The shareholders of every closely-held company with two or more shareholders should give serious consideration to having a shareholders' agreement.
Shareholders' agreements govern the relationship between the shareholders, their ownership of the company, and record their agreement on issues such as the control, management and future ownership of the company.
A shareholders' agreement does not replace the memorandum and articles of association, but it does provide a set of ground rules over and above those mandated by legislation.
A great advantage of a shareholders' agreement is the process of creating one, which forces the stakeholders to analyse:
the rationale for their "partnership" with their fellow shareholders;
the business values that are important to them; and
their vision or strategy for the company.
The process itself often uncovers areas of incompatibility or differing expectations. It is best to address these differences early.
Unfortunately, in legal practice we see many shareholder disputes and break-ups. It is a sad fact that some of the most acrimonious involve members of the same family. One of the primary purposes of a shareholders' agreement is to provide an agreed method by which disputes are resolved, thereby minimizing acrimony, legal fees, and loss of value of the company's business.
No two shareholders' agreements are exactly alike, as no two groups of shareholders are exactly alike. However, when discussing a shareholders' agreement, consideration should begiven to the following matters:
The structure of the company:
Harmonious shareholder relations require that all shareholders consider their share holding proportion to be fair. The division of the share capital of the company is something that must be specified in the memorandum of association of the company, but it is useful to specify the shareholdings in the shareholders' agreement for the sake of completeness, and deal with the issue of entitlements to future share issues.
The parties to the shareholders' agreement:
Consideration should be given to whether all, or only some, of the shareholders will be party to the shareholders' agreement. If the company has a significant number of shareholders,itcan be administratively difficulttogetallshareholders to agree to the contents of a shareholders' agreement, and in such cases it is an option to include only the major shareholders who can influence decisions. However,to ensure effective and uniform implementation, it is ideal if all shareholders commit to the shareholders' agreement.
The shareholders' obligations to the company:
Any obligations or commitments required of shareholders should be specified.Theseobligations may include the provision of funding to the company through shareholder loans, (or the provision of guarantees to third party funders), or the supply or delivery of products, services or special expertise. Shareholders may wish to restrict their co-shareholders competing with the business carried on by the company.
To avoid dispute, it is important to decide upon, and to record in the shareholders' agreement, the terms on which any shareholder loans are to be made, and the terms on which products or services are to be supplied to the company.
Before agreeing to incur any financial obligation to the company, any shareholder should ensure that they can meet these obligations when called upon to do so.
The shareholders' rights:
The rights of the shareholders to such things as information about the day to day operation, administration, and financial status and affairs of the company should be detailed, including the format for shareholder reports, and the intervals at which information must be provided. This is vital for shareholders who are not involved in the day to day business of the company, and also for shareholders who do not have Board representation. These rights to information must, of course, be balanced against the time and cost to the company of providing information.
There is also the issue as to whether shareholders are permitted to sell, pledge or give security over their shares. Changes in ownership or control of shareholdings may be important and adverse to the other shareholders.
Shareholders' meetings:
The shareholders may wish to specify the frequency at which shareholders' meetings will be held, and the rules governing the calling of shareholders' meetings.
It will also be important to set out in the shareholders' agreement the quorum required for a valid meeting, any matters of corporate decision making which are reserved for the shareholders (as opposed to the directors), and the voting percentages required to make such decisions. These rules require some balance to ensure that, on the one hand, minority shareholders are not oppressed but that, on the other hand, minority shareholders cannot hold the majority to ransom.
Directors:
Shareholders appoint directors to manage the company. It is therefore important that the shareholders agree on the composition of the board, and how the board is to make its decisions. Following are some of the specific matters shareholders should consider:
the number of directors;
the method of appointment of the chairman, and whether the chairman is to have a casting vote;
the respective rights of shareholders to appoint directors;
the frequency of directors' meetings, the method(s) by which they may be held e.g. in person, by telephone conference, etc, and the notice required;
the quorum required for valid directors' meetings;
the rules governing decision making by directors, including the percentage of votes required to pass a resolution on certain matters and what, if any, decisions require unanimous approval;
whether outside board members will be appointed; and
director compensation.
It is important when deciding on these rules that each shareholder is comfortable that they end up with an appropriate degree of control to protect their investment. It is also important that the company has the capacity to make and implement decisions. This can involve agreement on the steps to be taken to resolve a deadlock, particularly where there are only two shareholders holding an equal number of shares. The shareholders should be prepared to agree that the ultimate resolution may involve one of them being bought out for a reasonable price.
Day to day management:
Directors may delegate their management responsibilities to one or more employee managers, in orderthat the day to day operations and finances of the company are managed on a full time and professional basis. Senior managers will likely be required to report to the Board. The decision to appoint one or more managers, and brief details as to the scope of their authority and responsibility, are often set out in a shareholders' agreement. The scope of executive authority and responsibility is often limited by and defined in an annual business plan and budget, approved by the Board.
It is important that the relevant provisions in the shareholders' agreement clearly distinguish the roles of shareholder, director and manager (as discussedin the sections above), as these are commonly confused.
Dividend policy:
The distribution of profit is an area of potential differing shareholder expectation, and disputes can be avoided by agreeing a policy and recording it in the shareholders' agreement. Of course, any policy should make provision for the retention of profit to meet future funding requirements as well as mandatory legal retention requirements.
Issue of new shares:
A company's funding requirements are often met by the issue of new shares by the company. The issue of new shares will have an affect on the respective share ownership of the existing shareholders, and they should agree the rules and procedure to be adopted for the issue of new shares at the beginning of their shareholding relationship. While the shareholders may wish to adopt rules which protect their percentage shareholdings, it is important to look to the future and anticipate occasions when it may be beneficial to issue new shares, or options to subscribe for new shares, to outside parties, e.g. to attract senior management or key suppliers or customers to the company.
Exit Issues:
When a shareholder first contemplates share ownership, they should ask the question "Can I exit if I have to?"
Agreement by shareholders as to the rules and procedure to be followed when selling their shares is a vital part of formulating a shareholders' agreement. It is usual for shareholders to agree to a pre-emptive rights procedure, requiring a shareholder to offer their shares for sale to the other existing shareholders before being able to sell them to a third party. The question whether a shareholder must offer to sell all of their shares, or may offer only some shares for sale, should be addressed. It is important that the existing shareholders be given time within which to decide whether to accept an offer by a fellow shareholder, and time to arrange finance,ifnecessary.
There are many variations and add-ons to this basic pre-emptive rights procedure, including such things as tag-along provisions (where minority shareholders can require a third party purchaser of the majority of the shares to buy their shares as well, on the same terms) and drag-along provisions (where a selling majority can require the minority shareholders to sell their shares to the outside purchaser).
There is also the issue of what happens if there is a change in control of a shareholder, or an individual shareholder dies. It may be that the remaining shareholders will want to be able to purchase these shares under this scenario.
The issue of new shares and the sale of existing shares raise questions of share valuation. It can be useful to agree a valuation mechanism in the shareholders' agreement in the interests of both fairness and certainty.
Consideration should also be given as to whether it may be appropriate to restrict departing shareholders from competing with the company after their departure.
Termination:
Issues such as the term of the shareholders' agreement, a procedure for renewal of the term upon expiry, and the circumstances which will give rise to early termination, should all be agreed and recorded.
It is also sensible for shareholders to agree at the beginning of their relationship what happens if a shareholder breaches their obligations under the shareholders' agreement, or suffers an event such as bankruptcy.
One option is for defaulting shareholders to be given time to remedy the default, failing which their shares are bought out by the other shareholders. Whatever mechanism is agreed, it is important to specify clearly what constitutes a default, and the terms of any consequential buy-out, including the terms of payment and any penalty to be imposed on the defaulting shareholder.
Dispute resolution:
As mentioned in the introduction, a mechanism for resolving disputes among shareholders should be near the top of the list of matters to be agreed by the shareholders and recorded in the shareholders' agreement.
Shareholders often agree to a tiered and escalating process, whereby any dispute is first referred to senior managemen to feach disputing party, who are required to meet and use good faith endeavous to reach a resolution within a specified time frame. If a resolution cannot be reached, the dispute is then referred to mediation (a structured dispute resolution process conducted by a professional dispute resolution practitioner, albeit that resolution remains subject to agreement by the parties), and if mediation is unsuccessful to arbitration or to court where a decision is made which is binding on the parties.
Another way to resolve a deadlock is to agree a process of bids and counter-bids to allow deadlocked shareholders to buy out each other.
Conclusion:
The very process of negotiating a shareholders' agreement will give all the shareholders a real understanding of their fellow shareholders.
Each shareholder must consider the "worst case", and be comfortable that they can live with the arrangements agreed. Although it is tempting to put off difficult dialogue negotiations,itis much better that the shareholders go through the process and reach an agreement because the good news is that a shareholders' agreement, even if imperfect, lets everyone know where they stand and reduces the chances of future disagreements spinning out of control.
By Peter Stansfield
© Al Tamimi & Company 2007
