When you start a company with someone else there’s a lot at stake. You’re about to put in a lot of time, energy, money... and trust. It's important to have a Shareholders' Agreement in place not just to secure your interest in the business (a share of the pie) but also to minimise the risk of disputes (prevent pie-throwing if things turn ugly).
Let’s take a coffee break before we dig into the detail. And, help out Bob and Anna who are starting up a new company called Bobanna Rainforest Coffee Pty Ltd. To fill you in, Bob and Anna are excited to sell a special blend of rainforest coffee into shops. Anna makes a mean coffee and promises she can sell anything and Bob has found a supplier from Brazil. How can they get started?
You can get the ball rolling by incorporating a company to carry on business and dividing up ownership. Think of each share in the company as a share of a pie. You can cut a pie up into as many shares as you want.
These shares are usually divided up amongst the owners based on the expectations of what each owner (known as a shareholder) is going to contribute to the business. Of course, you will want to fight for a sizeable share of the pie since this will determine your share of the profits.
Since Anna is going to work full time in the business it is agreed that she will own 60% of the company and Bob, who has promised to arrange the coffee supply, will own the other 40%. After much dispute about the name, they agree to set up a (self-titled) company called Bobanna Rainforest Coffee Pty Ltd. They issue 60 shares to Anna and 40 to Bob.Anna and Bob have drunk far too much coffee together, they’re enthusiastic and ready to roll… they now need to agree on rules about how their company will operate.
Company law offers a wonderful basic framework for determining ownership and control but since every business is different, the owners should write their own rules to give them the best chance of shared success. These rules should be included in a Shareholders' Agreement.
Ok, so we are making a pie! Who’s doing the cooking?
To make it clear, a Shareholder’s Agreement should set out each shareholder’s duties.
If a shareholder is an entity such as a company or trustee of a family trust, rather than an individual, the Agreement should not only impose duties on the shareholder entity but also on the individual behind it. That is the person who will actually do the work in the business. These parties are generally named as the Shareholder and its Shareholder Representative.
Bob’s shares are owned by his family company, Bobo Pty Ltd, so the Shareholders’ Agreement names that entity as the “Shareholder” and Bob as its “Shareholder Representative”. Meanwhile, Anna holds shares in her own name and the Agreement names her as both the “Shareholder” and her “Shareholder Representative”.
It’s agreed that Bob and his shareholder entity Bobo Pty Ltd is responsible for sourcing the coffee and dealing with the suppliers. Meanwhile, Anna is responsible for the day to day management of the business. These duties are described in detail in the Agreement.
If you are investing in a company and you want some control, it’s worth fighting for a seat on the board. Think of it like this. The shareholders own a company and the board of directors are in charge of running it. They have the final say over day to day things like signing contracts, hiring staff and choosing suppliers (even though they may delegate these responsibilities, for example, to a manager).
So, getting a seat on the board is critical and without one, you are merely a passive investor.
You can secure a seat on the board if you hold the majority of shares or otherwise achieve majority support from the other shareholders (that is at least 50% of the shareholder’s votes).
That’s how company law works. It gives power to the majority. On the other hand, if you are a minority shareholder with only 40% of the shares then under company law you could not secure a directorship. That’s where the Shareholders’ Agreement comes in. It allows the parties to make their own arrangement rather than simply relying on company law.
A Shareholder’s Agreement can give a minority shareholder, who does not have power to appoint a director under company law, a secure directorship while also recognising the majority shareholder’s right to appoint one or more directors or perhaps control the board.
Although Bob only owns 40% of the shares and cannot secure a directorship under company law, Anna accepts in the Shareholders’ Agreement that she and Bob will both have a seat on the board.
It’s agreed that Bob and his shareholder entity Bobo Pty Ltd is responsible for sourcing the coffee and dealing with the suppliers. Meanwhile, Anna is responsible for the day to day management of the business.
These duties are described in detail in the Agreement.
If you think of a directorship as the right to wear a chef’s hat, what happens when there’s more than one chef in the kitchen and they can’t agree what goes in the pie? Do they all get to vote? Is there a head chef!
The way companies operate is, generally, that each director is entitled to one vote at a directors’ meeting and this is stated in company law and usually also stated in the constitution of the company. However, a Shareholders’ Agreement can override this rule and state, for example, that a director has one vote for each share held by its appointing shareholder or that a particular director is the chairperson and can break a deadlock if the votes are equal. This is called a “casting vote”.
At Bobanna Rainforest Coffee, both Bob and Anna are directors but instead of each having one vote, which could cause a deadlock, it is agreed that a director is entitled to one vote for each share held by its appointing shareholder.
This means that Anna has 60 votes and Bob has 40 votes at board meetings.
Other options for putting Anna in control of board meetings would be to agree that:
1. each director has an equal vote but that Anna can appoint two directors (while she holds at least 60% of the shares) and Bob can only appoint one director (while he holds up to 40% of the shares); or
2. Anna is the chairperson and has a casting vote at board meetings, if the directors are deadlocked.
Some decisions are so important that even governments must put them to the people: A referendum on Gay marriage or Australia getting rid of the Queen, that sort of thing.
Similarly, while the directors are generally free to run a company, there are some decisions that must be put to the shareholders. Under company law, this can include items like a change of company name or a change to the constitution which require shareholder approval.
It is common in a Shareholders’ Agreement to state that significant matters require special majority approval. The parties can set the level of support required for special majority approval (for example, it could be 85% of shareholder votes). The parties can also agree upon the list of significant matters that require such approval.
While Anna has 60 votes at a board meeting and Bob only has 40, they agree that special majority approval is required for significant matters. They set the approval level at 75% of the shareholder votes.
This means that while Anna controls the board of directors and can make all company decisions, she needs Bob’s approval before for significant matters.
They agree that these include employment of a managing director, the choice of coffee supplier, etc. Bob is happy that this gives him a say over some big-ticket items.
A Shareholders’ Agreement should outline the funding arrangements for the company. Generally, this will involve the shareholders lending (or committing to lend) money to the company, up to a certain amount, as the funds are required.
The terms of the loan, including the interest rate, should be set at a commercial rate so that the shareholders are compensated for putting up the capital, particularly if one shareholder is putting up most of the capital (or more than its proportionate shareholding).
A company can raise funds by charging the shareholders for the issue of shares. This is called equity funding. Alternatively, it can borrow money (usually from the shareholders) and this is called debt funding—it needs to be repaid. The choice of funding will often depend on tax considerations.
In our example, Anna and Bob estimate that they will require $100,000 to start up the business. Anna does not have enough money to advance 60% of the funding. They agree, instead, that she will lend $20,000 and Bob will lend $80,000 to the company at an interest rate of 13%.
Bob is happy with this arrangement because although he is lending more than his proportionate shareholding (80% instead of 40%) the interest on the loan is substantially higher than he would earn from a bank.
The Agreement should state what happens if a shareholder doesn’t “stump-up” the money it’s promised. The consequences of a shareholder defaulting on its loan commitment are addressed below.
What’s going to happen when the shareholders want to re-slice the pie by issuing more shares, bringing in a new partner or selling-out? Fortunately, shareholders don’t have to put on a kaftan and peer into a crystal ball. They can adopt some well-established rules.
A Shareholders’ Agreement will usually include a provision to the effect that the existing shareholders have the first right of refusal (also known as a pre-emptive right) in relation to a transfer of shares. This means that if a shareholder wants to sell its shares it must first offer them to the existing shareholders (in proportion to their shareholding) and can only sell them to a new shareholder (a third party) if the existing shareholders refuse the offer.
Similarly, a right of first refusal usually applies in relation to the issue of new shares. That is the board of directors must first offer new shares to the existing shareholders and can only issue them to a third party if the existing shareholders refuse the offer. The Agreement may however include some exceptions, for example, permitting a shareholder to transfer its shares to a related party and for the board to issue new shares to as an incentive to an employee without first offering the shares to the existing shareholders.
Put simply, it’s usually agreed that if slices of pie are handed around the kitchen, no one new gets a slice unless everyone in the kitchen has already had their fill.
Here comes the tricky part. What if one of the shareholders want to sell its shares and none of the existing shareholders want to buy them. Should the selling shareholder have the right to sell to anyone of its choosing or should the existing shareholders have the right to approve the third party?
A Shareholders’ Agreement might state that the approval of all existing shareholders is required before a new shareholder can join the company. This makes sense in a start-up company where the expertise of each shareholder is critical. However, in an established company with passive shareholders, it may be agreed that a shareholder can sell its shares to a new shareholder (or the board can issue new shares to a shareholder) without needing approval from the existing shareholders.
Beware that without a Shareholders’ Agreement, the existing shareholders generally won’t be able to stop one of the shareholders introducing a new shareholder without prior approval and they could find themselves in business with someone they've never met or don’t like.
As Anna controls the board she would have the power under company law to issue shares to a new shareholder without Bob’s consent. However, they agree in the Shareholders’ Agreement that a new shareholder can only be introduced with the “unanimous approval of the shareholders”.
This also applies if Anna or Bob want to transfer their shares to a third party. They will need each other’s consent.
When the pie is baked and it’s time for a big sale, the company needs special rules around who gets to sell. Most hungry, self-respecting pie eaters won’t buy a slice, they’ll want it all. But what happens if one shareholder is hanging on to a slither and refuses to sell.
A Shareholders’ Agreement will generally give a substantial shareholder (or group of shareholders acting together) the right to force all of the shareholders to participate in a sale of the company. This is referred to as a drag-along right since the majority can forcibly drag-along all the shareholders in a sale.
In other words, people who own most of the pie can force a sale of the whole pie even if the other shareholders’ don’t want to sell out. Of course, everyone gets their share of the sale price.
Anna and Bob agree that if a shareholder holds at least 60% of the shares it can drag along the other shareholders in a sale. This means that as Anna holds 60% of the shares, if she wants to sell all of the shares in the company to a third party she can force Bob to sell his shares at the same time that she sells hers.
What happens when the head chef finds a hungry pie-eater willing to pay a high price for a slice. Is it only the head chef that gets to sell or can the other shareholders sell part of their pie too?
Generally, a Shareholders’ Agreement will require a substantial shareholder (or group of shareholders acting together) to allow the other shareholders to participate in a sale of shares to a third party. This is referred to as a tag along right since the minority shareholders can tag along on a sale by the other shareholders.
In other words, when a customer comes in everyone gets to sell part of their pie and make some money. This is agreed up-front in the Shareholders’ Agreement so all of the shareholders can take part in the pie throwing when a sale opportunity arises.
Anna and Bob agree that if Anna (as the majority shareholder) finds a buyer for some of the shares, she must allow Bob to tag along on the sale. Specifically, they each get to sell the same proportion of their shares.
So, when the new shareholder buys 20 shares he must buy 12 of them from Anna and the other 8 from Bob consistent with the fact that Anna owns 60% of the shares and Bob owns the other 40%.
Note that a tag along right is the opposite of a drag along right. Instead of being forced to sell, Bob has the option to participate in the sale.
When the cooks are making the best tasting pie in town they don’t want anyone giving away the recipe or running off with the milk man.
To keep shareholders focussed on the success of the business, a Shareholders’ Agreement will usually include a restraint on competition and a duty to keep company information (such as pie-recipes) confidential. The restraint may also stop a shareholder from taking company staff, customers and suppliers (like the milk-man).
The restraint should apply both to the shareholders and their representatives and clearly specify the restrained activities, the time period and the geographical area of the restraint.
The restraint in the Shareholders’ Agreement for Bobanna Rainforest Coffee Pty Ltd lists the restrained activities as, among other things:
- competing with the business;
- Supplying a customer with goods or services that are supplied by the company; and
- Soliciting or enticing a supplier away from the business.In practice, this means that Bob cannot start up in competition with the company or steal away the coffee suppliers he has sourced. Likewise, if the business goes well, Anna cannot exclude Bob by starting up a competing company.
The restraint applies to both the shareholders and their representatives so, for example, it covers Bob’s family company, Bobo Pty Ltd, as the “Shareholder” as well as Bob as the “Shareholder Representative”.
The period of restraint in a Shareholders’ Agreement should be reasonable otherwise it may not be enforceable. A court will often void a restraint if it goes further than necessary to legitimately protect the goodwill of the business. To deal with this issue, a Shareholders’ Agreement will often include a “ladder” or “cascading” restraint period.
For example, Anna and Bob agree that the restraint applies to a Shareholder (and its Shareholder Representative) while the Shareholder holds Shares and for the following extended period after it ceases to hold Shares:
- an extended period of 9 months; or
- if that is unenforceable, an extended period of 6 months; or
- if that is unenforceable, an extended period of 3 months.
The Agreement should specify the geographical area of the restraint.
Since Bobanna Rainforest Coffee Pty Ltd will sell coffee in Australia, but there are no plans to sell overseas, Anna and Bob agree that the area of the restraint is limited to Australia.
Given the risk that a restraint may not be enforceable and the substantial effect it can have on a party’s ability to earn a living, parties are strongly advised to obtain legal advice on their specific circumstances before entering into an agreement that contains a restraint clause.
What happens if a shareholder breaks the rules (for example by disclosing the secret pie recipe)? A Shareholders’ Agreement will usually contain a technical version of the old adage, “if you can’t stand the heat, get out of the kitchen”. It will require a naughty shareholder who can't follow the rules of the Agreement to offer its shares in the pie to the other shareholders at a significant discount. This acts as a dis-incentive for bad behaviour. The discount should be agreed up front in the Shareholders’ Agreement. Often it will be agreed as a discount to the fair value (as determined by an independent valuer).
The Agreement may state that a shareholder is also forced to offer its shares to the other shareholders if it is insolvent or cannot perform its duties because the shareholder or its shareholder representative dies or is permanently incapacitated. However, in this case, the shares may be offered at fair value rather than at a discounted priced since that would be unfair.
Anna and Bob agree that if a shareholder defaults on its obligations under the Agreement, the defaulting shareholder is forced to offer to sell its shares to the other shareholders at 70% of the fair value. They also agree that if a shareholder dies or is permanently incapacitated it is forced to offer its shares to the other shareholder at 100% of the fair value.
This means, for example, if Anna dies Bob can buy out her shares for the fair value (as determined by an independent valuer). Likewise, Anna can do the same if Bob dies.
Download a Free Sample of the Shareholders Agreement Template and see how easy it is to write your own agreement.