Our last article covered why and when to use a shareholders' agreement: the methods shareholders can use to control a company, and the advantages of a shareholders' agreement over using different classes of shares.
This article covers what issues you should consider and what the steps you will need to take to draw up an agreement.
Many people wonder whether it is possible to write their own shareholders’ agreement or whether a solicitor is required. We believe that it is quite possible to draw it yourself, provided that you use a good template as a basis (such as our own).
The difficulty in drawing an agreement is not the legal wording but in considering the issues that the shareholders will face, and deciding what should happen in each scenario.
If you use a Net Lawman document, even if one shareholder still decides to use his solicitor, the whole process will be faster and less expensive that using a solicitor as a post box between multiple parties.
What is a shareholders agreement?
A shareholders' agreement is an agreement between the shareholders of a company. It can be between all or some shareholders, like holders of a certain share class. Its purpose is to protect your investment, build good relationships between you and other shareholders, and govern how you run the company together.
The agreement sets out the rights and duties of shareholders. It regulates selling shares in the company. It describes how you will operate the company. It provides some protection for minority shareholders and the company itself. And it defines how you make big decisions.
The agreement contains practical, important rules on the company and on your relationships as shareholders. This can help both minority and majority shareholders.
So what do you need to think about when drawing your agreement? We have 5 steps.
It is impossible to plan for every eventuality. What is more the agreement must be written within the framework of company law.
For example, you cannot simply stop Bill from voting a certain way. You must either give Bill only a different class of shares with reduced voting rights, or find some other words to deal with the issue without taking away his basic rights to vote his shares.
Directors versus members
Whenever some shareholders (also known as members) are directors and others are not, there will be potential for conflict.
Pay is an obvious possibly contentious area. Salaries and bonuses reduce the profit that could be paid to members as dividends.
While the payment of dividends is usually approved by members, often the payment of salaries and bonuses is approved by directors alone.
When some directors are also shareholders, there is an imbalance of power - some shareholders can decide on salary levels and bonuses that directly affect the level of dividends that can be paid to others, or of course, the cash resources left in the company.
Transfer of shares
Shares can change hands by accident (for example, on the bankruptcy or death of a shareholder) or intentionally (for example, for personal gain, after argument or injury, or to pay off a debt elsewhere). Other shareholders can control, to some degree, to whom the shares are transferred and what role the new member plays in the company by setting the rights and powers on transfer.
However, provisions that prevent the transfer to certain specific classes of people may be contentious.
Approving a change in business direction
Businesses evolve over time, maybe by changing the products or services they offer, or where or how they operate. Some changes are riskier than others, particularly if they involve shareholders acting in different roles (for example, trading with a company that is majority owned by a shareholder). An agreement should set out when member approval is needed for such business changes. For example, business direction might be managed by having shareholders approve a business plan produced by the directors on a regular basis (for example at the AGM).
Managing changes in the roles shareholders play
The directors manage the company. They are responsible to the shareholders. So your agreement can specify the role a director can play or the limits of his authority. A member can be as active as he wishes, from being a director, to being an active supporter offering advice, to being a 'sleeping' lender providing finance only.
Your agreement should reflect what happens when a member wants to be more or less active in the day to day management of the company.
Injection of debt
Loan agreements usually restrict what a company may do (such as take on additional debt or sell the collateral against the loan). This can gives the lender considerable power. There are extra complications when the lender is a shareholder.
Your agreement should consider how rights will change on the introduction of large creditor.
You may also want some protection for shareholder-directors against one of them making preferential payments if the company runs into financial difficulty.
Loan or share subscription money may be offered by trading partners or even competitors. There is nothing wrong with such a deal in principle, but existing shareholders should look very carefully at what knowledge and power they might accidentally give to some other person. The pleasant, easy-going person with who you deal today might be replaced next year by someone not so friendly. Your agreement may contain provisions linked to future trading with a shareholder or ownership of stock or other assets.
At some point, some members will want to sell their shares or wind up the company. Unfortunately, lack of knowledge of the future inhibits and restricts the arrangements you can make in advance! You can do just two things when planning for exit.
One alternative is simply to set down a statement of intention. This has no legally binding force, except perhaps in a supporting role, but it does act as a reminder that there is a time frame. It may be that a lender will have the benefit of a separate loan document, which does provide the right to enforce the action or proposal in the shareholder agreement.
The second alternative is to make provision for precise alternative events. They might include
- sale of the company;
- sale of the business out of the company;
- some shareholders buy the others out;
- a public placing of shares is sought;
- other third party capital is sought;
- the assets are sold and the company wound up.
Of course, you have to beware of severely damaging some interests in favour of others. For example, a shareholder-lender is in a very strong position once a loan has become due for repayment. They may have added strength if the other shareholders have agreed to sell the company on a specific date - and they are the only buyer around!
Another consideration is what happens when a shareholder leaves under bad circumstances. For example, they may have breached their duties as a director, terminating their employment contract and his role within the company.
With regard to agreements, shareholders in joint ventures are able to decide exactly what the deal is to be, subject only to compliance with the general law. Because parties to a venture have been discussing together for some time, the detail of what is agreed is often overlooked - with disastrous consequences.
In our experience, the only way to cover even the main alternative outcomes is to consider a multitude of possibilities.
We advise that you write down a list of assumptions, winnowed from your business plan, then for each, start asking 'what if' questions, always with a view to how the different results will affect the shareholders. The key question is always 'who will have the power if?'.
Preventing a former shareholder from setting up in competition
A disgruntled shareholder may decide that he can set up in competition, especially if he has also worked in the business. There may be linked employment issues in competition that are covered by the employment contract, but a shareholders agreement should also include provisions for competition. The Net Lawman template documents provide full protection for the company and the continuing shareholders.
Shareholders invest in companies for a large number of reasons. You should identify the interests of each party before drafting your agreement. The most obvious reason is to benefit financially from the value of the company increasing, but there can be others that are equally or more important to different people. These might include:
- the value and timing of dividend payments
- on-going employment as a director (status or benefits as well as pay)
- being able to influence business strategy and direction
- maintenance of relationships with suppliers or customers
The purpose of the shareholder agreement is to restrict the freedom of action of the directors and other shareholders in order to protect the rights of one of more minority ones.So identifying the interests of all parties is crucial. All Net Lawman agreements cover a full list of possibilities.
In your business there may also be precise actions about which a minority would like to be consulted. You should identify what these are as well.
The valuation of a company is highly subjective. There are many ways to estimate value (for example, discounted cash flow or multiples of earnings), but it is impossible to put a definite value on a company. Even the value in the accounts is based on subjective opinions made by the accountant. When considering how to protect shareholder value, remember that each shareholder will place more value on some things than others.
Intellectual property in particular can often have huge value to a business, but little worth on a balance sheet. Net Lawman's shareholder agreements place particular emphasis on intellectual property because the hidden value can be so high. Although most companies haven't registered patents, intellectual property can also include trading names, methods of production, website domain names and copyrighted material.
Shareholders can be as active or passive in running the business as they like. But they need to set clear boundaries with the directors. Clarity of decision making is crucial.
Conflicts of interest can occur when a director-shareholder, who as a director is accountable to all shareholders, makes an operational decision that benefits him, but not all shareholders.It is often difficult to ascertain whether he was acting as a director (accountable to all shareholders, and with a duty of care) or a shareholder (not accountable to his fellow shareholders). A good shareholders agreement should set out the decisions a shareholder-director may and may not make without agreement from others. These are known as reserved matters.
Disclosure of decision making is also important. A shareholder-director may be able to make decisions that aren't reported to other shareholders. Again, clarifying what a director may and may not do without notifying the shareholders prevents a shareholder-director from acting in a way that is against the interests of the other members.
So how should you best set out what a shareholder-director may and may not do in each role? The answer is to use a shareholders' agreement to set out the role as a shareholder, and a directors service contract to set out the role as a director.
A directors service contract should also double as an employment agreement that sets out disciplinary and grievance procedures. All executive directors are also employees. This gives shareholder-directors additional rights over non-employed shareholders because an executive director can threaten great disturbance and expense by taking the dispute to an employment tribunal.
Traditionally, one share 'buys' one vote. The shareholder who has more than 50% of the shares can make decisions and controls the company (for some decisions, holders of more than 75% of the shares must agree). This isn't always what shareholders want: sometimes it can be beneficial for everyone to have an equal say and sometimes it can be beneficial to give a greater say proportionately to someone who has contributed more.
You need to set out what is a 'majority' in the context of needing consent. A shareholder-lender with 5% of the shares might insist that 100% agreement is needed for the most important matters to him or her. A group of shareholders working together may decide to restrict a wider range of decisions, but agree that it needs only 60% of them to make such decisions. Keeping the equation simple is usually the best option.
Adam, Bill and Colin formed a company, which they run together. Adam invested £10, Bill invested £15 and Colin invested £25, all in £1 shares, each carrying one vote.Without an agreement, there would be constant stalemate because Colin has the same number of votes as Bill and Adam together. Adam, Bill and Colin decide that they want decisions to be made unanimously. They draw their shareholders agreement so that certain decisions require 100% in favour before they can be passed.
Alternatively, they could decide that having invested more than either of the other two, Colin should be entitled to enough power to make decisions by himself regardless of the wishes of the other two.
Be aware that unanimous decision making isn't necessarily a magic bullet either. If something doesn't agree, you'll end up with stalemate, which can prevent business carrying on. Only insist on it for the most important decisions.
We offer a range of comprehensive shareholders agreement templates that can be edited easily to your precise requirements.
You might be interested in redrawing your executive directors service agreements at the same time as creating a new shareholders agreement.