Business owners are often so busy getting a business up and running that they neglect a crucial step in the process of securing and protecting the future success of their business and their interests - a shareholders’ agreement or partnership agreement. This is the key document that sets out the relationship between the shareholders (owners) and directors of the company, and is what they will refer to when making important decisions about the company.
Ideally, such agreements are best prepared in the ‘honeymoon period’ at the start of the business, like a ‘business pre-nup’. At this early stage, constructive and practical discussions can be had and consensus more easily reached on how the business should be run, while all stakeholders are motivated and collegiate, and disagreements or disputes over the day-to-day running of the business have yet to arise.
Such agreements should evolve with the business and be reviewed at various stages of growth. Your original ‘cookie cutter’ template document can quickly become out of date and no longer reflect your intentions and current circumstances relevant to your business. You may need to review and amend your agreement in the context of adding or removing shareholders, when seeking capital injections and/or new investors, to ensure your interests continue to be protected.
Why do you need a Shareholders’ Agreement?
The critical need for such agreements to protect your interests becomes very clear when:
- Business relationships between shareholders sour or end.
- Disputes arise over how the business is run, money spent or dividends paid (or not paid).
- Business partners wish to exit the business and cannot agree a sale price or what is ‘fair’ or ‘market’ value
- The business needs more funding or a founding shareholder(s) wants to bring on an additional business partner or investor to inject capital, but is concerned not to lose control of the company or ‘be voted off their own company’.
A shareholders' agreement provides a road map for the life cycle of the business, from start, middle to end. It can reduce costs and uncertainty of a 'business breakup' or dispute. Every business is different and so is every shareholder or partner relationship.
A properly drafted shareholders' agreement can minimize conflict, and maximise opportunity for growth; it can even ensure that you can sell the business if you wish to do so (or conversely, stop the business from being sold out from under you).
Shareholders own the shares in a company and can be individuals or other entities such as companies or trusts. Often referred to as â€˜membersâ€™, shareholder rights are set out in the Shareholdersâ€™ Agreement and may vary depending on the class of shares they own.
The Board and the Constitution
Directors and collectively, the Board of the directors of the company, are usually responsible for the day to day management of the company. Their rights and responsibilities are usually governed by the Constitution, with certain important decisions referred to the shareholders in accordance with the Shareholdersâ€™ Agreement.
As a business owner or shareholder, one of the reasons a Shareholders' Agreement is so important is because otherwise the decision making power is likely to vest in the Board (where you can quickly be outnumbered and lose majority / control) pursuant to the Constitution.
Types of directors
There are many different types of directors, including:
- Executive Director: An employee as well as a director, an Executive Director usually works in the business and performs day-to-day management duties (e.g. CEO, Director of HR). An executive director is governed by both an Employment Agreement and the Constitution (and any other Director appointment terms or agreement).
- Non-Executive Director: Any director who is not an executive (or employee) of the company.
- Independent Director: A non-executive director who is not a member of management and free from any business or other relationship that could materially interfere with the independent exercise of that director’s judgment.
- Representative / Nominee Director: Usually a director appointed by a shareholder (with a certain significant percentage shareholding specified under the Shareholders Agreement) to represent their interests on the Board.
- Managing Director: A type of executive director who sits on the Board, but also has the ultimate authority to manage the organisation on a day-to-day basis.
It is critical to have regard to all relevant agreements when appointing or removing such directors, (and when drafting the agreements) to ensure they are removed simultaneously as an employee, director and shareholder. This avoids circumstances where employees or directors are removed but their shareholder voting rights remain, or terminating a director without having due regard to employment law obligations.
The Constitution and/or Shareholders Agreement will usually specify the specific rights that attach to each class of shares, such as:
- Voting rights: Whether a type of shareholder has the right to vote on particular issues or not.
- Dividend rights: A shareholder may or may not have rights to be paid dividends, or may be entitled to be paid first.
- Liquidation preferences: Payment of some classes of shareholders before other in the event a company goes into liquidation.
- Special rights: Bespoke rights for certain classes of shares e.g. veto rights for preference shareholders.
The most common types of shares are ‘ordinary shares’ and ‘preference shares’. The important difference is the rights attaching to the relevant type as set out under the Constitution or Shareholders’ Agreement.
Shareholders' Agreement Checklist
What key issues should your Shareholders' Agreement cover?
As no two businesses are the same, ensure your Shareholders' Agreement is customised by a specialist corporate lawyer to suit your business and personal interests as a business owner.
Use this checklist to review your Shareholders' Agreement:
- Decisions: Specify what decisions will be made by directors vs shareholders? What decisions must be made unanimously by all Shareholders or the Board? (e.g. purchase of major assets, loans or expenditure over a certain amount, appointment of CEO, buying, selling or issuing shares).
- Voting: Specify voting rights of shareholders and directors, including different classes or minimum percentage shareholders. (e.g. You may have a class of shareholder with no voting rights but a right to dividends, such as silent partner).
- Shareholder Rights: Do you have a right to appoint one (or more) directors on the Board (whether yourself or your nominee to represent your interests)? What is the minimum % shareholder for this right? Do certain classes of shareholder have observer rights only?
- Directors: How are directors appointed and removed? This could be solely by shareholders, a certain number by shareholders and some by the Board, or on a percentage vote/election basis.
- Dividends: Who has the right to a dividend and who decides the dividend amount? Importantly, how much profit must be retained by the company for working capital, cash flow or investment?
- New Shares: What is the process to issue new shares, buy back, split or convert shares and who decides this? Care should be taken to ensure your ownership interest is not diluted or one shareholder permitted to unilaterally issue more shares (to themselves or another person).
- Capital: Have you recorded capital contributions, loans and what assets are provided by each Shareholder? Consider the mechanism and/or priority for repayment of capital/loans. Specify how and when the shareholders will be required to contribute additional injections of capital or shareholder loans and implications for any shareholder who does not contribute in proportion to their shareholding.
- Sale: What is the process to sell existing shares (and the business as a whole), including:
- First rights of refusal: This is where a shareholder who wishes to sell must first give notice to the other shareholder(s) and offer them the option to purchase their shares, before selling to a third party you do not know or approve of.
- Drag Along: Majority shareholders can require the minority shareholders to sell their shares in the event of a sale (usually triggered in takeovers, with the minority shareholder able to sell on same terms and conditions and price).
- Tag Along: Where the majority shareholder wishes to sell to a third party and the minority shareholder
can elect to 'tag along' with the sale at the same price (or not sell and stay in business with the new owner of the majority shares).
- Share Price: How will the share price be valued in the event of a buy-out or sale to another party? Is there an agreement minimum price or agreed ‘fair market value’ calculation method?
- Bad Leavers: What events may lead to a shareholder being forced to sell their shares and leave the company?
Is there a penalty, such as a percentage reduction in share price or reversion to buy in price?
- Employees: Retention incentives (where appropriate) for employee shareholders. (e.g. vesting and leaver provisions.) Check to ensure employment agreements also align to ensure termination results in removal as a shareholder and vice versa.
- Operations: Who drafts and approved the Business Plan and Budget? What is the structure of the senior executive team? Will there be a Managing Director or CEO and who appoints them? How often will the directors meet?
- Reporting: What information must be provided to shareholders and how often?
- Deadlock: Who gets the casting vote if you can’t agree and the issue is tied? Consider a ‘golden vote’ or right to veto certain matters if you are the Founder. There are multiple deadlock methods, such as ‘Russian roulette’, mediation, ‘Texas shoot-out’, deterrence (forced sale at 125% of market value).
- Disputes: How do you resolve disputes between shareholders? (e.g. commercial attempts to resolve between shareholders, mediation, arbitration, appointment of an expert such as accountant, Industry Association.)
- Default and Termination: What constitutes a breach or event of default by a Shareholder? What events will trigger the termination of the Agreement or removal of the Shareholder? Does default trigger a forced share sale and at what price? (e.g. physically or mentally incapacitated, breach of duties under Corporations Act, conduct bringing company into disrepute.)
- Exits: What happens when a party wants to ‘exit’ the Agreement, retire or passes away? Are you stuck
in business with their successors (family or estate) or do you have to find cash to buy them out?
- Company protections: Non-competes, restraints and ownership of IP. This is rarely included in the Constitution and shareholders are not usually employees so this is critical to protect the business from competition
and retain company intellectual property and confidential information if a shareholder leaves.
- Buy-Sell Agreement: Consider also whether you need a Buy-Sell Agreement setting out rights and obligations of shareholders to buy or sell their shares in circumstances such as insolvency, disability, death or retirement, with an appropriate valuation mechanism.
How can a shareholder or director be removed?
It is not easy to remove a director or shareholder, so care should be taken to understand your rights and obligations before you give someone decision making power or a financial ownership interest in your business. Removal will require careful examination of the terms of the Constitution and Shareholders' Agreement, the Corporations Act and any other applicable appointment or employment arrangements to determine who has the right to appoint directors and in what circumstances they can be removed (and when shareholders can be removed or a share buy back conducted and at what price).
It can be very expensive process to resolve a dispute and/or remove a director or shareholder, so you should ensure you obtain legal advice on all documents (and make sure they are signed) before appointing a director and notifying ASIC, or issuing share certificates to a shareholder.
What if my business doesn't have a Shareholders' Agreement?
Without a Shareholders' Agreement, your company will be governed by the rules in its Constitution (if it has one), and the Corporations Act. The Corporations Act has a set of default 'replaceable rules', and your Constitution is unlikely to be tailored to suit your individual needs. It is never too late to put one in place.
Consider getting a tailored Shareholders' Agreement as it can be a useful process to optimise decision making and performance. In addition, it will put you in a better position should you wish to consider future investors, purchasers or exit strategies.
Other documents you may need
A Shareholders' Agreement or Partnership Agreement does not cover everything, and depending on the structure, specific commercial requirements and individual circumstances, you may need to consider reviewing, updating or seeking advice on the following:
- Director/Executive Agreements
- Buy/Sell Agreement
- Company Constitution
- Corporate Governance
- Company Secretarial
- Board Policies
- Conflicts of Interest
- Business Structuring
- Loan Agreements
- IP Agreements and Protection Strategies
- Business Succession Planning
- Asset Protection and Estate Planning
- Resolutions for share sales, buy backs, splits