It's not always fair weather: shareholders' agreements
The importance of a good shareholders' agreement for each and every shareholder cannot be overemphasized. Drafted in fair weather - that is, before a conflict arises - such an agreement can prove to be an excellent tool for preventing and managing disputes between a company's shareholders.
Together with a company’s constitution, a shareholders’ agreement provides the foundation for the corporate governance of the company and outlines what a shareholder can and can’t do. It also sets out a shareholders’ rights and obligations and their role in the management of the company.
The starting base for considering the terms of the shareholders’ agreements is to remember that there is no such thing as a ‘simple shareholders’ agreement. There is no cookie cutter solution or ‘one size fits all’. The shareholders’ agreement should be tailored to the specific needs of the company, its business and the respective shareholders.
That does not mean that the shareholder’s agreement needs to be unnecessarily long or complicated. What it means is that the issues and contingencies that need to be addressed in a shareholders' agreement are complex. There is no way around that.
General Drafting Considerations
Checklist. Never underestimate the value a checklist provides. The shareholders should each consider their own needs, the needs of the business and then work together to prepare a checklist of matters to be included in the shareholders’ agreement. This will force the shareholders to think and talk through all the major scenarios they may face in the company. This assures the shareholders have a complete and common understanding, avoids unspoken assumptions, and resolves many potentially contentious issues, at the beginning of their relationship.
Intrusion and Disruption. Situations change…people change…at some point a shareholder may want to sell or end the relationship with the company, or a shareholder may pass away or become bankrupt. The company might have to deal with someone else claiming through or on behalf of the shareholder and the company needs to have a clear record of what the shareholders agreed to for these other people to understand and implement if they come along.
Failure and Success. Both create conflict between parties. In a good shareholders’ agreement important matters are going to be addressed when you succeed (e.g. distributing profits, cashing in) or if you fail (winding up the company, getting out of the company).
The End. There is always an ending. Businesses and its people develop in different directions. If the association between shareholders breaks down or needs to change, you want to make changes as quickly, as fairly and as cheaply as possible for all concerned, and without destroying the underlying value of the business.
Specific Drafting Considerations
Funding. The shareholders’ agreement should specify how the shareholders fund the acquisition of their shares. For example, some shareholders may contribute cash funding to subscribe for the shares, whereas other shareholders may transfer IP to the company in exchange for their shares, or others may contribute services in exchange. Shareholders may also decide shares are not all issued to the shareholders at the same time and that shares may be vested or issued over a period of time.
Directors. The shareholders’ agreement should specify their rights (if any) to appoint directors, the circumstances when they may lose that right (such as if their shareholding drops below a percentage) and provisions so that other shareholders may not remove another shareholder’s appointed director as well as provisions relating to the appointment of alternate directors.
Management. The roles and obligations of the shareholders should be spelt out so that each shareholder is clear what is required of them and the level of commitment. The shareholders’ agreement should provide for rights to access information and financial reports so that shareholders (particularly minority or those without director appointment rights) are clear what they are entitled to receive. Additionally, the shareholders’ agreement should include provisions relating to decision making (voting rights of directors and shareholders), the resolutions required and other processes relating to major decisions.
Dividends and Financing. The shareholders’ agreement should specify the circumstances when dividends may be payable. Some shareholders’ agreements may also provide for broad terms on which shareholders have “first rights” to provide further funding before the company seeks external funding.
Transfers of Shares. These are critical in a shareholders’ agreement, and usually include a set of pre-emptive rights, and “drags” or “tags” or other similarly named clauses that broadly provide for circumstances under which certain shareholders may require other shareholders, or are required by other shareholders, to participate in a sale to a third party. Shareholders may also consider whether a shareholder must transfer their shares if they no longer participate in the management/operations of the company, and if so, whether all or some of their shares are transferred and at what value.
Exit Strategy. The shareholders’ agreement should also make clear and identify a general exit strategy, which could be a buy-out, listing, sale of business, as well as provide for what would happen if certain shareholders want to exit, and the value at which they may exit.
Default. The shareholders’ agreement should set out a list of events of default and the consequences of default by a shareholder, including whether that shareholder is forced to transfer their shares, and if so whether the valuation would be at market or “fire sale” value.
Business Succession. For example, if a shareholder dies or suffers permanent disability, ensuring that the surviving shareholders avoid having to work with a member of the deceased shareholder’s estate. This involves taking out insurance but also vendor finance provisions in the event insurance policies are unable to be taken out or the proceeds are not the equal to the fair market value of the shares.
Deadlocks. The shareholders’ agreement should set out the consequences if there is a deadlock or if a dispute cannot be resolved. Provisions that are sometimes seen in shareholder agreements include “shotgun” provisions where a party specifies a price at which it is willing to buy-out or be bought-out by the other shareholders. Other provisions include put and call options or sometimes even a forced wind up of the company.
Valuation Methods. It is prudent to set out the method by which shares are to be valued in relation to pre-emptive rights and mandatory sale events. For example, shareholders’ agreements often provide for the appointment of an external valuer with set criteria for valuation.
Alternative Dispute Resolution. To avoid the cost and uncertainty of litigation, it is often advisable that parties be required to try and resolve their disputes through alternative dispute resolution, before any formal litigation can be commenced.
A shareholders’ agreement is best prepared before the parties enter upon a venture, when there is goodwill between the parties and there have not been any disputes or disagreements about the management of the business.
If the parties to a shareholders’ agreement succeed in having a long and harmonious relationship, it may well be attributable to spending time at the outset considering how they want to work together and thinking through the possible pitfalls. If they can do that co-operatively, the parties will have a strong foundation for a profitable, long term relationship. The best shareholders’ agreements are often put in the drawer and never looked at again because that level of good communication and common understanding that good associations are based upon has been accomplished in the process of doing the shareholders' agreement.
Written by Righardt Allers
This publication is provided as general information only and should not be considered or relied upon as legal advice. The law is complex and you should always obtain specific legal advice about your circumstances from a qualified legal practitioner.