What is a shareholders’ agreement?
A shareholders’ agreement is a legally binding contract among the shareholders of a company that sets out their rights and obligations, maps out how the company should be managed, establishes share ownership, and share transfer rules – all in order to provide clear solutions to contentious scenarios that may arise in the future.
In contrast to the articles of association of a company, a shareholders’ agreement is a private, confidential document that does not need to be filed at Companies House. It is often a more appropriate document to address sensitive matters such as the company’s financing, assignments of intellectual property rights, the directors’ compensation, the procedure for transfer of shares, and other matters that may need to be kept confidential.
Both documents, the shareholders’ agreement and the articles need to work cohesively. If there are contradictions, it can be complex to make decisions and be aligned with the correct procedures.
How can a shareholders agreement provide safety?
It is often difficult to foresee a conflict at the beginning of a new business relationship, especially when a company is set up with friends and relatives. Consequently, the idea of legally formalising the relationship can seem unnecessary.
Unfortunately, the reality is much more complex and disagreements may happen. Think of a shareholders’ agreement as your insurance policy that offers protection against unforeseen circumstances and disputes that may emerge in the future – be it with your co-founders, investors or directors. When conflicts happen, having a solid legal framework is essential.
Without a shareholders agreement, any disputes will have to be settled by what is contained within the articles of association. However, this may not be enough protection. Shareholders’ agreements contain provisions that pre-empt disagreements and set out appropriate ways to address disputes, whereas the articles of association usually prevent this from happening.
Key clauses in a shareholders agreement
The clauses explained below are not all but just some of the clauses a shareholders agreement includes. Please get in touch with a solicitor to discuss your specific requirements.
Tag along and drag along rights
Tag along rights is the right of minority shareholders to have their shares bought on the same terms and for the same price as majority shareholders who are selling their shares to a third party.
Without tag along rights, in the event that a majority shareholder leaves the company, the minority shareholder could be left with new and unfamiliar partners. Tag along rights helps protect the minority shareholder, as it provides an exit route from the company to avoid this.
Drag along rights require the minority shareholders to sell their shares to a bona fide purchaser, on the same terms and for the same price as a majority shareholder. For example, when the majority shareholders (usually more than 75% of shares) in a company are selling to a third party, they can compel the minority shareholders to join in the sale, for the same price and on the same terms.
Drag along rights are beneficial to the majority shareholder because the potential offering of the total shares in a company serves as a good incentive to a potential buyer. Nonetheless, these types of clauses are also beneficial for the minority shareholders as terms for purchase will be the same as the majority shareholders.
Pre-emptive rights and right of first refusal clause
These clauses protect existing shareholders from the involuntary dilution of their stake in the company. Pre-emption rights provide the company’s existing shareholders first offer on an issue of new shares; or first refusal over the sale of existing shares.
In the context of a company creating new shares, shares are first offered to existing shareholders in proportion to their holdings before being offered to any new buyers. This allows shareholders to preserve their shareholding percentage in a company, provided they have sufficient funds to purchase the new shares being issued.
In the context of an existing shareholder of a company selling their shares, a pre-emption right is a right of first refusal in favour of the remaining shareholders. The purpose of such rights is to preserve the original shareholder base and limit the ability of a third party to acquire shares in a company.
Usually, the selling shareholder must offer their shares to the remaining shareholders on the same terms agreed with the proposed buyer before selling the shares to the proposed buyer.
Good leaver bad leaver clauses
If a shareholder decides to leave the company, good leaver bad leaver clauses will dictate the terms on which their shares are sold and the value they will receive for their shares.
A good leaver is an employee who departs from the company because of death, retirement, permanent disability or permanent incapacity through ill-health, redundancy (as defined in the Employment Rights Act 1996), dismissal by the company which is determined by an employment tribunal or at a court of competent jurisdiction from which there is no right to appeal, to be wrongful or constructive; or any reason after 3 (three) years from the date of becoming an employee shareholder.
A bad leaver is an employee who departs from the company on bad terms or circumstances, such as a breach of their contract of employment, gross misconduct or leaves within a certain defined period.
A good leaver can but not mandatory to sell their shares on departure. However, a bad leaver is obliged to sell his shares on exit to the other shareholders and will then get simply the nominal value of the shares.
Non-competition clause
Non-competition clauses clarify when and how a shareholder may carry out rival activities during and after his time as a company shareholder. It eliminates any ambiguity, including the dos and don’ts, the scope and the period of these restrictions.
The aim of this clause is to ensure that internal knowledge, which is crucial for the company to stay competitive, stay confidential.
However, you should be aware of the fact that mere incorporation of non-competition clauses, does not necessarily mean they are legally binding and enforceable. They must be reasonable and not drafted in an excessively broad manner
Deadlock resolution clause
Pre-agreed dispute resolution mechanisms allow overcoming deadlocks that may drive the business into a dead end.
This can occur when any of the shareholders are willing to change their decision in 50:50 owned companies or when a super-majority or unanimous consent is required but cannot be attained.
The shareholders’ agreement must define what constitutes a deadlock and the process to follow if this situation occurs. There are various types of deadlock resolution clauses, each bearing different implications.
All deadlock clauses tend to boil down to a requirement of one party to sell their shares to the others so that control changes and the remaining shareholders can pass a vote about the matter.
How can we help?
Our legal team can help you prepare a shareholders’ agreement that is specific to the needs of your company and co-founders.
Book a call with our legal team here.
Our legal commentary is not intended to be a comprehensive review of all developments in the law and practice. Please seek legal advice before applying it to specific issues or transactions.
