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Why do you need to have a Shareholders Agreement in place?

A Shareholders’ Agreement is a private contract setting out how the shareholders will behave in relation to a company. While the company is not usually a party to the agreement, it will typically include provisions as to what business the company can do, what matters require shareholders’ consent, the transfer of shares, the issue of new shares and holding a directorship. A Shareholders’ Agreement should be drafted in conjunction with the company’s Articles of Association, which may also (or alternatively) deal with some of the same issues.

We frequently see clients who believe that nothing will go wrong in the future and don’t have a Shareholders’ Agreement. This is usually the case where they start out in business. Unfortunately, we frequently support clients where things didn’t go to plan and they have a disagreement, which leads to a dispute. Without well-drafted contractual documents in place, the disputes can be expensive and costly for all parties. 

While it is not compulsory to have a Shareholders’ Agreement in place, there are certainly many advantages of doing so. We have considered below the crucial clauses we would expect to see in a Shareholders’ Agreement and importantly, what can happen when these provisions are not in place:

  • Non-competition clauses: It is important for the shareholders to consider the potential damage an exiting shareholder could have on the business. For example, would it be acceptable for a shareholder to set up a competing business? By including restrictive covenants in the Shareholders’ Agreement, it can restrict the shareholder from carrying out rival activities both while they own shares and for a period after. These clauses will also ensure that internal knowledge, vital for the company to protect the business from competitors, remains confidential.
  • Control over shareholders: The shareholders should consider the amount of control shareholders will have and what decisions will require consent. We recommend that the Shareholders’ Agreement contains a list of the types of matters that would commonly require shareholder consent. This should be carefully considered to reflect the business and any particular concern of the parties. In a recent case we advised two shareholders who wanted to exit their business and during the exit negotiations, the remaining third shareholder had the power to change the bank mandates without consent from all shareholders, which their agreement permitted them to do.
  • ‘Tag along’ and ‘drag along’ rights: These rights are particularly helpful when there are minority shareholders. A drag along right allows the majority shareholder to procure an exit by forcing the remaining minority shareholders to similarly sell their shares to a third party on broadly the same terms. A tag along can be applied where the minority shareholder wants to exit the joint venture, as the majority shareholder must procure that the purchase offer is extended to the minority shareholder.

These clauses essentially allow an exit route for the minority shareholder allowing them to receive the same price, terms and conditions as any other seller. In essence, these clauses enable the minority shareholder to leave the business should they wish to do so rather than being unable to sell their shares and be locked into a joint venture with an unknown new business partner.

  • Provisions for the resolution of deadlock in decision-making: Unfortunately, we frequently see situations where well-drafted documents are not in place and a dispute arises. For example, in a situation where a company with two directors and shareholders cannot reach an agreement it can create a ‘deadlock’ situation. Without a clear provision within the agreement clarifying what will happen in this situation then the parties will need to reach an agreement on a share sale or purchase, to allow one owner to gain full control of the deadlocked company. If this settlement cannot be reached then the company would be forced to wind up. We recommend that a Shareholders’ Agreement is drafted to pre-agree a dispute mechanism to avoid this type of scenario.

In a recent case we dealt with a shareholder’s dispute arose from a poorly drafted agreement, where inadequate legal advice had been provided and the agreement failed to include a practical mechanism to deal with a dispute. When the dispute arose, the parties were faced with a deadlock scenario. Given the practical difficulties, we recommend the inclusion of a deadlock resolution provision which will set out how the parties will deal with this scenario and include that deadlock must be referred to an independent third party, perhaps an expert in the relevant field or a mediator.

Provisions dealing with the departure of a shareholder: One of the main issues a Shareholders’ Agreement should deal with is what should happen if one of the shareholders wants to leave the business. Without an appropriately drafted agreement, one outcome is that the shareholder will be able to sell his shares to anyone which would leave the remaining shareholders working with someone they don’t know. The shareholders should decide if the other shares should be offered to the remaining shareholders first as this is usually the most common and practical option and include this within the agreement.

It is also worth considering what would happen if a shareholder dies, as without an agreement in place, the shares will pass to whoever inherits them under their will or intestacy. This may lead to undesirable and unintended situations. For example, the surviving shareholder may want to purchase the deceased’s shares, but the executor may not wish to sell them, or alternatively, the personal representatives may decide they want to be involved in the running of the business. We suggest that specific provisions deal with the death of the shareholder, depending on the circumstances of the company. This may include rights to allow surviving shareholders the first opportunity to buy the deceased’s shares.

This is not an exhaustive list of all the clauses we would expect to see in a Shareholders’ Agreement, but we hope it highlights some of the key issues to be considered.  Shareholder disputes can be costly but, with the right clauses in place, it will put the shareholders in the best position to deal with a dispute if it arises. For shareholders who do have a carefully drafted agreement in place, the clauses should deal with unexpected scenarios, and should a dispute arise, and the terms are broken, it will also provide a contractual remedy.

Our solicitors at Loch Associates Group can assist in all aspects of running your business, including preparing and advising on Shareholders’ Agreements and any disputes which may arise between shareholders.