Change is a constant in business. Changes don’t always lead to disagreements between the shareholders, but there is always that possibility.

The corporation is the most common structure for businesses around the world, regardless of their size or primary area of activity. A typical corporation is formed by two or more individuals, usually because the principals share a common vision and need their combined resources to achieve it.

But change is a constant in business, and within what may seem a very short time from the commencement of the enterprise a number of changes will have taken place. The corporation may succeed beyond the founders’ dreams and amass great wealth, or it could face challenges or opportunities that weren’t even considered when the business began trading.

These changes don’t always lead to disagreements between the shareholders, but there is always that possibility. And while a dispute will be damaging to the business at any time if it happens to arise at a critical juncture like transfer of ownership it can destroy business value and significantly reduce your reward from the sale.

Every business that consists of a number of shareholders needs to have a shareholder agreement in place. Once created, it should be regularly reviewed and updated as necessary. The alternative to having a shareholder agreement includes unnecessary dispute between shareholders, expensive litigation, and quite possibly the failure of the business itself.

The Function Of The Shareholder Agreement

A company’s Articles of Association can state how the company’s management and operations will be carried out and they form the primary mechanism for regulating these aspects of a company’s affairs. They do not, however, cover the relationships between the shareholders of a business.

The shareholder agreement is a vehicle that anticipates possible changes and takes into account that there may be disagreements between the shareholders; it provides mechanisms that will help resolve these disputes and outlines the duties of all parties to the agreement.

It can be as detailed or as brief as the shareholders wish, but the more work that goes into developing the agreement, and the more situations it outlines a procedure for resolving, the more effective it is likely to be in fulfilling its purposes.

A shareholder agreement is the preferred way of managing matters when the number of shareholders is not too large - trying to prepare an agreement that reflects the interests of more than ten shareholders will generally render the document unworkable.

A shareholder agreement is a legally binding document that defines the shareholders’ obligations with regard to the company and to each other. It is usually prepared in accordance with contract law instead of company law. Courts in most, if not all countries, generally uphold the intentions expressed in the agreement as they would in any other contract, accepting that when it was written all parties had given adequate consideration to the issues covered.

1. Terms of employment

Shareholder agreements are supplemental to the Articles of Association and can be made between some or all of the shareholders. The company itself can also be a party to the shareholder agreement in certain circumstances. As an instrument that regulates some aspects of a company, shareholder agreements offer the benefit of confidentiality as, unlike the Articles of Association, such agreements are not generally open to public inspection.

Shareholder agreements can act, in many ways, as a contract of employment for the shareholders of a business. They can specify compensation levels, outline a system of performance review and specify terms under which a shareholder’s employment can be terminated. They can state the conditions for selling the shares held by a shareholder, and can even contain the circumstances under which a director of the company can be removed.

Shareholder agreements can specify how new people can be brought into the company. Bringing new people into a company can often open up dissent among shareholders – is the new person really needed; do they have the right qualifications; are they too closely aligned with one of the existing shareholders and represent a threat to another shareholder’s voting power and so on. And yet bringing in new talent is sometimes the only viable strategy for business growth. With an agreement in writing that covers the concerns and sets out the circumstances for an acceptable adoption of new shareholders those issues can’t become sources of shareholder dissent.

Equally important is separation of shareholders from the business. A dispute between shareholders can be extremely disruptive and the damage caused by a disaffected shareholder who also happens to be an active employee can be considerable. Having the ability to terminate a shareholder who is also an employee of the business is often the only way to get a business returned to a focus on its normal activities. In some instances unhappy shareholders have sought legal redress, not as employees but as shareholders which gives them much more leverage. However, if the dismissal was conducted under the terms of their shareholder agreement it will usually be seen as lawful.

2. Stock disposition and valuation

After termination a shareholder’s stock will be a matter of concern. This too can be covered by the shareholder agreement. It can require that the dismissed individual sells their stock back to the other directors of the business and contain a formula for determining a fair price for the buyback.

The shareholder agreement can be used as a vehicle for establishing the future value of the company’s shares. This is important when a new shareholder makes an investment to join the existing directors in the business, or when an employee receives shares as a performance incentive.

Shareholders can use the shareholder agreement to set out their respective rights for disposition of stock in the event of a range of circumstances - death, disability, retirement among them.

A shareholder agreement can be particularly useful in a family business for a number of reasons. For instance, to manage expectations - some members of family businesses feel that merely by virtue of being related to a director they have some sort of entitlement to a share of the assets of the business. And while it is natural for the founders to want their children to become involved in the business this can be a cause of friction if some directors feel the founders’ children are not suited to running the enterprise; or that they may inherit stock in the company only with the intention of selling it – possibly causing detriment to the company. To cover these issue and concerns a shareholder agreement is essential.

What's A Shareholder Agreement?

All shareholder agreements are written to cover business specific situations and it’s highly unlikely that any two will turn out to be exactly the same. However, there are some issues that will need to be part of most agreements.

There are of course many possible components of a shareholder agreement. Some of the most common ones are shown below.

1. Shares buyback – will it be optional that shareholders sell their shares back to the company or to other shareholders, or will it be mandated in the agreement?

2. Right of First Refusal – if a shareholder wishes to sell or transfer their shares to an outside party will the corporation (other shareholders) have the right of first refusal that can force a sale to them at an agreed price? What information about the proposed purchaser must be given to the corporation?

3. Purchase price mechanism – A formula or other method for determining a ‘fair market value’ for the stock.

4. Decision making at board level - The board of a company sets the direction the business pursues and exercises control over key policies that can have important consequences for the organization. Shareholder agreements can state the way decisions are made by the board – for example, what decisions can be taken by the board and whether approval has to be unanimous or a simple majority.

This allows the individuals to protect themselves against majority rule and prevent the arrangements made between shareholders when the business was established being changed without their consent.

As example would be when minority interests are protected by requiring decisions to be unanimous, but this kind of restriction can also make it difficult to make any decisions at all. It is possible to instead have decisions made by a simple majority vote but protect minority shareholders with a dispute resolution mechanism they can use if needed.

5. Treatment of shareholder loans - Shareholder loans are usually equal when the business begins. Over time, however, share ownership may not reflect the exposure of an individual to loans made to the company. Some shareholders may not have any loans outstanding. The shareholder agreement can set such details as loan durations and interest rates to ensure that shareholders with outstanding loans to the business are adequately compensated.
 

6. Treatment of proprietary Information - A shareholder agreement should cover protection of proprietary information. The agreement should require the shareholders to hold all business information in confidence, protect it from disclosure, and not to use it for personal benefit.

This information can include data, customer lists, customer information, intellectual property, manufacturing methods, or any other information that the business feels should be confidential.

7. Transfers of shares - The agreement can prohibit all transfers, or it can permit gifts to certain family members, outright or in trust, and during lifetime or at death. It is possible to stipulate who can and who cannot be a recipient of transferred stock including restricting those to only related parties.

8. Redemption of shares - The agreement can enforce redemption of stock by the business, to keep it out of the hands of those outside the original shareholders. It can allow or require cross-purchases by the other shareholders or it can give first right of refusal to those persons remaining as shareholders in the company.

9. Mandatory sale of shares - The sale of shares can be mandated by the agreement under certain circumstances. It can also mandate the purchase of shares and nominate those who must purchase them. The agreement can also specifically allow the sale or transfer of shares to other parties if intended.

10. Triggers for the sale of shares - The shareholder agreement can define ‘triggers’ that will cause the shares to be sold. If a shareholder dies, is made bankrupt, declared insolvent or becomes unable to make informed decisions they or their estate can be forced to sell their shares to another party.

11. Setting the value of shares - The value of shares that are to be sold or redeemed can be determined in many different ways depending on the wishes of the signatories to the agreement. Some of these are:

 

• A price offered in good faith by a third party not part of the shareholder agreement
• A price determined by an independent authority
• A price determined by the book value of the corporation (where ‘goodwill’ has been included in the valuation formula)
• The earnings per share, averaged over the previous three years, multiplied by a predetermined number of years
• A value set by the shareholders and reviewed annually

12. Restrictive covenants - When a shareholder leaves the company, agreement on non-compete and non-solicitation provisions may be difficult to establish. These should be contained in the shareholder agreement, written in a narrow, well defined manner that will improve the chances of approval, and will also make it more likely that the restrictive covenants will be enforceable.

WHAT IF WE DON’T HAVE A SHAREHOLDER AGREEMENT?

Shareholder agreements protect the business and its directors from potentially damaging disruptions and the expenses of litigation. To be effective and stand up to legal scrutiny in the event of a dispute they must, however, be crafted with the intention of being fair to all signatories.  Having a properly drafted shareholder agreement will remove the elements of doubt and chance in the relationships between shareholders and helps them work to build a stable and profitable company.
 

Not having a shareholder agreement  leaves the door open to litigation and bad feeling in the event of the death, divorce or bankruptcy of a shareholder, deadlocks that damage business growth and a range of other unpleasant shareholder disputes.