Having a shareholder’s agreement, often called a founder’s agreement, is an area that is often overlooked by many limited companies including start-up’s and SME’s. They can however be invaluable in protecting the company and ensuring its smooth running moving forward. If there is more than one shareholder/founder it is of vital importance that you agree how the business will be operated. In essence this is what a good shareholder’s agreement does: it gives guidance on how certain issues in the business will be run ranging from how voting rights will be allocated to shares, intellectual property, and how disputes will be managed, and many other issues. This article will explain why your business needs a shareholder’s agreement.
Isn’t this what your articles of association do anyhow I hear you say. To a certain extent yes, however a well drafted and properly tailored shareholder’s agreement is complimentary to the articles, and perhaps more importantly the shareholder’s agreement is a private contract between the shareholders, which is not filed at Companies House. As it is not a public document it is often wise to include the shareholder terms of agreement and operational issues in your shareholder’s agreement which you do not want the public, including your competitors, to know about.
By way of a final introductory point shareholder’s agreements are particularly necessary different shareholders are to be treated differently, and where there are different classes of shares, or if certain employees will be granted vesting shares or other shares in return for their services.
So here are the main reasons why you need a shareholder’s agreement:
Shareholders may not agree
Disagreements happen, particularly in the running of the business because different people have different opinions about what is best for the company. This is inevitable, even when there is a good personal understanding and rapport between the key people in the company. Therefore it is rational to agree to provisions that should apply if a disagreement arises. This can be particularly beneficial to the long term interest of saving of time money and goodwill, as well as of course reducing the risk of legal disputes.
What systems are agreed upon will vary from shareholder’s agreement to shareholder’s agreement. The sensible approach would be for provisions to detail a dispute resolution framework, as well as provisions detailing what happens in a deadlock.
Checks and balances on the board of directors
The board of directors usually handles the day-to-day running of the business. The Companies Act 2006 stipulates what type of decisions are reserved for shareholders in a limited company. However shareholders may want to augment this and add certain issues which require shareholder approval which are not covered by the Act.
Control the transfer of shares
People move on and sometimes a shareholder may wish to sell their shares. A shareholder’s agreement can place limitations on this otherwise rather unlimited right. For example other shareholders or the company may have a first right of refusal over the shares, which will be particularly useful where the proposed buyer is a party the other shareholders do not approve of.
Protect majority shareholders
Majority shareholders can benefit from what is known as a drag along provision, which is where an offer is received for shares in the company and the majority shareholders wish to accept that offer. The rights allow the majority to force the hand of the minority shareholders on the same terms to avoid losing the deal. This is key for those that develop intellectual property and wish to sell once the product has been successful.
Protect minority shareholders
Minority shareholder’s can be protected by allowing certain decisions to only be made by the unanimous consent of all shareholders. Furthermore if there is a sale of the shares in the company, minority shareholders can insist on what are known as tag along provisions that enable a minority shareholder to tag on to a majority shareholder. This protects a minority shareholder because a majority holder may only attempt to sell his/her own shares instead of finding a buyer for all the shareholders. This is something that will look attractive to incoming investors who often come on board as minority shareholders.
Sometimes a company’s biggest asset is its intellectual property, and often that intellectual property is created by shareholders, particularly if the company is a start-up. Setting out how the intellectual property is owned in the shareholders agreement is of crucial value if this is the case, particularly if the plan is to find inward investment, or sell once a given milestone is reached.
Connected to this the company will want any intellectual property assigned to it that any employee or shareholder who leaves early creates.
These are becoming increasingly common particularly in the technology and creative industries sector, and briefly put include the rights of certain employees and key persons in the business to be issued shares on sale or once a particular milestone has been reached. The founder shareholders or existing shareholders will need to have vesting rights properly and clearly defined in order to protect their interest.
It will make you attractive to investors
A shareholder’s agreement will increase the attractiveness of the company for investors as they will be reassured that disputes can be dealt with adequately. Furthermore having an agreement in place adds credibility to your enterprise by demonstrating a certain level of professionalism and forward-thinking.
Vary how much dividends are paid
Not having a shareholder’s agreement in place means that some shareholders may end up receiving too much by way of dividend payments or vice versa, or the company could be held to ransom by a minority shareholder veto. Therefore a good shareholder’s agreement should set out the various dividends to be paid to each shareholder with a different classes of shares, or limit withdrawals to protect the capital and cash flow the company.
So if you would like to discuss this or any other issue please do not hesitate to contact us. Written by Bruno Rodrigues.