When and Why You Need a Shareholders’ Agreement; and What Should it Cover

Shareholders’ Agreements provide critical assistance when it comes to the operation and management of companies that involve multiple owners (shareholders). They also establish important rules that help protect companies and shareholders in relation to dealings with shares and disputes.

Simply put, all companies with 2 or more shareholders should have a Shareholders’ Agreement in place.

What is a Shareholders’ Agreement?

A Shareholders’ Agreement is a private binding contract between shareholders of a company.

Subject to the provisions of the Corporations Act and the company’s Constitution, Shareholders’ Agreements govern the relationship between shareholders (and directors) of a company and specify:

• who controls the company,
• how the company will be owned and managed,
• the rights and responsibilities of shareholders and directors,
• how shareholders’ rights are protected, and
• how shareholders can enter and exit the company.

Replaceable Rules Vs Constitutions Vs Shareholders’ Agreements

The rights and responsibilities of shareholders and directors are governed by:

• the provisions of the Corporations Act 2001; or
• by a company’s Constitution (if adopted); or
• a Shareholders’ Agreement (if any); or
• a combination of the above.

The Replaceable Rules provided for under Section 141 of the Corporations Act are the starting point and set out basic rules when it comes to company management.

As the name suggests, the Replaceable Rules are replaceable. Companies can adopt a Constitution to provide greater detail and more guidance than the Replaceable Rules. A Constitution may amend, add to or replace the Replaceable Rules.

Constitutions are however often generic in nature, given that they are public documents, and are generally not sufficiently sophisticated or particularised to deal with the challenges of a company with multiple active owners.

A Shareholders’ Agreement, being a private contract, is used to provide greater detail, in confidential a manner, over and above the Corporations Act and/or a Constitution.

Shareholders’ Agreements can provide greater flexibility and sophistication when it comes to management of a company and are, therefore, the trump card when it comes to corporate governance and management.

Why are Shareholders’ Agreements so important?

A Shareholders’ Agreement allows the owners (shareholders) in a company to reach a common understanding as to what they are expected to provide the company with and what they will receive in return.

A well drafted Shareholders’ Agreement sets out clearly how a company is to operate when things are going well.

Just as importantly it makes provisions for when things are not going well and how a shareholder or shareholders can exit the company or resolve disputes.

Without a Shareholders’ Agreement, disputes between shareholders can escalate quickly, often resulting in a protracted and costly disputes that are draining and damaging to all parties concerned, including the company’s business.

Shareholders’ Agreements are, therefore, instrumental in the maintenance of a profitable and successful organisation and operate to protect the capital value of the company’s assets (including businesses and goodwill), and in turn, the capital value of shareholders’ shares if shareholders have a falling out or a wish to move on from the company.

All of the above combine to make a Shareholders’ Agreement the most important document when it comes to company governance and why every company with 2 or more shareholders should have one in place.

When should a Shareholders’ Agreement be prepared and signed?

Short answer: the sooner the better.

It is highly recommended that a Shareholders’ Agreement is prepared and signed either:

• at the outset of a relationship between would-be shareholders and before any joint business plans or enterprise is commenced, or
• in the case of an existing company, before shares are either issued, sold or transferred to a third party/unrelated owner.

A Shareholders’ Agreement should not be put on the to-do list.

Too often clients put it on the back burner or think a “handshake deal” will suffice. Then, as so often happens, an issue arises between the shareholders, that turns into a costly and protracted dispute, that could have been avoided if a Shareholders’ Agreement was in place and could be turned to for guidance and resolution.

It is also worth noting that the process of formulating and drafting a Shareholders’ Agreement can be just as beneficial as the end product.

Discussions around what is or is not to be included in a Shareholders’ Agreement help shareholders consider and clarify issues that they may not have otherwise considered. It allows shareholders to formulate (and record in writing) a clear understanding on how the company is to be managed.

Importantly, if you cannot agree and reach terms in relation to a Shareholders’ Agreement, you may need to reconsider your decision to invest in a company and enter into a relationship with the other shareholder(s).

What should be included in a Shareholders’ Agreement?

A Shareholders’ Agreement is a private contract and can contain any (legal) provision that the shareholders wish to include.

Shareholders’ Agreements can be short form in nature, for example if there are only 2 shareholders in a company, then a Shareholders’ Agreement can often be simplified to focus on exit strategies and dispute resolution.

Alternatively Shareholders’ Agreements can be of a long and comprehensive nature if there are multiple shareholders and/or different combinations of shareholders, for example, founding shareholders, managing shareholders and investor shareholders that require more customised and personalised clauses.

We will now discuss certain key provisions common to most Shareholders’ Agreements, noting that it is always important to tailor a Shareholders’ Agreement to the specific needs of the company in question.

Basics Terms

Most Shareholders’ Agreements begin by laying down the basics.

Issues to be clarified and agreed upon upfront include:

1. What is the purpose of the company?
2. What can and can’t the company do?
3. Who are the directors of the company?
4. Who are the shareholders (owners) of the company?
5. How many shares and what type of shares are to be issued by the company?
6. Where will its offices be?

Appointment and Removal of Directors

Having clarified the basics, the board of directors should then be considered.

A board of directors has the authority and responsibility for the operation and affairs of the company. Who sits on the board of directors and has control of any board meeting is therefore critical when it comes to the management of a company.

How directors are appointed is often reflective on each shareholders’ percentage shareholding in the company. In short, ownership stake often dictates the power to appoint and remove a director.

Some examples:

COMPANY A

Shareholder 1 holds 50% of shares therefore Shareholder 1 can appoint 1 director to the Board

Shareholder 2 holds 50% of shares therefore Shareholder 2 can appoint 1 director to the Board

COMPANY B

Shareholder 1 holds 33% of shares therefore Shareholder 1 can appoint 1 director to the Board

Shareholder 2 holds 33% of shares therefore Shareholder 2 can appoint 1 director to the Board

Shareholder 3 holds 33% of shares therefore Shareholder 3 can appoint 1 director to the Board

COMPANY C

Shareholder 1 holds 75% of shares therefore Shareholder 1 can appoint 2 directors to the Board or is appointed chairman with a casting vote

Shareholder 2 holds 25% of shares therefore Shareholder 2 can appoint 1 director to the Board

When it comes to directors and board representation, issues to be considered and clearly recorded in a Shareholders’ Agreement are:

1. The minimum and maximum number of directors.
2. Rights of shareholders to automatic director representation.
3. Election of additional directors including non-executive directors.
4. Appointment of a chairman and the powers of a chairman e.g. casting vote in deadlock.
5. Provisions around how directors’ meetings are to be held, specifically the number of directors required to form a quorum and what happens if a quorum is not present.

Decision Making

Notwithstanding that the board effectively controls the company’s operations, shareholders can agree between themselves, under a Shareholders’ Agreement, that the company will not enter into certain transactions without certain shareholder approval first being obtained.

This additional level of shareholder control can be critical for both majority and minority shareholders. It also makes shareholders consider such decisions before they arise, hopefully avoiding the possibility for dispute in the future.

The level of approval depends on the importance of the decision at hand. Often the decisions are grouped into 3 categories being:

1. Decisions that require unanimous approval (100% of shareholder votes).
2. Decisions that require a special resolution (75% votes).
3. Decisions that only require a simple majority (over 50% of votes).

Shareholders should consider and record what level of approval they require for:

1. Approval of all business plans.
2. Approval of all budgetary plans and forecasts.
3. Any variations to the company’s dividend or distribution policy.
4. A call by the board, for shareholders to make, vary or repay a shareholder loan.
5. Entry into any contracts involving a value exceeding [$100,000].
6. Entry into a transaction by the company which is not at arm’s length basis.
7. Any activities by the company outside the scope of the company’s business.
8. Any material change to the way the company conducts its’ business.
9. The issuing of additional shares by the company.
10. Commencement of any legal proceedings by the company.

Funding & Finance

Shareholders’ Agreements should include provisions around company funding.

Shareholders should discuss and clearly record in a Shareholders’ Agreement:

1. How the company is to be initially funded.
2. Whether shareholders will be required to make further capital contributions.
3. Whether shareholder loans will be required and on what terms.
4. Whether personal guarantees from shareholders for company borrowings will be required.
5. When the company may raise capital by the issue of new shares.

Restrictions on Transfers of Shares

A Shareholders’ Agreement should provide clear terms around what a shareholder can and cannot do when it comes to any proposed sale or purchase of their shares.

Restrictions on how shareholders may exit the company protect all shareholders. They also provide an important framework for the buying or selling of shares in times of dispute.

The 5 most common restrictions placed on share transfers under a Shareholders’ Agreement are:

1. Pre-emptive Rights: these restrict shareholders from selling their shares to an outside third-party, without first offering the shares for sale to the other shareholders. If the other shareholders do not wish to purchase the outgoing shareholder’s shares then, and only then, can the outgoing shareholder sell or transfer their shares to an outside third party on terms no less favourable than those offered to the other shareholders.
2. Drag Along Rights: apply where a majority shareholder receives an offer from a third party to buy all the shares in the company, which in turn gives the majority shareholder the right to require all remaining shareholders to sell their shares to the third party on the same terms.
3. Tag Along Rights: apply where one or more shareholders receives an offer for the purchase of their shares in the company, and give the remaining shareholders a right to ‘tag along’ and sell a proportionate quantity of their shares on the same terms.
4. Lock-ups: prohibit a shareholder from disposing of their shares during an initial lock-up period. This is either measured from the date of the Shareholders’ Agreement or the date on which a later shareholder accedes to a Shareholders’ Agreement.
5. Default: set out what restrictions apply when a shareholder is in default. A defaulting shareholder might be defined as someone who breaches a term of the Shareholders’ Agreement, or becomes bankrupt or insolvent, in which case their rights are often automatically suspended (no rights to vote and dividends) and the company can buy back their shares or trigger a Transfer Notice on behalf of the defaulting shareholder.

Whilst typically covered under a separate Buy/Sell Option Agreement or Business Succession Planning Agreement, Buy/Sell Options can also be included in Shareholders’ Agreement. These options allow shareholders to record what they want to happen to an outgoing shareholder’s shares in the unfortunate event of death or disability of a shareholder.

When considering the above restrictions and their inclusion in a Shareholders’ Agreement, the method for valuing shares on a sale or exit by a shareholder is of great importance. In times of dispute, for example, it is vitally important that the Shareholders’ Agreement includes a mechanism whereby shares can be valued and a price set, for example by way of independent expert valuation, if the shareholders cannot agree on a price between themselves.

Restraints of Trade

Shareholders often bring different skills and resources to a company.

• The founder might bring the IP (intellectual property rights).
• Investors may bring the money.
• The managing shareholder might have the business systems.

As such, one or more shareholders may be more important to the success of the company than another.

In situations where the company would suffer loss if a particular shareholder ceased to be involved in the operation of the company, provision is often made in a Shareholders’ Agreement requiring the shareholder(s) who is integral to the day-to-day success or management of the company, to enter into fixed term Executive Employment Contract with the company and/or to be a party to the Shareholders’ Agreement personally..

Just as importantly, a Shareholders’ Agreement should record that all shareholders and any related key persons are bound by mutual restraints of trade. These restraints restrict shareholders (and key persons, where applicable), from:

• engaging in activities that compete with the business of the company, in a defined territorial area, while they hold shares in the company and for a set period after they cease to hold shares in the company.
• using or disclosing confidential information or soliciting or enticing away customers or employees of the company.

Dispute Resolution

It is often said that Shareholders’ Agreements are important at the outset of business and critical in times of dispute.

In times of dispute, it is important that the parties have the ability to fall back on and resolve disputes in accordance with a clearly defined dispute resolution procedure.  Generally, dispute resolution procedures must be followed before a party can commence any Court proceedings in relation to a dispute.

Dispute resolution procedures generally provide for a party to serve a Dispute Notice clearly articulating what is in dispute and then require the parties to meet to try to resolve and write down the dispute. In the absence of a resolution, the clause will typically provide that the parties must attempt mediation.

If mediation is unsuccessful, and the parties do not agree on an alternate mechanism for resolution of the dispute, the Shareholders’ Agreement may require the dispute to be determined by independent expert determination or Arbitration.

These alternate dispute resolution mechanisms can be particularly useful for avoiding protracted and costly litigation and maintaining confidentiality in relation to the subject of the dispute.

Dispute resolution clauses coupled with provisions around restrictions on transfer of shares, therefore, reduce legal costs and stress and protect share value in times of conflict.

Summary

• A Shareholders’ Agreement is a private contract between shareholders of a company.
• A good Shareholders’ Agreement creates a pathway and plan that allows shareholders to understand how a company will be managed and operated.
• A comprehensive Shareholders’ Agreement clearly defines the rights and responsibilities of shareholders on entry and exit.
• Shareholders’ Agreements increase a company’s chances of success and protect share value.
• Every company with 2 or more shareholders should have one in place.