Shareholders Agreements 101

A shareholders agreement is an agreement between all shareholders of a company that governs how the company will be run and what are the rights of each shareholder. Of course, this article will also be relevant to other similar co-owner agreements such as unitholder agreements, partnership agreements, and joint-venture agreements.

Do I really need a shareholders agreement?

If a company has more than one shareholder, it is almost always essential to have a shareholders agreement. Whilst everyone likes to think that they get along fine with their business partners, you never really know what the future holds. Some of the benefits of a well-written shareholders agreement include:

• it reduces the potential and expense of business-threatening disputes by:
  • clearly defining each party’s rights and obligations, and
  • by setting a dispute resolution process;
• it places obligations on the shareholders towards each other to behave in good faith and to avoid conflicts of interest (for example, prohibiting them to set up a rival business); and
• it provides a framework for what happens when there is a sudden (and often unforeseen) change to the personal situation of a shareholder such as death, disability or insolvency.

What do I need to look for in a shareholders agreement?

Whilst the importance of different provisions will change depending on the type of business and industry, as a rule of thumb we always look for these four key areas:

1. Board of directors and decision making
2. Dealings with shares
3. Capitalisation and funding
4. Dispute resolution

Board of directors

A shareholders agreement almost always sets out provisions for how directors are appointed (and removed) and how decisions are carried out by the board of directors.

Appointments

It is important for you to examine what is your entitlement as a shareholder to appoint directors. The base position in the Corporations Act 2001 is that directors are appointed by a majority vote of the shareholders.

This means minority shareholders are especially at risk at being excluded from the decision-making of the company. Ideally, you want the ability to appoint your own ‘representative’ director, which cannot be voted out by other shareholders (except sometimes in extreme circumstances such as fraud or crime). It is reasonable for you as a shareholder in an SME to expect to have ‘a seat at the table’, except maybe if your shareholding is very small. Always insist on it.

Decision-making

After that, you need to check how the board of directors actually makes decisions. Usually each director has one vote, but often there is a chairman with a casting vote, or sometimes a certain director can have a veto power. Also, there is usually a list of decisions should require a special majority (ie, 75% of the votes) or even shareholder approval – make sure you are comfortable with what the board can do ordinarily, what requires a special resolution, and what is reserved to the shareholders.

Deadlocks

Finally, there must be a mechanism for what happens when the board is in a deadlock (namely, there are equal votes for and against a resolution). There are many types of ways to resolve a deadlock such as an adjournment of the meeting, a referral to a dispute resolution process, and a series of speciality clauses. A favourite of ours is a ‘shotgun’ provision, which states that upon a deadlock a shareholder may make an offer for the shares of the dissenting shareholder, which triggers a reciprocal right, and one party must sell. This provides a commercial incentive to reach an agreement (otherwise, it results in a party losing its shares).  

Dealings with shares

Ultimately, a time will come when you will exit your business. Your shareholders agreement will specify under what circumstances you are allowed to transfer your shares (whether by selling to a third-party, selling them to another shareholder, bequeathing them upon your passing or otherwise).

Right of First Refusal

Almost all shareholders agreements contain preemtpive rights (or, the right of first refusal). This means an exiting shareholder must first offer its shares (on the same terms as to a third-party) to the existing shareholders before it offers them to a third-party.

Watch out for tag-along/drag-along provisions!

Sometimes, shareholder agreements will contain tag-alone or drag-along provisions. These provisions provide for situations where (1) a majority shareholder is exiting the business, and a minority shareholder wants to ‘tag-along’ and also sell (this may cause problems to the exiting shareholder); and (2) a majority shareholder is exiting the business and wants to ‘drag-along’ a minority shareholder and force him to sell to the third-party (usually because the third-party requires it). Please make sure you look for these provisions and think about whether they should (or shouldn’t) be in.

Events of default

Finally, there will usually also be provisions that govern special situations – death or total disability to a shareholder, a shareholder becoming insolvent, or another event of default. Usually, the shares are valued at a market rate and are offered to the existing shareholders.

Capitalisation and funding

Your company needs to have mechanisms in place governing what happens when the company requires further funding. Questions to consider include:

1. Are shareholders required to contribute further funding?
2. Can they be kicked out of the company if they refuse to provide further funding?
3. If further funding is contributed, will shareholders contribute equity, put funds in as loans, or will they be obtaining third-party funding?
4. What happens if a shareholder has no funds to contribute?

Dispute Resolution

Lastly, you need to have an organised process to follow in case of a dispute. Usually, this involves a combination of alternative dispute resolution processes (for example, good-faith negotiation followed by mediation). Once those options are exhausted, you can set up a mechanism where the parties submit offers to buy each other out, or simply allow them to commence litigation. The dispute resolution provisions may also apply if there is a dispute as to share valuations.