What is a shareholders' agreement and why is it necessary for your small business? Shareholders’ agreement: Why is it necessary for your small business?

Asif Robbani discusses why getting a shareholders' agreement in place at the start of a business is so important.

A shareholders' agreement is a vital document to have at the beginning

A shareholders' agreement is a vital document to have at the beginning

It’s very easy for shareholders/owners to start a business and postpone their shareholders’ agreement; it is important to get these agreements in place to begin with.

When incorporating a company with two or more shareholders, a shareholders’ agreement is a key consideration. Although it is not a legal requirement, its purpose is to further regulate the way business between shareholders are conducted. This is very different to partnerships. In the absence of a partnership agreement, the partners can rely upon the provisions contained within the Partnership Act 1890. The same however does not apply to shareholders.

A shareholders’ agreement is a private agreement and there is no requirement to file it at Companies House. The shareholders can therefore enjoy confidentiality with regards to the terms contained therein. There are many benefits and they are as follows:

Shareholders can retain the right to make certain decisions

Directors are responsible for the day to day management of a company’s affairs. Shareholders may take the view that certain decisions should not be left to the discretion of directors. Instead, they may wish to make those decisions such as approving a financial transaction that exceeds £5,000. This is particularly useful where the company directors are not shareholders.

Sense of direction

A shareholders’ agreement can provide direction and stability. It implies that the shareholders have mechanisms in place to deal with future events and/or even disputes. It may assist when seeking to secure credit facilities as they are often looked at favourably by lending institutions and/or creditors.

Share issues

A frequent scenario involves the sale of shares or even the creation and allocation of shares. A well drafted shareholders’ agreement will provide a mechanism to allow a shareholder to sell his shares to either the remaining shareholders and/or to the company in the first instance prior to selling them to external third parties. This is useful as it restricts people (who may be complete strangers to the remaining shareholders) from acquiring shares in the company. There should also be provision for valuing the shares which should avoid further confrontation when during the valuation process.

There are instances in which a shareholder seeks to sell his shares to a third party at a price higher than the valuation given by the company accountant. A well drafted shareholders’ agreement would have allowed for the following:

The shares to be valued by the company accountant

The shares to be offered for sale to the remaining shareholders at the value specified by the accountant (and not the higher price offered by the third party).

If the remaining shareholders are unable to purchase the shares, then the company would have the right to purchase the shares again at the value specified by the accountant.

The above would have avoided unknown third parties from acquiring shares in a company with existing shareholders.

Flexible dividend policy

A shareholders’ agreement can provide for a flexible dividend policy allowing for different dividends to be paid to different shareholders depending upon the class of shares that they own. The same flexibility may not always apply when attaching rights to newly created shares.

Shareholder/employee relations

In today’s working society, directors and/or senior personnel are incentivised by being offered company shares. If their employment and/or directorship terminates (including an amicable resignation) a well drafted shareholders’ agreement will allow for their shares to be returned and/or sold failing which the exiting director and/or employee may retain the right to dividends and/or exercise voting rights notwithstanding the fact that they have left. A carefully-drafted shareholders’ agreement can include mechanisms that allows for a different valuation mechanisms depending upon the circumstances under which the relationship with the company comes to an end. This could be a key factor the ongoing shareholders.

Minority shareholder protection

A much cheaper alternative in comparison to a claim for unfair prejudice. A shareholder’s agreement can provide protection for minority shareholders by reserving certain decisions, such as company’s ability to issue further shares so that it requires the consent of all shareholders and not just the majority.

Disputes do happen and majority shareholders often make decisions that minority shareholders oppose. Without a shareholders’ agreement in place, majority shareholders control the company. The alternative for the minority shareholders is to pursue a claim at considerable cost in addition to risks.

Majority shareholder protection

A shareholders’ agreement can include ‘drag along’ provisions. In circumstances where an offer is received to buy all of the shares in a company, the majority shareholders can compel the minority shareholders (who may oppose the sale) to accept the deal.

Nothing stays the same

The reality is that shareholders do sometimes leave for varying reasons. A well drafted shareholders’ agreement can help to ensure that the matter remains amicable. If a shareholder wants to leave, the ongoing shareholders may wish to apply restrictions on the exiting shareholder’s ability to start a competing business. Such restrictive covenants can be invaluable in terms of protecting the interests of the company.

Resolve disputes

In case of a dispute, a shareholders’ agreement can include specific provisions for dealing with disputes. These can include mediation and/or arbitration and in most cases is much cheaper and quicker than legal proceedings.

Shareholders do have disputes

This is perhaps the most important reason.

It is often difficult to contemplate a scenario in which the shareholders may fall out, or find difficulty in making decisions. This is particularly at the beginning where there is a lot of energy and positive thinking between shareholders.

However, disagreements can and they do occur. In fact, there is a separate division of the high court (companies court) that deals with company matters. Trying to agree provisions that should apply if there is a dispute is too late. It is easier to agree mechanisms before a dispute arises which is usually fairer and with all parties’ agreement.

The above are some of the reasons why a shareholders’ agreement is important. The primary purpose of the agreement should be to protect the shareholders and the company. With those objectives, why would shareholders not want to enter into such an agreement? The alternative is to risk disputes that could arise in various scenarios and engage in lengthy and costly legal proceedings when in reality clear provisions to avoid a dispute could have been agreed and documented at the outset.

Any agreement should be reviewed periodically to ensure that it remains up to date and relevant.

Asif Robbani is director of Francis George Solicitor Advocate.

Further reading on legal considerations

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