A shareholders’ agreement is an agreement between the company’s shareholders setting out how the shareholders will own and operate the company and their rights and obligations towards each other. It will cover areas such as what happens if a shareholder wants to sell their shares, what decisions require shareholder consent and board appointment rights.
What is a Shareholders’ Agreement?
A shareholders’ agreement is an agreement between the shareholders in a company setting out how the shareholders will own and operate the company and their rights and obligations towards each other. Unlike the company’s articles of association, it is a private document which does not need to be filed with the UK register of companies. The agreement therefore can include confidential provisions covering things such as the company’s business plan or how profits will be distributed among the shareholders.
In a shareholders’ agreement, the shareholders agree on certain principles. For example:
- the management and operations of the company (corporate governance) (for example the right to appoint directors to the board, and reserved matters or veto rights where certain resolutions and decisions require a minimum majority);
- resolutions on new share issues and subscription of new shares;
- the transferability of existing shares;
- drag-along (where the majority shareholder(s) can force the minority shareholder(s) to sell to a third party) and/or tag-along provisions (where the minority shareholder(s) can make sure their shares are bought on the same terms by a third party buyer); and
- non-compete and non-solicitation clauses.
For founders, the shareholders’ agreement also sets out the expectations on each founder’s working time and responsibilities, and includes, for example, vesting schedules (setting out how each founder “earns” his or her shares over a period of time).
When should you use a Shareholders’ Agreement?
As a rule of thumb, as soon as a company has more than one shareholder, we strongly recommend that you enter into a shareholders’ agreement. For founders, we recommend entering into a shareholders’ agreement as soon as possible after incorporating the company. Codifying expectations and what will happen in certain situations reduces the risk of future conflicts, facilitates cooperation and increases the likelihood that the company will be successful. As an alternative to a shareholders’ agreement, you can also use a founders’ agreement, which is a shorter version of a shareholders’ agreement.
Why is a Shareholders’ Agreement important and why should you use it?
A shareholders’ agreement complements and functions in conjunction with the provisions in the Companies Act 2006 and the company’s articles of association. While the Companies Act 2006 and the articles of association provide a legal foundation for the company, a shareholders’ agreement covers situations that are not regulated.
The agreement sets out how to handle future events, e.g. a sale of the company, where a founder suddenly quits the company or can no longer dedicate his/her working time to the company, or what happens to an owner's shares if they pass away. It may also include specific terms which protect the interest of minority shareholders which are not afforded under the Companies Act. Unlike the articles of association, the shareholders’ agreement is not a public document and can therefore include confidential provisions covering things such as the company's business plan or how profits will be shared etc. The terms of the shareholders’ agreement can also be changed in the future, as long as all parties agree on the changes. It is therefore common for a new form of shareholders’ agreement to be re-entered into when an investor comes on board and specific terms need to be included to protect the investment.
What are the common pitfalls of a Shareholders’ Agreement?
The most common pitfall is not having a shareholders’ agreement in place at all! Many founders feel that it is unnecessary to have a shareholders’ agreement when starting a company with a friend. You already know each other, so what can really go wrong? Well, as in all types of relationships, even a friendship can end due to unforeseen events. Maybe one of you wants to withdraw from the company and instead start working for a competitor. Or maybe you want to cash in on your success and sell the company. Agreeing how you deal with these issues at the start of the venture will avoid a falling-out later on.
By ensuring that all shareholders have entered into a shareholders’ agreement (either by signing the agreement when it is originally entered into, or by way of a deed of adherence to the agreement) you can avoid significant future headaches.
However, a shareholders’ agreement requires careful consideration in relation to, for example, board representation, as well as drag-along and tag-along thresholds. Under the Companies Act, directors can be appointed by a majority vote of the shareholders, which means that any shareholder or group of shareholders controlling more than fifty per cent of the voting rights effectively controls the board of directors. The shareholders’ agreement however allows you, for example, to provide minority shareholders the right to board representation which the majority shareholders cannot deviate from without breaching the agreement. With respect to drag-along and tag-along thresholds, it is important to put some thought into what the ownership of the company looks like so that the thresholds are properly balanced - PocketLaw provides you ample guidance and recommendations on appropriate thresholds.
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