This Article was written by Brian Jones of Burley Attwood Law. This firm provides the full range of legal services from property contracts, to company and commercial business transactions, dispute resolution and litigation.
Just as relationships between spouses can breakdown or encounter difficult issues which threaten the relationship, the same can happen between shareholders and directors in a company. Spouses can enter into private Relationship Property Agreements classifying and dividing relationship property, and custody rights. But what happens in the case of shareholders and directors of a company in similar circumstances? This can be a significant problem in private, closely held, small companies, where directors and shareholders are often friends or family.
Shareholders and directors should have a set of rules governing their rights and obligations, how the company is to be managed and ultimately how they can exit the company or buy the other shareholders out should there be a death, a dispute that cannot be resolved, or an event making continuation with those shareholders undesirable. This requires processes for; valuing shares, the removal or resignation of directors or employees, dealing with shareholders current accounts, loans made to the company, and guarantees given for the benefit of the company to third parties, such as landlords and financial institutions.
This is best achieved by way of a Shareholders Agreement (“SA”) working in tandem with a Company Constitution. The SA is a private document, unlike a Company Constitution which is registered as a public file at the Companies Office. The SA sets out how the company is to be funded, managed and administered. It prescribes the rights and obligations of the shareholders, and how the shareholders intend to run the company. It is designed to ensure the company business is a success, whilst protecting your investment in the company. It should provide for exit strategies and mechanisms, and adequate compensation if you want to get out.
It is desirable to agree upon the terms of an SA at the beginning, when everyone is on friendly, amicable terms and are still alive. Trying to reach agreement after a dispute has arisen or someone has died is often very difficult and all too often results in opposing parties calling for their lawyers. In worst case scenarios it can be very expensive. Prudent company investors will ensure they have an appropriate SA in place for their protection and for the success of the company business.
So what things can an SA provide for? Common features they cover are:
- The shareholding structure, including number of shares and the holders. They often state the company cannot issue further shares without the approval of all shareholders and if new shares are issued, existing shareholders have a right to subscribe for them in the same proportion as their existing holding. This helps keep the voting rights in the same proportions at all times, unless shareholders choose otherwise.
- The initial directors of the company and if there is a minimum shareholding requirement to be a director. Whether you have to hold a certain percentage of shares before you have the right to have a representative director on the board (which can be yourself or someone else you choose) for your holding or a particular group of shareholders. Sometimes shareholders are simply content to be shareholders alone, relying on directors to manage the company prudently for them.
- The initial funding requirements to be provided by the shareholders for paying up the issued share capital of the company in full, and also loans which fund the initial business venture. This includes whether or not interest is payable on loans, whether they are for a term or on demand, and if repayment is demanded, whether they may be repaid over time, to make it easy on the company.
- That the directors will manage the company in a proper and business-like manner for the benefit of all shareholders (not any one shareholder). For some special events the directors must follow the decision of a majority of 75% of the shareholders. For example an amendment to the constitution, the issuing of shares, the determination of directors’ remuneration, lending to any shareholder, employing a shareholder, transactions incurring expenses or liabilities over a set limit, granting security over company assets, declaring dividends and so on.
- Whether additional loans to fund the company have to be in proportion to existing shareholdings, to keep the shareholders’ exposure and risk in proportion to their investment; and whether there is to be security for those loans. For guarantees from shareholders in favour of third parties, whether all shareholders have to give guarantees to keep risk and exposure the same.
- What the dividend policy of the company will be, determining when dividends are to be paid out of profits, and what reserves the company will retain for working capital.
- Who is to be employed by the company, on what terms and in what capacity. If they are shareholders and cease employment, whether they have to sell their shareholding and exit the company. Whether past employees will be subject to restraint of trade provisions (ie. not to compete with the company or solicit its customers or business), to protect the company after they have gone.
- Under what circumstances a defaulting shareholder must sell their shares in the company and have their representative director resign. For individuals this is often in the case of death, bankruptcy, or they cease employment by the company, or become permanently disabled. If a company is a shareholder this will be in the case of receivership, liquidation or winding up. This often applies if a shareholder breaches the SA or is convicted of a criminal offence etc. In those circumstances the fair value of those shares is often determined by the SA, usually by referring the valuation to a particular expert or accountant. The shares are usually first offered back to the other shareholders so they can buy the defaulting shareholder out at that fair value, following pre-emption rights.
- Sometimes there is a “put option” where the other shareholders can force a defaulting shareholder to buy their shares out, thereby providing an exit mechanism. A put option can also be used by shareholders to force a sale of shares to other shareholders on the happening of a specific event, for example a separation from a spouse, the cessation of employment by the company, or if the company fails to achieve financial targets, or loses key business contracts.
- If a shareholder dies there is often a right of first refusal given to the other shareholders, to buy the deceased shareholders shares, so continuing shareholders are not faced with the possibility of being burdened with an incompatible new shareholder.
- Where a shareholder wants to sell their shares it can provide that they must first be offered back to the other existing shareholders so that no shareholder can sell to a third party without the consent of the other shareholders. They often provide that no shareholder can mortgage their shares without the consent of the other shareholders.
- They may include “tag along” rights so if a shareholder sells to a third party the other shareholders may require that purchaser to buy their shares also. This is often used to protect minority shareholders so they share in a premium being paid for major shareholders’ controlling shares.
- They may also provide for “drag along” rights where a shareholder (usually a controlling majority shareholder) can force the other shareholders to also sell to the same purchaser at the same price, enabling the controlling shareholder to control the whole company.
- They should provide for the release of guarantees on leaving the company and the repayment (or zero balancing) of shareholders’ current accounts.
- Dispute resolution clauses often provide for mediation of disputes to avoid having to go to court. Often they include (either in the SA or the Company Constitution) deadlock provisions for resolving disputes where there is no unanimous decision by shareholders or directors, even if there is a majority in favour of a resolution. A disgruntled director or shareholder may refer the matter to an independent referee or a particular person, who makes a decision based on what is in the best interests of the company, as opposed to any group of shareholders or directors.
- They will often contain confidentiality provisions so that vital company information including the contents of the SA, may not be disclosed to third parties without the consent of the shareholders.
In conclusion it is crucial for the success of the company and the protection of shareholders that you have an SA which works in tandem with the Company Constitution. It should be done at the beginning, when everyone is still getting on with one another. Don’t wait until it is too late, when no one can agree on terms because of conflicts, and the hardening of positions. Resolving disputes in court, especially shareholder disputes, can be both lengthy and very expensive. Contact Burley Attwood Law and they can assist you work through the various options for an SA that will suit your company, your personal goals, will offer you the protection your investment deserves and will see you get fairly compensated if you decide to leave instead of stay.
This article does not constitute legal advice. You should obtain specific advice before you make any decisions or take any action based upon information contained herein.