Founders of new companies are all too often put off implementing a shareholders’ agreement with good intentions of doing it later when they have more time and more money. However, not only is it much easier, faster and cheaper to get this agreement in place at the outset rather than trying to negotiate a settlement in the event of a dispute, the process of developing it is as vital and valuable as the document itself.
What is a shareholders’ agreement?
A shareholders’ agreement is a contract between shareholders of an incorporated business that provides mechanisms to deal with important issues before they become problems.
It establishes the nature of the relationship and sets expectations, enabling the shareholders to work through the principles underpinning their business, identify areas of commonality and flush out any issues that might arise - perhaps even to the extent of realising that they shouldn’t be doing business together.
It is not a legally required document. However, a shareholders’ agreement addresses a lot of other specific issues that foundation documents do not, ranging from rules for major business decisions including mergers, disposal of major assets and corporate financing, through to how to determine a price of a shareholder’s interest and the conditions under which the interest can be transferred.
To a certain extent, the value of a shareholders’ agreement is determined by need. Around 10% of small businesses and about 90% larger private companies have one in place. Most private equity investors will want to protect their interest, so a shareholders’ agreement is something they will typically require.
Commonly, a shareholders’ agreement is put in place at the time of a business acquisition. However, there are other trigger points such as a new investor coming on board or a change in shareholding.
But for any business, it will provide shareholders with a higher degree of certainty and some protection. The agreement usually covers a broad range of matters, including the nature of shareholders working relationship, their obligation to each other, to the company and to fellow shareholders. It’s a framework for determining how the owners or shareholders are going to run the business day to day.
For start-ups and small businesses where individuals are often wearing several hats as owner, director, and manager, there is less need to define roles and responsibilities at the outset. But as businesses evolve and as new shareholders are added or considered for succession, those issues become increasingly more important and it is better to contemplate those issues early, than wrestle with them after the fact or worse, when a costly dispute has occurred.
Having a clear framework with an understanding of the rights and responsibilities attached to each shareholder and how they exit is critical. In these situations the agreement will be legalistic, focused on capital structure and the rights attached to that.
It is also a powerful tool in succession discussions as it will typically outline how a successor will buy the business, covering key areas such as how shares will be valued; how cash in the business will be treated; the transfer of shares and the timelines for a transition of ownership process.
The shareholders’ agreement can facilitate that process, managing expectations and setting timelines.
Beyond the establishment of an agreement, it’s important that a shareholders’ agreement continues to be seen as a living document. It should be reviewed regularly to ensure it is reflecting current events of the business and evolving alongside the shareholders who play such a critical role. Realistically, a review should be carried out at least every five years or in the event of a dramatic event such as the global financial crisis, a major change in the company or other significant events.
Given the often confronting nature of what needs to be addressed in shareholders’ agreements, especially around succession, it is a process that requires time. Real value can be found in working with trusted advisers who can facilitate the process, help lead the thinking and provide guidance to work through what can be difficult conversations.
For example, a founder shareholder contemplating retirement, arrangements around the death of a shareholder or a falling out between partners can be challenging issues to confront. But it is to the company’s benefit to consider those potential scenarios when things are working well rather than trying to solve them after the fact.
What does a shareholders’ agreement deal with?
A shareholders’ agreement should not be an overly prescriptive document that attempts to pre-empt every possible scenario, but rather should reflect the shared philosophy and guiding principles for the particular company. It should ensure all shareholders have clarity on specific areas:
▶ Exit – shareholder exit process, either voluntarily or involuntarily as a result of death, illness or reasons such as marital disputes or financial hardship. An experienced adviser can ensure the agreement deals with all major contingencies. Exit clauses should also deal with tax management, liquidity issues and how shares are redistributed.
▶ Entrance – shareholder entry process, particularly in conjunction with the exit of another shareholder, documenting areas such as rules for purchase including principles for making the price affordable to both the shareholder and the business.
▶ Governance and decision-making – guidance on multiple issues from voting, dispute resolution and privileges to signing authority and confidentiality; ensuring alignment of views on whether managers
who own shares have equal or more authority than non-owner managers.
▶ Compensation - processes for compensating those shareholders who contribute to the day-to-day management of the business either as employees or as directors or consultants to the business.
▶ Return on investment - shareholder’s return on investment, specifically criteria for valuation and distribution of proceeds and when and how dividends are paid to shareholders in alignment with entry and exit terms.
There is great value in the process of working with a trusted adviser to assist in the initial steps of considering and developing the core elements of the agreement. They can provide a framework and guidance for fleshing out the concepts and broadly agreed terms. They will also consider the tax and financial perspectives as depending on how the agreement is set up and the rules included, it can impact the tax situation of the business.
While it is virtually impossible to think of and address every possible eventuality a company and its shareholders may experience, working with experienced advisers and lawyers who have experience in the relevant area will help ensure a document is as robust and relevant to your situation as possible.
Once completed, a shareholders’ agreement will help navigate change, deal with disagreements or disputes, facilitate smooth transitions and provide the reference point to the original agreed-on principles. But of equal value is that process of having worked together at the outset to define these foundation themes and achieve real collective buy-in from all of the participants.