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The Pitfalls of Shareholders Agreements

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The information contained in this article is for information purposes only and is not intended to constitute legal advice. If you require further information our team would be more than happy to assist you. Please contact us at [email protected] or call us on 029 2009 5500 to speak to one of our team.

A shareholders’ agreement is an agreement entered into between all or some of the shareholders in a company.

They seek to regulate the relationship between shareholders, the management of a company, the ownership of the shares and the protection of the shareholders. They also govern the way in which the company is run.

Leanne Thomas, Associate Director of Greenaway Scott takes a look at the importance of shareholders agreements and, in particular, the common pitfalls and how to avoid them.

When entering into a new business venture especially with friends, family or long standing acquaintances it is easy to assume that nothing can go wrong.

However, unfortunately, sometimes things do go wrong so it is important to have an agreement in place which gives protection to the shareholders and also gives them a contractual remedy which would otherwise not be available by relying solely on the company’s articles of association.

Whilst there is no legal requirement to put a shareholders agreement in place, there are many advantages of doing so. Here are a key few:

  • Do it your own way – The shareholders agreement can be entered into before the incorporation of a company which lets the shareholders have a clearer idea of what they are entering into and the general direction and purpose of the company. This could also include how the shares will be issued and whether initial funding will come from shareholder or third party loans.
  • Confidentiality – the agreement is a private document between the shareholders and does not need to be filed on the public register.
  • Deadlock – Provisions can be put in place to resolve any deadlock between shareholders. This will be particularly important where the shareholder arrangement in a company is 50/50 between two shareholders. One example is having a put/call option where one shareholder can purchase the others shares in the event of a deadlock where a deadlock cannot be resolved.
  • Flexibility – the agreement can be tailored to suit the company’s needs. It may set out how company is structured, the day-to-day operations of the company, how many directors there will be, and the remuneration for the directors. The agreement can be as simple or as detailed as the shareholders want.

What could go wrong?

As previously mentioned, if a shareholders agreement does not exist, then any disputes between the shareholders or directors of a company would have to be settled by what is contained within the articles of association. One of the issues with relying on the company articles rather than a shareholders agreement is that in law a company cannot promise to do or not to do certain things. Whereas a shareholders agreement could be worded to bind the company. Also, there is nothing to prevent a director from being removed by 50% of the shareholders by an ordinary resolution. Similarly, even if the articles are drafted so as to protect the shareholders, they can be amended by a 75% majority of the shareholders, effectively removing any protection of the minority shareholders.

What happens if shareholder wants to leave?

One of the main issues to consider when putting a shareholders agreement in place is what should happen if one shareholder wants to leave the company. Without any such clause in a shareholders agreement a shareholder who leaves may be able to sell his shares to anyone, leaving the remaining shareholder(s) running a company with an unknown shareholder. It is therefore important to have a set route in terms of how shares are to be dealt with.

The most common and practical way to avoid this would be for there to be a provision in the agreement which requires the shares to be offered to the remaining shareholders first.

You may also wish to consider whether the shares could be sold to a third party, although, whilst this could bring about its own problems, it may not be as onerous as having an unhappy shareholder ‘locked in’ to the company. The shareholders’ agreement helps iron out such issues before they arise by setting out a clear structure to the sale or transfer of shares.

If there is no particular way out of the shareholding, or if there is a stalemate between the shareholders or directors, then the shareholders’ agreement can provide for what happens if there is a ‘deadlock’, and this could include the above situation where a shareholder is ‘locked in’ to the company.

Further protection can be drafted into the agreement in the form of drag along and tag along rights. A drag along right allows a majority shareholder of a company to force the remaining minority shareholders to accept an offer from a third party to purchase the whole company. The majority shareholder who is ‘dragging’ the other shareholders must offer the minority shareholders the same price, terms and conditions that the majority shareholder has been offered. A drag along clause will allow the majority shareholder to ‘drag’ the remaining minority shareholders with them and require them to sell their shares to the potential buyer at the same price, in order to allow the buyer to purchase the entire company.

Conversely, when a majority shareholder sells their shares, a ‘tag along’ right will entitle the minority shareholder to participate in the sale at the same time for the same price for the shares. The minority shareholder then ‘tags along’ with the majority shareholder’s sale.

Lastly, it’s important to consider what should happen if one of the shareholders were to die. As without such a provision the executors of the deceased’s estate could obtain control over the shares and may not be willing to deal with them in a way that is beneficial for the remaining shareholders or the company as a whole.