Why have a Shareholders’ Agreement?
The Articles of Association of a company will bind all shareholders automatically and as soon as they become a shareholder in a company.
A shareholders’ agreement is a contract between specific named individuals and so is incapable of binding anyone else unless they also become a party to it.
The Articles of Association and other company formation documents are documents of public record available to the world at large, whereas a shareholders’ agreement is a confidential contract which is not open to public scrutiny.
Shareholders’ agreements are frequently used for small private or family companies and particularly where additional rights are required for investors or minority shareholders.
Shareholders & Directors
It is also quite often the case that a shareholders’ agreement will regulate the affairs not only of the shareholders but also of the directors (if they are also shareholders) and will frequently regulate how votes are exercised either in respect of shareholder votes or director votes or both.
It is also common for a shareholders’ agreement to deal with a deadlock situation; a situation in which company stagnates and is unable to move forward at management level.
There are various options for dealing with deadlock situations and none are attractive – that is essentially the point. It is essentially a mind-set issue designed to prevent rather than cure. If shareholders have in the back of their mind a fear of deadlock (i.e. triggering an unattractive resolution) it is hoped that this will prevent the deadlock from arising in the first place.
Typical deadlock resolution clauses could provide for the ultimate sale of the business or for one or other of the shareholders to be able to buy out the other. Glorious remedies along the lines of “Russian roulette” or “Texas shootout” clauses have been devised.
Share transfers are frequently covered in a shareholders’ agreement sometimes on a basis which is entirely inconsistent with the Articles of Association.
A question often asked is whether or not this inconsistency should result in an amendment to the Articles of Association. On occasions, this is desirable but it is not always necessary as the shareholders’ agreement should have a “prevail” clause which means that, in the event of any inconsistency, the shareholders’ agreement will prevail over the Articles of Association.
Indeed, for the reason given above (the Articles are open to public inspection and a shareholders’ agreement is not) sometimes people feel “comfort” knowing that they are in a sense screened from public inspection.
However, this may be dangerous in certain circumstances. A new shareholder will not be bound by a shareholders’ agreement until he or she has signed up to it (normally through a deed of adherence) whereas he or she will as a new shareholder automatically be bound by the Articles of Association.
It is also a frequent minority shareholder protection device to insert either “tag along” or “drag along” rights.
Tag along rights would protect a minority shareholder from being left “stranded” by an existing majority shareholder should the majority shareholder receive an offer for their shares. The clause works on the basis that, if triggered, a majority shareholder must require a buyer of shares to purchase all the other shares in the company.
Drag along rights, on the other hand, are designed to protect a large shareholder who may be considering selling and wishes to avoid any resistance from the minority shareholders.
It works on the basis that a shareholder holding at least say 75% can deal with the transfer not only of that shareholding but of all other shares in the company on similar terms. This will avoid any difficulty for a prospective buyer of shares to be offered merely 75% rather than 100% of shares in the company.
There should be valuation provisions for the shares which specifically exclude discounting provisions that would otherwise apply to a minority shareholding.
It has frequently been said that up to 90% of the value of the company is represented in 51% of the voting shares with the effective remainder of the value being in the level of shares 52% to 75%. A minority shareholding of up to 24% could, therefore, be argued to be virtually worthless although it is frequently agreed in a shareholders’ agreement that all shares are equal as far as valuations are concerned.
It would also need to provide that valuations for a prospective sale or transfer of shares would be agreed between the parties or in default of agreement assessed by an independent party. Great care would need to be taken in deciding who the appropriate party should be and who should make a decision on appointment of the independent expert if the parties are unable to agree.
In the case of a small private company, whilst it is tempting to think that the company’s auditors would be a good starting point, there is some risk of bias here which could affect independence of assessment.
Please see our Snapshot Shareholders’ Agreement Checklist for further points to consider. If you need specialist legal advice then call rhw’s commercial law team on 01483 302000 or email rhw Solicitors in Guildford at firstname.lastname@example.org