Shareholders’ agreement: FAQs
A shareholders’ agreement is a confidential agreement between shareholders in a company that governs the relationship between those shareholders and the company, and between the shareholders themselves. It is also called a (co-)founder agreement in the startup scene, and they serve the same function. There is no legal requirement to put in place a shareholders’ agreement, but in most cases it will be a good idea to have one. Below, we answer some commonly asked questions about shareholders’ agreements:
Why should you have a shareholders’ agreement.
What key items should be included in a shareholders’ agreement.
How do you future proof a shareholders’ agreement.
Is a shareholders’ agreement different to a (co-)founder agreement.
Do you need a constitution as well as a shareholders’ agreement.
Photo by Camylla Battani on Unsplash
1. Why should you have a shareholders’ agreement?
It’s because not having a shareholders’ agreement can create awkward and unsatisfactory outcomes. If you do not have a shareholders’ agreement (and there is no legal requirement to have a one), the default rules under the Companies Act 1993 will apply. The default rules are designed to capture the lowest common denominators in most company environments. This can be problematic because either the default positions under the Companies Act is not appropriate for the shareholders or the Act is silent on particular governance matters. For example, the default legal rules are:
Directors must be appointed by “ordinary resolution” – a simple majority of the voting shareholders. The directors form the board, and the board oversees and is responsible for the management of the company. So whoever has a simple majority of the shares control the company. If you hold less than 50% of the shares, you have no say on director appointments and can be removed as a director by those who hold a simple majority.
Your shares are freely transferable to another person. If your co-founder decides to sell their shares to a competitor, your competitor becomes your new partner.
If there is a dispute between the shareholders, the Companies Act does not specify how you can resolve them. Your options are commercial negotiations if everyone is willing, or expensive litigations.
Your other shareholders can freely compete with the company while they are a shareholder or after they leave the company. Complicating this issue further, it will not be clear who owns the IP used by the company.
If you have less than 25% of the shares in the company, you do not have a say on the more fundamental company decisions. These include decisions to sell the business and its assets, or to enter into key supplier or customer contracts that count as a “major transaction”.
In general – and especially if you are an equal co-founder or a minority investor – you shouldn’t be happy with the default rules. A shareholders’ agreement helps to make the rules more appropriate and fairer for the shareholders.
2. What key items should be included in a shareholders’ agreement?
The purpose of a shareholders’ agreement is to change the default rules or to add to them. There are no set rules, and the starting position is that everything is negotiable. However, there are some key items that are frequently included:
Director appointment rights – Parties can agree that each shareholder can appoint a director even if each of them has less than a simple majority of the shares. The right to appoint a director may also be “personal” and tied to the shareholders’ identity, regardless of their shareholding percentage. In some cases, the right to appoint a director should be lost when you reduce your shareholding below a certain threshold.
Decision-making – The default rule is that the board makes decisions of the company, acting with a majority. The proviso is that in specific situations they may require shareholder approvals, such as when entering into major transactions. If you do not have a board seat or are in the minority as a board member or a shareholder, you may expect to have further say in that decision. It is possible to carve out specific corporate actions to require a special board or shareholder approval.
Governance and information – The shareholders’ agreement should include key governance items such as the frequency of the board meeting, the type of information the company should prepare for the board and their frequency, whether an initial business plan should be prepared and the frequency of its review (generally annual), and a dividend policy.
Capital raising – The company should have a broad outline of how it will go about raising new capital. If new shares are to be issued to raise capital, existing shareholders should have the first right of refusal to subscribe for further shares. If one or more shareholders are to lend money to the company, the shareholders may want to agree on how those amounts should be repaid and whether the company will grant the lender a security interest over its assets.
Sale and exit – If a shareholder wishes to exit the company, the remaining shareholders should have the first right of refusal to buy out the exiting shareholder. They may also want to have a right to veto third party purchasers on reasonable grounds, e.g. if the purchaser is a competitor. The shareholders may want to stipulate when they can “drag” all shareholders to an exit event or to tag along to a sale procured by the others.
Restraint and IP – Every shareholder has an aligned interest to protect the goodwill of the company. Non-compete and non-solicitation obligations help protect the business goodwill. Similarly, and especially for SaaS co-founders, they will want to make sure that the IP developed prior to and during their venture together vests in the company.
Dispute resolution – A dispute resolution mechanism should help parties navigate their disputes and deadlocks, encourage voluntary settlements and avoid litigious processes and outcomes. Depending on the subject matter of the disputes, parties may want to include an expert determination process for a speedier resolution.
This is not an exhaustive list. Depending on individual circumstances, you may want to include investor protection clauses such as anti-dilution rights and tag-along rights, create different classes of shares with different rights attaching to those shares, set out delegated authorities for senior management and more.
3. How do you future proof a shareholders’ agreement?
This can be a difficult, undesirable task when initially preparing a shareholders’ agreement. It is not practical to contemplate and set out every eventuality that may surface with a company. Rather, the goal should be to make sure that the shareholders’ agreement will be binding on all shareholders – present and future – and has flexible and fair mechanisms to change in the future.
Once a shareholders’ agreement is signed, it will be binding on the initial shareholders. Typically, it will be a term of the shareholders’ agreement that no other person can become a shareholder of the company (by being issued new shares or being transferred existing shares) unless they agree to be bound by the terms of the shareholders’ agreement. This ensures that the shareholders’ agreement continues to be binding on current and future shareholders.
As the company grows and the shareholders increase or decrease in size, the initial terms contemplated by a shareholders’ agreement may no longer be appropriate. In these cases where change is inevitable, every party to a shareholders’ agreement must agree to amend the agreement to reflect the new circumstances of the company. A unanimous agreement may be difficult or impossible to achieve if there are shareholders who will be disadvantaged by the changes. One way a lot of the shareholders’ agreements deal with this situation is by having a 75% approval threshold to make changes to the agreement, except in limited situations. This rule is generally accepted as it is similar to the default position at law for adopting or changing a company’s constitution (see more below on why you need a constitution). The threshold can be lower or higher than 75% and helps the company to adapt to changing circumstances more practically.
4. Is a shareholders’ agreement different to a co-founder agreement?
They broadly deal with similar shareholding terms in a company. How should co-founders – that is, initial shareholders – deal with each other and their shares? So the name of the agreement is interchangeable especially with the start-up companies.
However, co-founder agreements also often include “founder vesting” terms. Founder vesting works by giving the company the option to buy back a co-founder’s initial shareholding if they cease to be a shareholder or work for the company, or they default in making an agreed contribution to the company. The number of shares that can be called under option will generally decrease over time and may or may not require a fair value to be paid for those shares.
5. Do you need a constitution as well as a shareholders’ agreement?
A constitution is a must and sits alongside the shareholders’ agreement. By law, a company may only take certain corporate actions if its constitution expressly allows them. For example, unless its constitution expressly permits it:
The company cannot buy back its shares or hold them as treasury stock.
The company cannot put in place a directors & officers liability insurance or provide an indemnity in favour of its directors or officers.
The directors must always act in the best interest of the company – and not in the best interests of a holding company or their appointing shareholders in joint venture settings.
While a shareholders’ agreement is a private and confidential agreement between the shareholders of the company, a constitution is a public document. It must be filed with the Companies Office and is viewable by anyone on the public register. It may not be desirable to share the details of how a company is run (such as how its financial information is shared and its dividend policy). So these matters are recorded in the shareholders’ agreement, while the constitution is adopted and registered to ensure that the company has the flexibility to take the desired corporate actions.
If there are any other questions regarding shareholders’ agreements, please feel free to reach out to Josh Woo, or let us know (we may add them to this FAQ page).
Disclaimer
This publication should not be construed as legal advice. It is necessarily brief and general in nature. Please seek professional advice before taking any action in relation to the matters discussed in this publication.
