Shareholders’ Agreements

Going into business with someone is one of the most exciting things that you can do. The world is your oyster – you have a great idea, have spotted the gap in the market, your partner is the perfect complement to you and the sky is the limit. Things are going to go absolutely brilliantly and you and your business partner have been friends for ages – what could possibly go wrong?

Unfortunately, life and business are not so simple. The trials and tribulations of business life cause frictions, even in the most secure of business relationships. Worries about sales, cash-flow and just paying the bills can have a corrosive effect on a work relationship. Once this sours, it can mean that every problem or irritant becomes magnified out of proportion, which can eventually destroy both the relationship and the business.

However, no one thinks it will happen to them. Just as ever marriage starts out with chirping birds and not a thought of divorce, so every business relationship starts with an expectation that the path will be smooth and that the relationship can survive anything.

A shareholders’ agreement can actually help with that. By setting out the parties’ expectations upfront and dealing with things like what will happen if they wish to split apart, a shareholders’ agreement can take some of the heat out of a disagreement and prevent the relationship suffering a permanent breach. This means that the parties can still work together to make the business a success, despite any personal disagreements.

A shareholders’ agreement is exactly what it says on the tin. It is an agreement between shareholders as to how that relationship is going to work. It can be a simple or as complicated as it needs to be.

Shareholders’ agreements are used where the business structure being used is a company limited by shares. Similar agreements can also be put in place for partnerships and limited liability partnership, which have the same goal, but these are structured in slightly different ways to deal with the difference in the business structure.

A shareholders’ agreement is broadly divided into two sections. The first deals with how the business is going to be managed. The second section deals with what happens if one party wants (or is required) to exit the business.

This sections sets broad limits for how the company is going to be managed. It will cover things like:

• How many directors the company will have and whether all the shareholders are entitled to be or appoint a director.
• How often the directors will hold a formal board meeting.
• What decisions of the company (if any) must be agreed by all or a majority of the shareholders.

Decision making of the company is a key part of this section. Generally, the shareholders have very little influence on how the business is run on a day to day basis. This is preserve of the directors and directors make their decisions by majority decisions. Imagine a situation where either not all of the shareholders are also directors of the company or where there are three shareholders who are also directors. In both cases, major decisions of the company could be taken even if one shareholder does not agree with them. This could include large capital expenditure, buying or selling property, granting charges over the company’s assets, taking on employees (and deciding their salary) or even ceasing trading.

Using a shareholders’ agreement, the shareholders can set limits to what can be done with the company in which they have all invested without all (or a certain proportion) of them giving their consent.

What this does is set expectations as to what decisions will be the subject to discussion and debate before they are undertaken. This will set up an obligation to communicate, which will often mean that no just the subjects which are set out in the shareholders’ agreement are discussed, but all matters relating to the business.

The management section is also one of the key reasons why shareholders’ agreements should be reviewed on a regular basis. As a company grows, some of the limits and items which are detailed in the shareholders’ agreement may become too restrictive and may need to be reset or replaced to ensure that the directors are using their time in the most productive manner (rather than having to review, discuss and agree on every little decision being made).

Issuing of shares

One issue which falls within the management section of a shareholders’ agreement is what happens when a company wants to issue more shares, normally in order to raise additional funds. The issue of further shares dilute the existing shares, so can significantly change the balance of power within a company depending on who they are issued to.

Shareholders will normally be quite keen to ensure that in the case of any such proposed issue, the shares are offered to them first, to ensure that the proportion of shares that they hold in the company is maintained. If they do not want to (or cannot) participate in the share issues, they will normally want to ensure that they can at least have a say in who those shares are going to be issued to.

When most people think of a shareholders’ agreement, this is the section that they tend to focus on. Shareholders’ agreements are generally thought of as documents to look at when things go wrong, which is true to a certain extent. This section is generally of most importance when things have gone wrong and one party wants to leave or the others want to get rid of him.

Types of Exit

Exits are generally divided into two types; voluntary and involuntary. A voluntary exit is where one party decides, for whatever reason, that he wants to leave the business. This could be for retirement, family reasons or because he just wants to leave. In this case, the exiting shareholder makes the decision and triggers off the process. In an involuntary exit, the exiting shareholder does not make the decision. It is either made for him (in the case of an expulsion) or is triggered by an event such a death, critical illness or bankruptcy.

Voluntary Exit

The usual structure for a voluntary exit is that the exiting shareholder gives a notice to the company that he wants to leave. The company then informs the other shareholders that the exiting shareholder wants to depart and that his shares are therefore up for sale, together with the price that the exiting shareholder wants. The other shareholders then decide whether they want to purchase their allotted proportion of the exiting shareholder’s shares and, if so, if they want to pay the price he is asking. If they think that he is asking too much, the other shareholders can request that an independent valuation is undertaken, normally by the company’s accountants or auditors. If they elect to go for an independent valuation, the other shareholders have to agree to pay that price, whether it is more, less or the same as the price originally requested by the exiting shareholder.

If some of the other shareholders do not want to take up all of their proportion, the shareholders who do wish to participate can take up the left over shares. If not all the shares are taken up in this way, the exiting shareholder either has to keep hold of them or can sell them to a third party. Normally the directors retain the ability to have the final say over whether they are prepared to register the new shareholder.

Involuntary Exit

With an involuntary exit, the same basic process is used, except that the exiting shareholder (or his representatives) does not give notice; it is automatically triggered by the relevant event. Also, the exiting shareholder (or his representatives) do not specify the price they want for the shares – it is automatically sent for independent valuation.

In some cases, the other shareholders may not want to pay the full value of the shares to the exiting shareholder. This is normally the case where:

(a) the exiting shareholder is bankrupt, as the money will just be going to pay off his creditors or,

(b) where the exiting shareholder is being made to leave because he has breached the shareholders’ agreement or otherwise done something that has made the other shareholders expel him.

In these types of cases, a “bad leaver” discount is applied. This discount has to be set out in the shareholders’ agreement. It can be anything from a small discount (such as 10% off the normal value of the shares) to a discount which reduces the price down to the nominal value of the shares (normally £1 per share). Clearly, this is a huge incentive on the shareholders not to act in a way that would lead the other shareholders to expel them.

Shareholder Insurance

It is not unusual for the shareholders to have life insurance in place to give a pot of money from which to purchase the shares of a shareholder who dies (or suffers a critical illness). In this case, the value of the shares purchased is normally set at the value paid out by the insurance, to ensure that there is no shortfall. Where shareholder insurance is in place, the provisions relating to maintaining the insurance at the correct value can get quite complicated and the buyout of the shares is normally broken out into a separate document known as a cross option agreement.

Exceptions

It is fairly common for people to want to transfer shares within their families or to trusts for the benefit of their families, normally as part of a wider tax planning structure. This can be covered in the shareholders’ agreement, allowing the shareholders to transfer the shares to specific people without triggering the requirement to offer those shares to the other existing shareholders. This can either be limited to transfers within the shareholder’s lifetime or on his death.

Restrictions on Shareholders

Once a shareholder leaves, it is normal for the other shareholders to want to restrict his activities for a period of time to protect the business of the company. You would not want a shareholder to leave the company and then use all the contacts and knowledge he has built up in order to start his own business down the road. Clauses to prevent this, known as restrictive covenants, are usually included in shareholders’ agreements, covering both the period during which a shareholder is involved in the business and a period after he leaves.

The length of time after he leaves that he can be excluded from operating or being involved in a competing business is a question of what is reasonable. This requires consideration of a number of factors, including the type of business, its customer profile and turnover and what other opportunities there are for the exiting shareholder to be able to make a living doing something else. Restrictions which are too heavy can be unenforceable, so legal advice on this is absolutely essential.

A shareholders’ agreement is a document which sets boundaries. As the parties know what they can expect, this can make dealing with any disputes considerable easier, as neither party can take an unrealistic line. Shareholder disputes can be protracted, bitter and extremely expensive. A shareholders’ agreement can work like insurance – pay a bit to put it in place, but save a lot in potential cost if there is a falling out later down the line.

You can draw up your own shareholders’ agreement, but it is a bit like drawing up your own will. Unless you know what you are doing, you could end up with a document which does not actually reflect what you want to say. It is normally a good idea to take legal advice on the best way forward.

Gardner Leader Solicitors can help with drawing up shareholders’ agreements, reviewing them and dealing with how to exercise the rights contained in them. To speak to one of our experts, please give us a call or visit our website.