Written by Harry Croft and Jennifer Tutty (Principal).
If you are involved in a company with more than one shareholder, it is a good idea to agree to, and have a properly drafted shareholders agreement in place for the company.
A shareholders agreement is a binding contract that sets out the rights and obligations of shareholders. It deals with key issues including:
– Who controls the company and how it is managed;
– How key decisions are made; and
– How shareholders can exit the company.
It’s generally best to get a shareholders agreement drafted and assembled early on, while everyone is enthusiastic to work together. This will also help prevent any awkward and prickly issues if relationships hit a bump in the road!
Read on for our 7 key considerations to think about when drafting a shareholders agreement.
1. How is the Company Funded and How are Dividends Paid?
The agreement should include details for how the company is funded, including initial cash contributions of shareholders, and how the company will obtain further funding (for example, by way of a shareholder or third-party loan).
It should also include how dividends are paid, for example:
– How to determine when the Company will pay dividends. This may be determined in relation to the minimum working capital requirements (the amount of money required to cover the company’s operating costs) and the repayment of debts (such as shareholder loans or third party loans).
– Timing for the payment of dividends (eg. monthly, quarterly, bi-annually, annually).
2. Exit Strategy
Shareholders should agree on what will happen when a shareholder sells their shares, for example:
– If a shareholder wants to sell, is there a buyout mechanism offered to the remaining shareholders before the leaving shareholder can sell to a third party?
– How will the leaving shareholder’s shares be valued?
– In what circumstances should a shareholder be forced to sell their shares (for example, a default event)?
Shareholders can participate in the management of a company directly (in their capacity as shareholders) or indirectly (by appointing directors).
The agreement should clearly set out:
– Decisions that are made by directors (without shareholder approval) and those made by shareholders;
– The percentage of approval required for decisions to be made;
– How a board operates, including when and how it meets; and
– What percentage of shareholding allows a shareholder to appoint a director.
4. Tag Along and Drag Along Rights
When preparing a shareholders agreement, consider including ‘drag along’ and ‘tag along’ provisions. These clauses restrict the sale of shares to third parties.
Drag along provisions
Under ‘drag along’ provisions, majority shareholders may force minority shareholders to sell their shares at the same price and on the same terms, where the majority shareholders have received an offer to purchase. These provisions are appropriately termed, as minority shareholders will be ‘dragged along’ by the decision made by majority shareholders.
One commercial intention of this type of clause is to ensure that where a majority shareholder has received an offer for its shareholding from a third party, it can confidently offer the whole company to a prospective purchaser (who may otherwise not be interested in purchasing part of the company).
Tag along provisions
‘Tag along’ provisions are the reverse. These protect minority shareholders in circumstances where majority shareholders are selling the whole of their shares to a third party.
A minority shareholder can require their shares to form part of the deal at the same price and on same terms. In doing so, a minority shareholder will ‘tag along’ with the deal!
5. Dispute Resolution
The agreement should clearly set out what occurs in the event of a dispute between shareholders.
Shareholders should consider including obligations to meet and attempt to resolve the issue and seek advice from third parties (such as lawyers and accountants) before engaging in any mediation and litigation (as this can quickly become expensive)!
6. Including An Options Pool
Commonly used in start-ups, including an option pool is a way to:
– Incentivise key employees to remain with the company;
– Align those employees with the success of the company in future success; or
– Compensate a talented employee without paying an extremely high salary. For example, an early stage start-up without significant cash may choose to do this.
A shareholders agreement may include a pool (usually between 10 – 20% of total shareholding) reserved to:
– Provide options for key employees to purchase or be issued with shares; or
– Create an employee share option plan (ESOP), providing key employees the option to receive shares where certain milestones or performance criteria are met (for example, relating to years of employment).
There are various tax considerations with these arrangements. Therefore, when considering whether to implement and how to structure an option pool, both the company and shareholders should obtain tax advice.
Shareholders should consider obtaining insurance policies, which deal with any unplanned exits of a shareholder or key person.
Particularly for small to medium-sized businesses, the running of a company will often be significantly impacted if key shareholders or individuals associated with the company pass away or are unable to work because of illness.
Key Person and Buy / Sell insurance policies can lessen this impact, by providing cover to:
– Pay for the value of a departing shareholder’s shares on death or incapacity;
– Provide a payout to cover for lost revenue and increased costs where the unplanned exit of a key person occurs; or
– Repay certain company debts associated with a key person (for example, debts that have been personally guaranteed).
Looking to rent a space for your new company? Check out our blog: ‘6 Key Questions to Ask Before Signing a Lease for Your Business‘.
Published 18 April 2023
Written by Harry Croft and Jennifer Tutty (Principal).
The information in this article is of a general nature. It does not constitute formal legal advice and should not be relied on as such. Please see the full disclaimer in our website terms. Please contact Studio Legal if you are seeking advice about a specific legal matter.