A shareholders’ agreement is an agreement between the members of the company to exercise their rights as shareholders and their voting rights in such a way as to give effect to the terms of the agreement. Sometimes the company itself is a party to the agreement.
Shareholders agreements are desirable when a company is managed, controlled and/ or owned by a relatively small number of people. This is because the default company law rules which apply, where nothing to the contrary is agreed, are more appropriate to larger businesses with a separation of managers and shareholders.
This remains the position, even after the 2014 Act which sought to make the private limited company, the default type of company. A separation between shareholders and controllers is largely assumed.
The “default” position under company law and standard memorandum and articles of association give minimal rights only to shareholders. These default rights comprise little more than the right to vote at general meetings, to receive dividends if declared by the directors, to receive any surplus of assets on a winding up and to obtain certain information about the company.
The default company law position gives the holders of more than 50% of the shares almost complete control over the affairs of the company. A shareholders’ agreement can increase the individual shareholder’s rights and can be negotiated to include whatever the shareholders as a whole agree. By the shareholders’ agreement, the shareholders enter a contract to exercise their voting rights to achieve the objects of the agreement.
Many private companies are financed and managed in a manner that is more like a partnership than a company. A number of shareholders may participate as directors, while one shareholder or a shareholder bloc may hold a majority of the shares. In another common class of case, there are some shareholders involved in management and other shareholders who are not involved, but who want to keep a certain level of involvement in and control of the company’s affairs. These scenarios call for an appropriate shareholders’ agreement to protect the minority or “outsider” shareholder.
Shareholders agreements are commonly used to regulate a joint venture when a corporate structure is used. They are used in the context of venture capital and equity investments. In this latter case, the agreement has the purpose of protecting the investor who does not take an active part in the business.
Many of the same types of clauses appear in each class of shareholders’ agreements. Other clauses are tailored to the nature of the relationships and the particular circumstances.
The default company law position is that the holders of a bare majority of the shares capital, control the company. They can fire the directors and take complete control of the company at any time. They need only declare dividends when they wish. The may choose to pay themselves such salaries as they want. They may choose to may give themselves overly favourable employment contracts. The may spend company money in a wasteful way or in a way that is in their exclusive interests.
Private companies, unlike public companies which are listed on the stock exchange, are not subject to detailed disclosure obligations and scrutiny. Their directors can more easily run the company in a way which is abusive of the interests of the minority or “outsider” shareholders.
A minority shareholder may make an application to the court to challenge oppressive management by the majority. However, the expense and impracticality of taking court action based on oppression or the disregard of the minority shareholders are a considerable practical barrier. Both criteria applicable and the possible remedies involve a significant element of discretion.
The capital clauses in a company’s constitution offer flexibility in relation to how the ownership rights in the company are defined and divided. It is possible to create a wide variety of classes of shares with different rights.
A Shareholders’ key rights are to dividends, the return of capital in a winding up and the right to vote at general meetings. It is possible to recast the income, capital and voting rights to meet the requirements of the situation. It is possible to create preference shares which have the first call on the income and/ or capital of the company. It is possible to create shares, which can be redeemed by the company. It is possible to issue loan stock that can be converted into shares.
The directors are usually free to issue new shares on such terms as they see fit. Although they must act in good faith in the interests of the company as a whole, they may in practice dilute minority shareholders.
Company law gives the shareholders the right of pre-emption and the authority to issue new shares. However, these rights can be reversed by the constitution or be by resolution of the majority.
A shareholders’ agreement may, therefore, control the issue of new shares so that shareholders are not diluted without the opportunity to subscribe for new shares.It may limit the issue of new share entirely.
A company need not pay dividends at all unless the board of directors sanctions payment. A shareholders’ agreement may provide for an agreed dividend policy. There may be a business plan which sets out the parameters of future dividend payments. There may be an obligation to pay a fixed share of earned income as dividends. Alternatively, there may be no provision or obligation to pay dividends on the basis that it may be better to leave this to the judgment of the directors at the relevant time.
The subscription for ordinary shares and the making of loans are the most common form of investment in a company. The subscription for the shares may be by way of cash and/ or non-cash assets.
Shareholders will often lend money to the company in addition to subscribing for shares.Loans can be repaid, and interest can be paid on more favourable terms from a tax and company law perspective. Capital paid into a company cannot be easily withdrawn. Interest on loans is generally a taxable expense and are therefore subtracted from profits in computing tax liability. In contrast, dividends are not deducted in computing corporation tax on income.
It is possible to provide for complicated funding structures, where there are outside investors who are not involved in management. They could, for example, receive one or a combination of preference shares, ordinary shares and loan stock, possibly with rights to convert to shares. The terms of the shareholding rights can be structured in any way required to reflect the risks and rewards that the investors take.
Outside funders, such as a bank, may require guarantees from shareholders. The shareholders’ agreement may set out the extent to which the parties are obliged to give guarantees to banks and other funders in respect of the company’s borrowings.
The shareholders may be obliged to contribute money to the company when the shareholders’ agreement is entered. The shareholders’ agreement may deal with future financing requirements.
A shareholders’ agreement may provide as to whether the parties are obliged to provide further equity or loans or to guarantee company debt. If shareholders are to be required to give guarantees for the benefit of the company, this should be set out and limitations and conditions should be provided.
If there are likely to be future financial commitments (where significant capital expenditure is contemplated), default procedures might be provided for circumstances in which one party fails to make the requisite contributions. If one shareholder contributes funds and another does not, this may affect the relative share of equity held by each shareholder.
One shareholder may be willing to inject capital, with an adjustment of the relative entitlement to the equity/ ownership of the company. Default provisions may provide for ayment of interest, loss of voting rights, buy-out or ultimately the reduction of the defaulting shareholder’s share of the company.
A right to participate in management is usually important to a shareholder who is actively involved in the company’s business. Different considerations will apply depending on the shareholding balance. With a 50/50 shareholding, equality of representation and voting rights may be deliberately engineered. Minority shareholders may wish to have the right to veto major business decisions.
The board of directors runs the business of the company. 50 / 50 shareholders may each expect to nominate an equal number of directors and to be entitled to equality at board level. If one shareholder has made a significantly greater contribution and /or has a higher shareholding, that shareholder might want a final say such as the right to be or to nominate the chairman with a casting vote, the right to appoint a majority of directors or the right for its directors to have “weighted” voting rights.
Generally, directors owe obligations and legal duties to the company and not to the shareholder who nominated them. Their obligation is to act in the company’s best interests. This potential conflict of interest can be particularly acute in the case of a joint venture company. The 2014 Act, has eased this position, by allowing for the appointment of nominee directors.
In the absence of the shareholders’ agreement, a minority shareholder would not have a right to participate in the management of the company. A shareholder’s agreement may provide for the right of each of a small number of shareholders to nominate a director. It may provide that there was no quorum for directors’ meeting unless a director nominated by each shareholder is present. The shareholders may themselves be directors, or they may nominate others to represent them.
The minority shareholder may have rights of access to the companies, books, management accounts and other information relevant to the management of the company,
The default position for a private limited company is that the transfer of shares can be vetoed by the directors of the company. Shareholders’ agreements commonly regulate the transfer of shares. The shareholders may wish to prevent outsiders coming into the company. They may preclude share transfers entirely or allow them only in limited circumstances. Alternatively, they may provide that shares must be first offered to other existing shareholders, before being sold to outsiders.
The shareholders may not wish to allow for the free disposal of shareholdings. An unrestricted right to sell could lead to the substitution of an incompatible party. This may be inappropriate to a business that depends on personal factors.
There may be a complete prohibition on the transfer of shares. This may apply for a period or indefinitely. Transfers may be allowed, subject to conditions or with the consent of all or a number of shareholders.Issues may arise in relation to taking over loans and guarantees already given, in the event of a transfer.
The transfer of shares may not be completely prohibited but may be subject to pre-emption rights (i.e. right of first refusal) for other shareholders. It is standard to require that a shareholding is bought as a whole or not at all, so as to prevent it splitting into small shareholdings.
Issues arise in relation to the price and other terms upon which shares might be transferred. The share price may be fixed by an expert or a fair price. This could be based on a multiple of earnings or a net asset basis. Issues will arise in relation to taking over loans and guarantees already entered, in the event of a transfer.
A minority shareholder may seek a “tag along right” under which it can require a majority shareholder to include its minority stake in any sale it purposes to a third party. This is to ensure that the shareholder is treated equally on a sale. It also prevents the majority selling their controlling stake in the company, without the minority having the opportunity to receive the pro- rata value of their shareholding.
Another common provision is a “drag along right”. This allows a majority or (perhaps a smaller group) to require that all shareholders sell their shares if a third party wishes to buy the company. An alternative is that the remaining shareholders can buy out at the same sum.
Deadlock Resolution I
Deadlock can arise in a 50 / 50 shareholding or joint venture company where the directors/ shareholders take different views on a matter. There are a number of mechanisms which seek to deal with this scenario.
The chairman of the Board of Directors may be given a casting vote. This is usually not acceptable with equal shareholdings. The chairman is unlikely to be sufficiently independent.
An outsider may be given a swing vote. A suitable person with appropriate business expertise must be available and the parties must be able to agree on the appointment either at the outset or at the time when the dispute arises.
Deadlock Resolution II
There may be a role for mediation, which is a non-binding dispute resolution mechanism. In the case of more routine disagreements in a joint venture, it may be feasible to resolve the deadlock by reference to the chief executives of the joint venture shareholders collectively.
The matter may be referred to an expert or arbitrator. The expert or arbitrator may be appointed by agreement or by an independent body, appropriate to the nature of the dispute. Arbitration (and to a significant, but lesser extent expert determination) is usually inappropriate for business decisions, for which there is no right or wrong answer. The arbitrator/ expert may not have sufficient knowledge of the business and his decision is unlikely to resolve fundamental differences.
Where none of the above mechanisms is sufficient to resolve the dispute, a last resort may be to trigger the termination of the agreement / joint venture. This may involve the transfer and sale of shares or liquidation and winding-up of the company’s assets. The whole business may be sold to an outsider. In a liquidation the assets are sold, the liabilities paid and any surplus proceeds are distributed.
Deadlock and Buy Out
Where there is an irresolvable deadlock, one party may wish to buy the other out, so as to continue the business alone. Each party may wish to buy out the other. There are a number of mechanisms that can be used to determine who buys out whom and what price is paid.
Put and call options entitle the holder of the option (which may be in favour of each party or one party) to acquire the interest of the other. The price may be expressed as the fair value or may be ascertained by reference to a formula.
The so-called “Russian Roulette” option involves mutual put and call options. The party making the offer may serve a notice on the other requiring the recipient to purchase his shares or alternatively to sell the recipient’s shares to the person making the offer, at the price set out. The purpose is to ensure a fair price is offered at which the offering party is willing both to buy and to sell. This would be appropriate for companies with two shareholders parties of equal financial strength so that either party could afford to buy out the other at the relevant time.
Deadlock and Buy Out
A further option is a “Mexican” or “Texas” shoot out. Under this mechanism, the initiating party may serve a notice stating that he is willing to buy the other out and specifying the price at which he is prepared to buy. The recipient has a period in which to serve a counter notice, either stating that he is prepared to sell at the specified price or that he is willing to buy the shares of the initiating party at a higher price.
Both parties may make simultaneous sealed bids, with the person whose bid is highest being entitled to buy out the other. Alternatively, the bidding process can be run as an auction with the parties raising their bidding in competition with each other.
If a joint venture has irretrievably broken down, the parties may decide that it should be wound up and its assets distributed. As a termination mechanism, this may have the advantage of concentrating the minds of the parties on resolving the dispute without a complete termination of the relationship. It may be better to settle the dispute, than to see the business or venture die.
Minority shareholders rights under company law are minimal, so it is usually desirable for them to procure an increased level of rights, where possible. There may be no shareholder, who hold or controls a majority of the shares.
Shareholders agreements commonly provide that a significant minority shareholder or each of a number of approximately equal shareholders have the right to veto key proposals by the company.
Sometimes the rights are only granted to a shareholder who has a certain minimum percentage shareholding. The veto may be voiced through a shareholders meeting or through the representative directors. Commonly, a right of veto may be granted in respect of matters such as the following:
- q change in articles of association;
- the issue of new shares;
- capital expenditure in excess of specified borrowing limits;
- major disposals of changes in the nature of the business;
- dividend distribution below or above an agreed level;
- the appointment or dismissal of key personnel and directors;
- highly important or material contract;
- dealings between the company and shareholders, except arms’ length dealings;
- winding up.