What does a shareholders agreement do and why might you need one?
A shareholders agreement governs the relationship between a company, its shareholders, and the shareholders themselves. A well-drafted shareholders’ agreement will provide a framework for the ownership and management of the company and related businesses.
Here are some of the common pitfalls we see when parties are preparing or reviewing a shareholders agreement.
- Failure to address what happens if a shareholder or related key person ceases their involvement
In the context of start-ups or SMEs, shareholders will usually take responsibility for specific aspects of the company’s business either as an employee or a consultant referred to as a ‘working owner’. Shareholders should consider what happens if a ‘working owner’ is absent from ordinary work or the performance of their key roles and whether this should trigger an automatic sale of shares.
Those key persons should be parties to the agreement so that their obligations (including restraints) are enforceable.
- Lack of deadlock provisions
A shareholders agreement should address what happens if there is a deadlock. This is particularly common in companies where there are two business partners, who each hold 50% of the shares and are directors on the board. One suggestion is to appoint a third-party ‘referee’, who can make non-binding recommendations. We often suggest that this is the company accountant, as they will have knowledge of the company’s operations.
A more extreme example is to add a ‘shotgun clause’ to the shareholders agreement. This provides that if the parties can’t agree, one can give notice to the other, stating that they will agree to sell their shares at a nominated price. If the deadlock is not resolved, then the other shareholders must either:
- a) Buy the shares at the agreed price;
- b) Force the seller to buy their shares at that price; or
- c) Wind up the company.
- No drag and tag provisions
Drag along and tag along provisions should also be considered.
A “drag along” provision allows majority shareholders to force the minority shareholders to sell their shares in the event of a sale. This is usually triggered in takeovers, with the minority shareholder able to sell on the same terms and conditions and price.
On the other hand, a “tag along” provision grants the right to a minority shareholder to “tag along” in a sale of shares at the same price should they choose.
- No allowance for capital raise or employee share scheme
Typically, a shareholders agreement will allow existing shareholders a first right to purchase any new shares issued.
This may pose an issue if the company is intending to capital raise or implement an employee share scheme. A well-drafted shareholders agreement can include pools of shares (up to a specified percentage) that may be issued without following the usual pre-emptive rights procedure.
- Lack of buy/sell provisions including insurance
Shareholders should also carefully consider what happens if a key person dies or is permanently disabled. Insurance funding arrangements can be included in the agreement to facilitate funding and an orderly buyout in these circumstances. The parties should consider whether they wish to put this insurance in place and, if so, how the insurance will be held. Note that these insurance policies are separate from any life/TPD policies that are held by a shareholder for their own private estate planning purposes.
If the insurance proceeds are unable to cover the purchase (either because the insurance taken was too low, or insurance was not taken out at all), the shareholders should also consider vendor finance to enable the surviving shareholders to pay for the deceased’s shares over time.
A shareholders agreement can be drafted to include these provisions even if there is no immediate intention of taking out the relevant insurance.
- Failure to update the agreement
As business conditions change or new shareholders join, the agreement should be periodically reviewed and updated to reflect current circumstances. Arrangements that are appropriate for a company with two shareholders may be insufficient or inappropriate for one with multiple shareholders.
What’s next?
These are only some of the issues that may arise with a shareholders agreement. If you’re reviewing or need a new shareholders agreement in Australia, the seasoned team of commercial lawyers at Rouse would be pleased to assist.
Disclaimer
The information contained on this website is for general guidance on matters of interest only. The application and impact of laws can vary widely based on the specific facts involved.
Accordingly, the information on this site is provided with the understanding that the authors and publishers are not providing legal advice. As such, it should not be used as a substitute for consultation with professional legal advisers. Before making any decision or taking any action, you should consult with a professional lawyer from Rouse Lawyers.
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