's rights against the majority shareholder.
The Shareholders Agreement is the best form of legal protection for a minority shareholder. By incorporating certain express contractual provisions in the Shareholders Agreement, the minority shareholder can be protected by contractual rights beyond those afforded by statute and corporate law.
A well-drafted Shareholders Agreement should include
Here are some questions you should have in mind when drafting a Shareholders Agreement:
Ownership generally corresponds to voting rights, but there can be exceptions. So, the first thing you should consider is whether you would like shareholders to hold equal shares in the company.
The main advantage of holding equal shares is the balance of power between shareholders. However, having equal shares between an even number of shareholders can create a 50:50 deadlock company. Therefore, some prefer having a Majority Shareholder and a Minority Shareholder.
As mentioned previously, having a shareholders agreement is in particular important to protect the interest of minority shareholders. It allows the minority shareholder to take a more active role in participating in the management of the company and be involved in any major decisions (through board representation if possible).
Right of first refusal and restrictions on new shares can also be included in the shareholders' agreement to protect the minority against its share from being improperly diluted. Having a right to inspection of the accounts and a clear dividend policy would give the minority access to finances and a fair and proper distribution of profits. In case of any exit from the company, the minority shareholder can be protected through tag-along and drag-along rights.
In a Shareholders Agreement, it is crucial to establish the legal obligations of the shareholders in respect of capital contributions, both at the outset and in the future.
Here are some questions that you may want to consider:
Funds can be raised by debt (borrowing money) or equity (selling interests in the company, sometimes through Shareholders' Loans). By opting for debt, beware of the debt repayment ratio. By selling shares to Shareholders, initial capital can be provided in cash or non-cash assets. One shareholder might be holding a key technology, intellectual property or license that is crucial to the development of the company.
Hence, please make it clear that it will be contributed to the company under the Shareholders Agreement. If you would like to restrict the form of capital contributions from Shareholders, make sure that you incorporate that in the Shareholders Agreement.
A Shareholders Agreement can oblige Shareholders to contribute further capital. You may want to set a maximum amount of contribution and/or a limited contribution in defined tranches. In case you come to a consensus that Shareholders have no responsibility to contribute further capital, you want to express the absence of a legal obligation to commit future finance in the Shareholders Agreement.
In the Shareholders Agreement, you may also oblige Shareholders’ provision of guarantees or counter-indemnities to support finance raised by the Company. Usually, a guarantee is given by a Shareholder’s parent to the other Shareholders.
A Shareholders Agreement should provide for the procedures and the authority for new issues of shares to shareholders. Shares are usually issued by mutual agreement or by a majority decision of the Board of Directors/Shareholders on a pro-rata basis. This will protect minority shareholders from being diluted by the majority.
Many start-up ventures now seek funding in part from venture capital or similar equity provider. Such finance providers commonly prefer negotiation of exit routes to ensure an ability to sell their investment at a profit within a relatively short period of time. Such routes may include:
A put option;
A redemption or buyback of shares;
A right to initiate a trade sale or public offering;
Rights of "drag along" or "tag-along"
Techniques may also be used to incentivise management or founders of the Joint Venture Company.
Management structure and corporate governance rights are closely related to the Shareholders’ equity ownership most of the time. These rights and obligations are commonly addressed in the Shareholders Agreement, including:
The rights to appoint the Directors;
The right to appoint the Executive Management Team;
The authority of individual managers (e.g. the Chief Executive Officer (CEO));
The authority of the Board of Directors;
The scope of matters considered as "reserved matters" for decision by the Shareholders themselves
The requirement of a "super-majority" vote for particular decisions at the Shareholders level or Board of Directors level, including matters relating to
Changes in the Articles of Association in a Joint Venture Company;
Issues of share capital (including the grant of share options);
Significant changes in the nature of the business of the Joint Venture Company;
Major acquisitions or disposals;
Capital expenditure or contract commitments in excess of pre-agreed limits;
Material dealings with intellectual property;
Dealings between the Joint Venture Company and its Shareholders (except arms' length dealings in the ordinary course of business)
If a minority interest is involved, such a participant will wish to protect its interests in several areas. In a Shareholders Agreement, you may incorporate provisions for Minority Shareholders in order:
To ensure their participation in management through Board representation;
To ensure their involvement in major decisions (including, possibly, a right of veto);
To protect them against its equity stake being improperly diluted;
To ensure proper distribution of profits among Shareholders;
To establish adequate access to information regarding Company affairs;
To establish "exit" routes (including, possibly, put option rights or "tag-along" rights).
The interests of the Minority Shareholders will, of course, need to be reconciled with those of the Majority Shareholders. The latter will often have different objectives such as:
To control management appointments
To minimise minority veto rights;
To establish "drag along" or other rights to enable it to deliver a sale of the Company as a whole to a third party.
A balance between the interests of Shareholders is difficult to be struck. But it has to be struck.
Oftentimes, joint venture companies are formed between actual or potential competitors. Establishing clearly the scope of non-compete constraints hence becomes vital. You should state the following in detail in the Shareholders Agreement:
The scope (territory or field) of restriction;
The exceptions, if any (E.g. the freedom to make acquisitions of businesses not significantly in the competing field, possibly subject to offering the competing business to the company)
Including such a non-compete clause will prevent a shareholder from stealing business from the company at the expense of other shareholders.
The Shareholders should have a common understanding of the distribution policy to be adopted by the Company. Particularly, if a Shareholder is a Minority Shareholder, it will have little control subsequently and future dividend policy can cause considerable friction. Should there be a requirement to distribute a minimum proportion of distributable profits? By clearly stating the shareholders' understanding in a Shareholders Agreement, it will ensure a fair and proper distribution of excess capital to the shareholders of the company.
Shareholders are often reluctant to discuss the possibility of its break-up or termination at the start of their Company. A well-prepared Shareholders Agreement should, nevertheless, provide for that possibility.
Basic exit or termination scenarios include:
Unilateral Exit or Termination (The wish of one party to terminate and/or exit by notice)
This will usually involve a right to sell to a third party purchaser subject to a right of pre-emption in favour of the continuing Shareholder(s). Sometimes, it will not be feasible to permit transfer without the consent of the other Shareholder(s) (this simple formula at least reduces the length of the agreement!). The question then is whether a party should have a right to compel liquidation in certain circumstances.
Termination for a Cause or as a result of a "Trigger Event"
If the parties agree that a particular event should trigger the right of another party to institute a call option or other termination procedure, the "trigger event" needs to be carefully defined, for example:
Insolvency of a Shareholder;
Change of control: Inclusion of a change of control provision can be material and contentious, particularly if the company comprises a significant part of a party's business;
Material breach: This is often more relevant for a venture where funding commitments are significant;
Sometimes the parties will agree at the outset that one party will have a right, at a specified time and usually at a specified price or a third-party valuation, to "put" its shares or to “call” for the other Shareholders’ shares.
“Putting one’s shares” means requiring the other Shareholder(s) to buy that Shareholder's shares. "Calling for shares” means acquiring other Shareholder(s)' shares in the Joint Venture Company. A Shareholders Agreement gives rise to such rights while a Put and Call Option Agreement executes the rights.
It is common for companies to include contractual clauses so that Shareholders can get a pre-emption right before a proposed transfer of shares to a third party. To do so, you may want to consider the following in the Shareholders Agreement:
The price may be set by reference to
A price which an identified third party purchaser is prepared to pay (the continuing Shareholder having a right to match that price - a right of first refusal);
A price proposed by the transferor before it finds a third party purchaser (the continuing Shareholder having a right of the first offer at that price);
A price determined by a third-party valuer (Do establish the valuation criteria to be applied - including whether or not a discount/premium is to apply to reflect the size of the shareholding being sold);
If a Majority Shareholder wishes to sell, should it be entitled to "drag along" the Minority Shareholder (i.e. require him/her to sell his/her shares at the same price per share as that offered by the third party) so that it can deliver the whole Joint Venture Company to the third party?
Should the Minority Shareholder have the right to "tag-along" or "piggyback" by requiring that a third party purchaser must extend to the Minority Shareholder the same offer price per share as it is offering to the Majority Shareholder?
The company carry with them an inherent possibility of management deadlock. Schools of thought differ as to the desirability of formal deadlock resolution mechanisms. Some prefer the certainty of outcome, leading to mechanisms such as voting.
A common formula is for any deadlock/dispute to be escalated to the Chairmen/Chief Executives of the Company participants - or, perhaps, to be referred to an intermediate panel of experts - or, sometimes, to be subject to a formal mediation procedure.
If there is a prolonged and fundamental dispute, consider whether the Shareholders wish to include a specific `divorce' mechanism such as a right to terminate and initiate liquidation; or to commence a "shoot-out" procedure (e.g. a "Russian roulette" or "Texas shoot-out" procedure) between the Shareholders as a result of which one will buy out the other:
"Russian roulette" procedure is basically one which allows one Shareholder to offer to buy out the shares of the other Shareholder at a certain price - but with the other Shareholder having the right to decide either to accept and sell its shares or, instead, to buy out the first Shareholder's shares at the same price;
"Texas shoot-out" (at least in some variants) is where both Shareholders wish to buy and a sealed bid procedure takes place to determine who is the higher bidder.
These mechanisms can be contentious. Their most significant advantage is that the uncertain outcome may act as an incentive to persuade the parties to reach a commercial solution before they are implemented.
Another school of thought dislikes such formal deadlock resolution mechanisms and believes that the inherent continuing damage to a company of a prolonged deadlock will create, for all parties, a commercial need to reach an agreed solution.
A business plan is rarely itself a legal document and failure to achieve future targets will not usually give rise to a legal claim. However, it can be a vital document to ensure that the Company Shareholders "own" common and clear objectives for the Venture. It is common to identify the opening business plan in the Shareholders Agreement.
It is crucial for Shareholders to establish the accounting principles and policies to be adopted by the Company in its subsequent accounts. In particular, issues such as depreciation/amortisation policy can cause potential conflict between Shareholders. In case of disputes, a Board Resolution should be given a high priority.
The governing law should be established in the Shareholders Agreement, as it is necessary for litigation and hence often affects the choice and role of particular lawyers. However, arbitration, a form of alternative dispute resolution, is usually preferred over litigation in settling disputes regarding the rights and obligations of Shareholders. Not only does it offer greater privacy of proceedings, but also allows more effective enforcement internationally according to the New York Convention 1958.
A Shareholders Agreement is suitable for the set up of a relatively simple joint venture - a company with equal shareholding. This agreement is drafted for 4 parties and can be in Neutral, Strict or Loose Form.
A Shareholders Agreement to be entered into upon completion or establishment of the Joint Venture Company with standard clauses for minority protection. This agreement is drafted for 4 parties and can be in Neutral Form, or in favour of the Majority / Minority Shareholder.
In relation to a Joint Venture / Shareholders Agreement, a guarantee is given by a party's parent to the other shareholders for the party's obligations.
Please note that this is just a general summary of shareholder agreements under common law and does not constitute legal advice. As the laws of each jurisdiction may be different, you may want to speak to your legal advisor.
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