Shareholders' agreements: why and when to use

If you are looking for an agreement

You may have reached this page looking for a shareholders agreement, not information on them. If you do just want a document, Net Lawman offers a number of comprehensive ones at: shareholders' agreements.

Introduction: controlling a company

In a limited company (whether public or private), each share (usually) carries the right to one vote. When it comes to making most decisions, if the members who together hold more than 50% of the shares agree on a motion at a meeting (perhaps to approve directors' bonuses) then that motion is carried, regardless of the opinions of the other shareholders. So, if a single person (or another company) owns more than 50% of the shares, he or she controls the company outright and can veto the decisions of all other shareholders.

This arrangement doesn't suit all shareholders. Common situations where it does not include:

• a small number of people work together and want decisions to be taken unanimously, or nearly so;
• some shareholders want to be able to influence certain decisions that are important to them;
• some shareholders are not directors and therefore are not in any position to influence the company's day to day affairs at all (outside of a general meeting);
• a shareholder may have lent money to the company but has no personal involvement in day to day management;
• some shareholders may have contributed other things to the company (such as their time founding it, or their intellectual property);
• the members have formed the company for a specific joint venture.

So how do you protect a minority investor from having his investment controlled by a dominant majority shareholder, and how can you distribute power over decision making more equally between the owners?

In these situations, there are two options: use different classes of shares, or use a shareholders' agreement.

Using different classes of shares

The first option is to create different types of shares that have different values and rights. For example, preference shares are commonly used to give their owners (preference shareholders) rights to receive dividends before the holders of other classes, but without conferring rights on them to vote on decisions. A company may use multiple classes of preference shares: Preference A, Preference B, Preference C etc all with different rights. There is no restriction on what you can call different classes or what rights they give, so a company could even have a class called "Lions" that gives the right to be the first in line at the buffet following the shareholders' meeting.

However, creating multiple classes of shares is disadvantageous because:

• those extra classes of shares have to be “administered”. They must be set up, articles must be changed, meetings called, shares issued, plus there is regular annual work;
• all information about shares must be lodged at Companies House, where anyone can see it. A lack of privacy over who controls your company may not be desirable;
• the rights are attached to the shares and not the circumstances. If a shareholder sells or gifts his shares, the rights that those shares give the holder are immediately transferred to the new owner. Remaining shareholders are likely to encounter difficulties in protecting their investments whenever the shares are sold (the interests of the selling shareholder are no longer in the long term success of the company but the short term value of the shares) or one of the shareholders dies (his beneficiary could be an inexperienced or uninterested family member). The other shareholders have no control over the transfer and no control over who obtains the rights.
• you may want to be specific about aspects of running the company that cannot be covered by descriptions of rights in shares.

Using a shareholders' agreement

By far a better way to regulate the power between shareholders and particularly to set out the limits of freedom of director-shareholders is to use a shareholders’ agreement.

We very strongly advise every shareholder in every company to use a shareholders’ agreement. If you own 90% of the shares, you will want to be sure that your minority shareholder will not be rushing to a judge to assert his statutory rights. Of course, if you are the minority shareholder, you will want to make sure your fellow shareholders are not taking you for a ride.

A shareholders agreement:

• protects minority shareholders' rights and investment value

Without an agreement, majority shareholders may force issues that are not in the minority shareholders’ interests. These in turn could reduce the value of the minority shareholders’ interests in the company.

• clarifies who makes decisions

In circumstances where some shareholders are also directors, operational decisions that would ordinarily be taken by directors accountable to all shareholders or made only with the consent of all shareholders might be made instead in the interest of a single shareholder without having been brought to the attention of the others. A good shareholders’ agreement should set out the decisions that must be made in the capacity of a shareholder rather than a director.

• empowers shareholder-directors

Shareholder-directors may feel unable to take business decisions (and act as directors) without the approval of other shareholders. When decisions need to be made fast, gathering all shareholders together to vote on a motion isn't a practical option. A shareholders agreement lets shareholder-directors how far they can act without needing the approval of others.

• acts as a record of agreement

Disputes between shareholders and other stakeholders are expensive and can be disruptive and detrimental to the on-going operation of the business. A shareholders agreement is a record of what can and can't be done and prevents claims that something was agreed when it was not.

In a dispute, a judge or arbiter is likely to make a subjective opinion without a full understanding of the past contributions of shareholders. Unless there is an agreement to state otherwise, he or she may well give the majority shareholder the benefit of the doubt.

• keeps your company business private

The agreement does not need to be disclosed to anyone other than the shareholders. It is not made available to the world at Companies House. For sensitive arrangements, a shareholders agreement is the best way of recording the deal.

• offers flexibility when shares are transferred

A shareholders agreement can be written to deal with scenarios of transfer, particularly those such as on death. For example, rights could only be given to shareholders who have held the shares for a period of time, or to those that also work in the company. The effect is that simply owning the shares doesn't necessarily confer rights or confer them immediately.

• requires no on-going administration

Once agreed, signed by everyone and dated there is no further work or administration.

When to create a shareholders agreement

A shareholders agreement can be put in place at any time. Any member can suggest using an agreement. It doesn't require a vote to explore using one, although all shareholders will have to sign and agree to it for it to become valid.

A new agreement is essential on occasions when:

• the company is formed
• a shareholder dies or sells his shares or wants to do so soon
• shares are issued to a new shareholder
• one shareholder's holding is divided amongst many others (for example, if a shareholder dies and leaves the shares to his children)
• the appointment, resignation or exit of a director-shareholder
• the company borrows money from a shareholder
• the company business model changes: new products or services, new markets, all require change to “how we do things”

The best time to create an agreement is always 'now'. The issues that it deals with may not have yet happened, but by the time they do, it may be too late to do much. If you already have an agreement, now might also be a good time to check that it plans for the situations that might change the value of your investment in the company. Shareholders agreements should be updated if circumstances change.

Further information and documents

Our comprehensive model documents that can be easily amended to suit your requirements can be found at: shareholders agreements. We also offer a legal drafting service if you would prefer that we take your instructions and draw your agreement for you.

This was the first article in a series. The second is Shareholders agreements: step by step guide.