Shareholders Agreement

Shareholders' Agreement 

A company is the most common form of business structure to house on an ongoing business. Corporate entities exist in most countries. Structuring your business as a 'company' offers advantages such as identity; limited liability; more opportunities for financing; continuity in the event of transfers; flexibility of share rights; established laws. Structuring as a 'company' also poses some disadvantages: there are additional publicity, formality and compliance requirements.

The most common form of company is a 'company limited by shares' (usually, a private company, or its equivalent in the relevant jurisdiction, unless a subsequent public offering of shares is completed).

Shareholders’ disputes are one of the most common causes of business failures. A Shareholders' Agreement is the best way to avoid disputes and offer legal protection for shareholders. A Shareholders' Agreement is concluded between the shareholders of a company to (i) define their respective rights and responsibilities, and (ii) organise the management of the said company. It allows shareholders to incorporate express contractual provisions addressing key management issues above and beyond those afforded by statute and corporate law but is not intended to govern the day-to-day operations of a business.

The following table is a quick reference guide to the documents available on DocPro:

A well drafted Shareholders' Agreement should allow the minority shareholder to: 

• participate in management through board representation;
• involve in any event in major decisions (including, where feasible, a right of veto);
• protect against its equity stake being improperly diluted;
• receive a fair and proper distribution of profits;
• access to information regarding the Company's affairs;
• protect itself and the Company against the majority shareholder;
• exit the joint venture.

1. Board of Directors

A minority shareholder will often seek a right to appoint a director to the board of the Company. A Shareholders' Agreement should ensure that, although the board may not be involved in day-to-day operations, the minority shareholder is kept fully informed about the Company's business through its appointed director and that it has a voice at board discussions. In the case of a multi-party joint venture, the formula may be that a number of minority shareholders (perhaps aggregating not less than a certain percent of the voting share capital) should, collectively, be entitled to appoint a director. A minority shareholder should consider whether certain additional protections are appropriate in order to ensure that its right to participate in management is not circumvented:

• the presence of its appointees should be necessary for a quorum of the board;
• prevent the delegation of key powers of the board (for instance, to an executive director or a committee) or, if delegation to a committee takes place, a right of representation on that committee;
• reasonable notice is given of all board meetings and of the agenda items for discussion (including advance circulation of relevant board papers) and that no decisions can be taken (unless all agree) outside the matters on the agenda;
• written resolutions need the approval of all directors.

In practice, much will continue to depend on the spirit of the joint venture relationship to ensure appropriate participation by a minority shareholder.

2. Veto Right

A minority shareholder may wish to have a right of veto over certain major decisions by the Company under the Shareholders' Agreement, such as:

• changes in the Company's articles of association;
• changes in the share capital of the Company (including the grant by the Company of any share options or convertible securities);
• any significant change in the nature of the Company's business;
• the Company incurring capital expenditure or contract commitments in excess of pre-agreed financial limits or not specifically contemplated by an agreed budget;
• any borrowing by the Company which would cause a pre-agreed borrowing limit to be exceeded;
• major business acquisitions or disposals by the Company;
• dividend distribution below an agreed minimum level;
• appointment and dismissal of executive directors or other key personnel and directors (including approval of long-term service contracts or material variations to their remuneration or benefits);
• material dealings by the Company with its intellectual property;
• dealings between the Company and any of its shareholders (except, perhaps, arm's length dealings in the ordinary course of business);
• voluntary winding-up.

It is necessary to decide whether these matters should be entrenched at the board or shareholder level. Should the unanimous approval or super-majority vote be required of the directors or of the shareholders of the Company? It may be appropriate that decisions on these major matters should be reserved to the parties at the shareholder level with more operational matters being left to the board level. In smaller ventures, decisions at board level will often amount to the same thing and be sufficient. It may not be appropriate for each minority shareholder to have a separate right of veto. In joint ventures where there are a number of joint venture parties, it is common for certain matters to require the approval of a "super majority" of the shareholders (normally 75% to 90% rather than unanimity). 

3. Protection against Dilution

A minority shareholder will wish to ensure that its equity stake in the Company will not be diluted by alterations to the share capital of the Company through the Shareholders' Agreement, including:

• an issue of shares which is not made pro rata to existing shareholders;
• an issue of shares to the other shareholders (and/or to a third party) at less than a fair price;
• a "rights" offer of shares to existing shareholders where the majority knows that the offer cannot in practice be taken up by the minority;
• a purchase by the Company of its own shares at a price in excess of their fair value; and
• certain other reorganisations of share capital - such as a sub-division of share capital which alters the voting balance or an alteration in the rights attaching to certain shares and not others.

Some of the common protections against dilution included in Shareholders' Agreements include:

• a requirement that new issues of shares in the Company must be offered pro rata to all existing shareholders;
• a requirement that any issue of shares should require the consent of the minority shareholder - such requirement for such approval will obviously be inappropriate in those joint ventures where it is always envisaged that substantial further funding will be required up, perhaps, to a certain limit;
• a requirement that shares must be offered to shareholders at a fair value - with a right for a party to require certification by the company's auditors or an independent valuer that the offer price is fair; or
• a requirement that the minority shareholder's consent is needed if the Company wishes to issue, allot, redeem, purchase or grant options over any of its shares or other securities or reorganise its share capital in any way.

Another protection to preserve a minority shareholder's equity stake is for it to retain an option to ensure - possibly for a specified period - that it can buy back its full equity stake by subsequently acquiring from the majority shareholder sufficient shares, at the current full market or fair value, to take the minority shareholder's stake back to an agreed percentage level. 

4. Right to Distributions

The board of directors of a Company will declare dividends, and the amount of each dividend distribution. A minority shareholder may wish to ensure that an agreed distribution policy is established under the Shareholders' Agreement at the outset - and, in some ventures, to ensure that profits cannot be diverted in a discriminatory manner to the majority shareholder. The following may be outlined in the Shareholders' Agreement:

• the parties agreeing that the Company shall distribute not less than a stated percentage (or such other percentage as may from time to time be agreed) of its available distributable profits for any year - subject usually to the retention of such profits as the board considers reasonable or desirable to meet the working capital or other financial requirements of the Company;
  
  
• in cases where the minority is afraid that sums may not be retained to assist the development of the Company, the formula might provide for a certain proportion of profits to be retained in the business of the Company to fund future growth before there can be any distribution to shareholders;
  
  
• where a minimum dividend policy is established, provision for the auditors to certify the amount of distributable profits available for that year;
  
  
• a requirement that the consent of the minority shareholder is necessary for any management or service agreement to be entered into between the Company and the majority shareholder (or connected parties) or any variation in the payment terms under any such agreements; and/or
  
  
• ensuring that any remuneration paid to directors appointed by the majority shareholder is also subject to approval by the minority shareholder.

Another approach is to require that the dividend policy should be dealt with in the annual business plan if the minority shareholder has rights of approval over the annual adoption of that plan.

5. Right of Inspection

A minority shareholder's rights to information regarding the Company's affairs is limited under Common law. Apart from the right to receive the annual audited accounts, a shareholder has no statutory right to inspect the accounting records of the company nor, as a shareholder, a right to inspect the minutes of board meetings. A minority shareholder should consider seeking the following under the Shareholders' Agreement:

• right of access to inspect (and take copies of) accounting records and the other documents of the Company and, if thought appropriate, to visit the Company's premises and interview its directors and senior staff (sometimes termed "visitation rights");
• right for a director nominated by a particular shareholder to give his appointing shareholder such information regarding the Company's affairs as he thinks fit. It should be remembered that information regarding the Company will invariably be confidential and there is no automatic right for a director to disclose that information with his parent organisation. A right to such disclosure, subject to due confidentiality restraints, should generally be made clear in the joint venture documentation;
  
  
• obligation on the majority shareholder and/or the Company to keep the minority shareholder informed of material developments regarding the Company's business;
  
  
• obligation for the board of the Company to circulate monthly or quarterly audited management accounts and other financial information (budgets, cashflow forecasts, etc) to the shareholders, including the minority shareholder, in such form as may be agreed;
  
  
• draft of annual budgets or business plans relating to the Company for approval and/or comment by the minority shareholder.

6. Exit

A minority shareholder can find itself locked in the Company without any effective exit route. The following are possible protective provisions to include in the Shareholders' Agreement to enable an exit for a minority shareholder:

• Transfer Although a minority stake will rarely be marketable to a third party, a right to sell will normally be preserved. This will usually include:
  • ensuring that the minority shareholder is free to transfer its shares, albeit after the other members have been able to exercise a pre-emption right;
  • removing any right of the directors to refuse to register a transfer to a third party if the other members do not purchase the shares and a third party purchaser is found; and
  • ensuring that, where the pre-emption right is exercisable at a fair value, it is made clear that there will be no discount in determining the value of the minority shareholding being sold (i.e. its value will be on a per share basis pro rata to the value of the Company as a whole).
    
    
• Redeemable Shares In some cases, one method of establishing a pre-determined exit route for a minority shareholder is to issue shares to the minority shareholder which are redeemable at the option of the shareholder (or the Company), usually at a stated price. Factors affecting the issue of redeemable shares under Common law include:
  • redeemable shares must be issued at the outset since rights of existing shares cannot be altered so as to become redeemable;
  • shares can only be redeemed out of distributable profits or a fresh issue of shares for that purpose although a private company can, subject to certain conditions, also redeem shares out of capital;
  • the shareholder may wish to have a veto over transactions which could reduce the level of distributable reserves and therefore make redemption more difficult (such as bonus issues or dividends beyond a certain fixed maximum level).
    
    
• Put Option One safeguard (particularly if limited voting rights are granted to the minority) is for a minority shareholder to negotiate a put option, whereby it can oblige the majority shareholder to buy out its investment in the Company, usually in accordance with a pre-determined price formula and at a defined time or times. Such an option will provide the surest protection against the risk of a minority shareholder being "locked in" if the joint venture is unsuccessful from its viewpoint or it wishes to exit. 
  
  
• Tag along Right A minority shareholder should also consider establishing a "tag along" right, in its Shareholders' Agreement, whereby it can oblige the majority shareholder to include the minority's stake, at the same price per share, in any sale which the majority shareholder may make of its controlling interest to a third party. This right ensures that the minority shareholder cannot be left unwillingly as a minority shareholder in a joint venture with a new majority partner. The same principle, in appropriate cases, should apply to enable the minority shareholder to "piggy back" and participate proportionately in any public offering or private placement of shares in the Company (including, where applicable, participation in the US in any registration by the Company of securities prior to any such offering).
  
  

7. Tax Structure

The structure of the Company may lead, and indeed be designed to lead, to the ability of the majority shareholder to exercise rights that assist its own tax planning. Examples could include arrangements (between the Company and its shareholders) concerning the use of group relief or consortium relief. In most cases, the co-operation of the Company itself will be required before any of these rights can be exercised. The minority shareholder should ensure that these rights cannot be exercised to the prejudice of the Company (and indirectly the minority shareholder) and that provision is made, in the Shareholders' Agreement, for proper payment to the Company by the majority shareholder for any benefit obtained by it. 

8. Claims Against Majority Shareholder

If the minority shareholder considers that the majority shareholder or any of its directors is in breach of any obligation to the Company (including, for example, breach of other ancillary contracts or breach of warranty under any asset transfer agreement at the time of forming the Company), the minority shareholder needs to ensure that the Company's right of claim cannot simply be blocked by the majority under the Shareholders' Agreement. Common solutions are:

• to provide that responsibility for pursuing any such claim against the majority shareholder should be delegated to a committee of the Company board excluding the appointees of the majority shareholder - or delegated to the minority shareholder as an agent of the Company; or
  
  
• to provide, generally, that the majority shareholder (and/or its appointed directors) shall not vote on or interfere with or obstruct any such claim - but without prejudice to its right to defend or resist any such claims.

9. Other Minority Rights

Other possible protections which a minority shareholder may seek in a Shareholders' Agreement include undertakings that the majority shareholder will ensure that:

• the Company maintains proper insurance (particularly product liability insurance), prepares and maintains proper books of account and conducts business in accordance with all applicable laws;
  
  
• key employees enter into appropriate non-competition covenants, confidentiality agreements and employment contracts - including, in technology ventures, employment contracts which provide (so far as possible) that intellectual property devised by employees belongs to the Company.
  
  

10. Shareholders Agreement or Articles?

Once the protections for the minority shareholder have been agreed, the next question is whether they should be set out in the Shareholders' Agreement or in the Company's Articles of Association or both. The answer will depend on a mixture of practice, drafting style, practitioner preference and legal considerations.

11. Class and Voting Rights

Class rights include any rights conferred on a particular class of shares in contrast to one or more other classes. They may also, importantly in the joint venture context, include rights conferred on a shareholder by name under the company's articles even though they are not attached to a particular class of shares identified as such. Company law generally includes certain protections for the members of a class against any change in the rights attaching to shares of that class. 

An alternative approach, in circumstances where it is considered not appropriate to establish class rights, is for a minority shareholder to protect its position by having "weighted voting rights" on particular matters. This method has been used to ensure that a minority shareholder's appointee as director cannot be removed by the majority shareholders. This appears to be a technique capable of general application to entrench the rights of a shareholder under Common law.