When Do You Need a Shareholder's Agreement?
A shareholder's agreement is necessary when a company has multiple shareholders, especially in cases where ownership is divided or no clear majority is in place. You need such an agreement to outline the responsibilities and rights of each shareholder, avoid future business disputes, govern decision-making individuals, set out how the financing will work, and determine the course of action if a shareholder wants to leave the company or sell shares.
There are several more instances when you'll find yourself in need of a reliable framework to ensure the smooth running of your company.
This guide will explain what a shareholder's agreement involves, why it's useful, and when it can benefit your interests in a company with example scenarios relating to different clauses of a shareholder's agreement so you can get a practical sense of its purpose.
What is a Shareholder’s Agreement?
A shareholder's agreement is a contract that regulates the business relationship between shareholders in a company.
This type of legal document contains a range of clauses that deal with matters such as the rights and responsibilities of each shareholder, the appointing of directors, clarifying who gets to vote for approval of certain actions, the funding arrangements, and the trade restrictions that shareholders and directors must comply with.
The provisions in a shareholder's agreement go beyond directing the company's operation. It dives into rules for managing more complex aspects for example, if a shareholder wishes to sell their shares or if a shareholder becomes incapable of fulfilling their duties.
Although it’s not legally mandatory to have a Shareholder’s Agreement, they are highly recommended to avoid potential disputes and legal matters.
Benefits of a Shareholder’s Agreement
Now that you're more familiar with the concept of a shareholder's agreement, let’s discuss why you need one for your company.
It regulates the flow of everyday management in the company.
It protects majority and minority shareholders.
It ensures the continuity of business in the event of a deadlock.
It controls how shares are transferred.
It prevents and resolves disputes among shareholders and directors.
It outlines financing aspects and paying dividends.
It defines the steps to be taken for shareholders exiting the company.
When You’ll Need a Shareholders’ Agreement
Even with all the benefits listed in front of you, it can still be confusing for the non-attorney eye to decipher how a shareholder's agreement can help their business in real-life situations.
This brings about the question; when will you need a shareholder's agreement?
Well, there are plenty of times when a shareholder would not only benefit your company but also keep it from falling apart.
When Deciding How to Run Daily Operations
In many cases, for example, shareholders don't participate in the day-to-day running of the business. Even if things start as such, shareholders typically end up bringing in directors to form a board to take up the duties of decision-making.
A shareholder's agreement can state who the directors are, how they're selected, when they're held accountable for decisions, and when they're obligated to get the shareholders' approval on major decisions.
When Majority Shareholders aren't Considering Minority Shareholders' interests
A provision in a shareholder's agreement can also make unanimous approval a must-meet condition for certain decisions to go through.
This prevents majority shareholders from enforcing decisions that aren't in the best interest of minority shareholders. In other words, minority shareholders get to "veto" specific decisions.
When Majority Shareholders Try to Sell or Transfer Shares
A shareholder's agreement can also come in useful in instances where majority shareholders try to sell shares. A tag-along clause ensures that minority shareholders receive the same offer as the majority shareholders, so they're not left behind after the sale or pushed into accepting a lower price or unfair terms.
Additionally, if a shareholder wants to transfer or sell all or a portion of their shares, you don't want them selling or transferring shares to a competitor or an unknown party.
A provision in the shareholder's agreement can give existing shareholders the right of pre-emption. This enables the remaining shareholders to buy the shares first before they're offered to an outside entity.
When Minority Shareholders are Preventing Good Deals from Going Ahead
As a majority shareholder. you may need minor shareholders to get on board with certain decisions. In this case, a drag-along clause in your shareholder's agreement can force minority shareholders to consent to these decisions (such as business deals or sale arrangements), preventing them from hindering the company's interests.
When Disputes or Deadlocks Break Out
Another situation that may occur, even if you have an amicable relationship with other shareholders and directors, is business disputes. These can cause disruptions that waste plenty of the company's precious time and money.
You can avoid that loss with a shareholder's agreement that includes guidelines for handling potential disputes regarding the decision-making process.
Even in the event of a deadlock where shareholders and/or directors fail to agree on key decisions, a shareholder's agreement can solve this. It can navigate the company through stalemates with a deadlock clause for quick resolution.
When Funding is Due
A shareholder's agreement can save you the hassle of figuring out where the funding for the running and expansion of the business should come from, as well as when to pay out dividends (for example, preventing the board from releasing dividends until the shareholder's loan is repaid).
The contract can give certain shareholders the right to provide funding before money from external parties is brought in. It can also include provisions for giving shareholders who contribute to funding preferential interest rates.
Additionally, the shareholder's agreement can specify who can access company funds and whether shareholders are personally responsible for providing guarantees for loans (and the consequences if they fail to do so).
Now that you have a better understanding of when you'll need a shareholder's agreement, here are three examples that'll further convince you of the importance of this business contract.
Scenario 1
Imagine Adam and Victor, business associates who decided to launch a company as co-founders. Adam owns 30% of the company's shares whereas Victor owns the rest.
Adam wants to sell his shares in the company, and a competitor is willing to buy them for a 25% premium above market value.
Thanks to a shareholder's agreement that Adam and Victor had set up beforehand, a ROFR (Right of First Refusal) provision grants Victor 30 days to match the offer made to Adam, reach a compromise, or negotiate a different deal.
The ROFR allows Victor to buy from Adam before the latter sells to an outside party.
At the end of the specified period, if Victor can't complete the purchase or they decline, Adam can sell to the competitor.
Scenario 2
Say that a VC (venture capitalist) firm is interested in buying a 60% majority stake at a 20% premium above market price in a company where Sarah is a 15% minority shareholder.
The shareholder's agreement includes a Tag-Along clause at the same price and terms.
In this case, Sarah has two options; she can exercise the Tag-Along right and sell with the company to the VC firm and receive the same lucrative offer, or she can choose to keep her shares and stay a minority shareholder in a VC-backed company.
Sarah should weigh the outcome of each option. She needs to consider that her influence and voting power might suffer under the new majority shareholder, while also studying the potential future growth of the company under the new leadership.
Scenario 3
Company Alpha has a board consisting of 6 members. They're split 3 against 3 on a decision to launch a new product that would require bringing in substantial investment. They turn to their shareholder's agreement to find a way to resolve this deadlock.
In the agreement, there's an outline of a deadlock resolution process that starts with non-binding mediation (a discussion facilitated by a third party) and moves to binding arbitration (an independent arbitrator makes a decision that everyone must accept) if mediation is unsuccessful.
The outcome is that the shareholders reach a final decision using one of the specified methods, avoiding a potentially prolonged and costly standstill.
What Can Happen if You Don’t Have a Shareholders’ Agreement
Establishing a company with fellow shareholders can be an exciting journey, but without a roadmap to keep everything on track, your venture can go downhill faster than you think.
Unguided partnerships can turn into financial and legal nightmares, even between friends or family members.
Without an outline that ensures all parties are aware of their responsibilities/rights and safeguards the business against potential conflicts, you could easily encounter the following pitfalls;
Spontaneous/Uncontrolled Shareholder Exits
If there's no ROFR provision in place, a shareholder who wants to cash out is free to sell to any outsider, who can very well be a competitor. If the shareholder decides to keep the sale domestic, disputes can still arise if there's no clear guideline for share valuation and sale
Missed Opportunities Due to Deadlocks and Disputes
Many important business-enhancing decisions may never come to fruition because shareholders and directors don't see eye to eye. Without an effective dispute-resolution process outlined in a shareholder's agreement, conflicts and stalemates will cost the company valuable time and money.
Unbalanced Power
If there isn't a shareholder's agreement to clarify the control mechanism within the company and the rights of all parties, chaos is bound to emerge. A majority shareholder can simply make one-sided decisions that may harm the business and create resentment.
Unfair Ownership Dilution and Buyouts
The absence of a governing outline for decision-making, such as anti-dilution clauses, makes issuing new shares uncontrolled and induces sudden, significant reductions in ownership stakes.
Additionally, without Tag-Along clauses, majority shareholders can sell shares without considering the minority shareholders' interests and cheating them out of a fair offer.
Distrust and Withholding Information
Without a shareholder's agreement to provide a protocol for sharing information (meeting minutes, financial statements, etc.), minority shareholders might feel out of the loop, generating mistrust and hindering their participation in key business decisions.
How To Create Your Shareholders’ Agreement
Drawing a shareholder's agreement requires a broad knowledge of business law and great attention to detail. You need to plan for everything, taking into account that all your provisions should comply with corporate law.
The process of crafting a solid shareholder agreement involves a lot of work including the following steps:
Identify the key shareholders and engage them in discussions to understand their interests, goals, and concerns.
Determine the problem areas that the agreement needs to cover to pinpoint the clauses you should work on.
Establish communication channels with all parties involved so you can openly discuss and negotiate the provisions.
Check the agreement terms before finalizing it to make sure everyone is up to speed.
Review the agreement regularly to verify that it still serves the interests of shareholders and addresses their needs.
Here at Parr Business, we have the expertise to create a shareholder's agreement tailored to your specific needs. Get in touch or take a look at our shareholders’ agreement services.
Final Thoughts
A shareholder's agreement outlines each person's responsibilities and rights when venturing into a shared company. It's not a legal obligation, but it's crucial for smooth-running business. It's highly recommended when there are multiple founders or partners, when ownership percentages differ, and when you bring in external investors.
