By Jacob Carswell-Doherty
A shareholder agreement is one of the most important documents a company can have. As well as setting out how the company/business will be managed, it also deals with resolution of disputes between shareholders and how shares may be dealt with. The risk to shareholders and a company in not having a shareholder agreement in place is considerable because of the potential for a dispute amongst shareholders to affect the profitability of a business.
It is also important to have a shareholder agreement drafted by a lawyer who specialises in drafting shareholder agreements. A free precedent will rarely be sufficient.
Here are some scenarios which commonly arise where a shareholder agreement provides certainty of outcome:
- Death of a shareholder or principal who holds shares
- Ensuring majority shareholders are not hamstrung by minority shareholders
- Ensuring shareholders do not deal with or encumber their shares in a way which might not be in the best interests of other shareholders
- Dispute between shareholders
- Restriction on shareholders competing with the company
Common mechanisms found in shareholder agreements
If a shareholder passes away or becomes disabled for any reason, sometimes the last thing the surviving shareholder wants is to go into partnership with the next of kin of the deceased/disabled shareholder. Buy/sell provisions ensure that in the event of death or disability of a shareholder the remaining shareholder has the option of acquiring the shares of outgoing shareholder. It is common for there to be a life insurance or TPD policy which pays out to the estate, so no one is disadvantaged. Some shareholder agreements also contain “vendor finance” terms, which means the shares don’t have to be paid for right away, but the surviving shareholder takes the shares.
Tag/drag along rights
If a majority shareholder wants to sell their shares in a company, it is sometimes important to a prospective purchaser that all the shares in the company be sold. “Drag rights” provide that in some situations a shareholder who wants to sell their shares can compel other shareholders to sell their shares as well.
Conversely, tag rights act to compel a shareholder who intends to sell its shares to include other shareholders in the sale as well.
Dealing with shares
All shareholder agreements contain provisions which prevent shareholders from transferring or encumbering their shares in the company unless the process set out in the shareholder agreement is followed. Put simply, a shareholder who wants to sell its shares must offer those shares to the remaining shareholders first, before selling them to an unrelated purchaser.
Some shareholder agreements also contain provisions which provide that if a share is be used as security (for instance, for a loan) then the borrowing shareholder must procure agreement from the lender to be bound by the relevant terms of the shareholder agreement (i.e. the lender must agree to offer the shares to existing shareholders at market value before exercising any right of sale).
A well drafted shareholder agreement should always clearly set out what the core business of the company will be and the procedure for altering the direction of the business if necessary. It should also set out the number of directors of the board and the procedure for replacement of directors. However, disagreements between shareholders can and do arise. Litigation is a costly venture and can quickly put a shareholder out of business. Dispute resolution clauses ensure that litigation is not easily used as a way for one shareholder to get their way, as well as providing an opportunity for the parties to resolve disagreement using alternative dispute resolution techniques.
Restriction on competition and acting in the best interests of the company
It is not unheard of for a shareholder to actually compete with a company in which it holds shares. For instance, a stronger shareholder might not like being hampered by an underperforming shareholder and decide to take the clients of the business to another company, without the weaker shareholder.
If a shareholder exits a company, for instance by selling its shares in accordance with the terms of the shareholder agreement, the company may be at a disadvantage if the exiting shareholder starts competing with it. If there is no employment agreement, the post separation arrangements might be uncertain. A shareholder will have developed expertise and built client relationships whilst being involved with the company. This IP and those client relationships are the property of the company (not the shareholder) and need to be preserved.
Shareholder agreements will prevent situations like the above arising and set out a clear procedure for resolution of disputes (as above).
We have also written elsewhere (here and here) on restraint of trade and non compete clauses in employment contracts. Whilst not identical, employment restraints are similar to those in shareholder agreements. Please read the articles if you want to know more.
These are just some of the reasons a shareholder agreement is important. There are many more reasons why such a document is important. In all cases it is vital that a shareholder agreement be drafted by an experienced commercial lawyer who specialises in drafting shareholder agreements and tailored to meet the particular requirements of each company. If you would like a shareholder agreement drafted or reviewed by one of our Sydney based commercial lawyers, please call us on (02) 9232 8033.