Shareholders Agreement

Do you really need a shareholders’ agreement?

It’s a bit like home insurance. You don’t expect your house to burn down, but are you really going to take the risk by not insuring it?

If you are in one of the following categories, the risk you are taking by not having a shareholders’ agreement is disproportionate to the cost …

1. An investor in a private or Pty Ltd company
2. A minority shareholder, whether you work for the company or not
3. A majority shareholder. Yes, a majority shareholder!
4. Any private company with more than one shareholder

So why is a shareholders’ agreement so important?

• For the protection of your investment (whether it’s your time/effort or money you’ve invested);
• For protection against personal liability (if you are a director); and
• For protection of the business.

Protection against what?

In summary – protection against the type of problems which commonly occur between shareholders in private companies.

But no one talks about these things so most people have no idea how common it is, what type of problems occur and how significant the financial consequences can be.

What type of problems?

For example, a difference of opinion between shareholders about a wide range of issues (from the direction of the business to appointing a new director or issuing new shares) is invariably resolved by a majority decision. That sounds fair but, if a minority shareholder feels aggrieved, that can cause a rift, particularly if there is some justification for the way he/she feels e.g. he/she may have had an expectation that owning 25% of the shares would mean 25% of the profits, but there is no guarantee of this in the absence of a shareholders’ agreement.

The end result is a deterioration in relationships which often results in a shareholder deciding that it is best to sell his shares and go his own way.

But that is easier said than done. What usually happens in this situation is that the only buyer is another shareholder, who invariably thinks the shares are worth a lot less than the seller thinks.

This often puts an end to a sale which means one of two things …

Most drastically, if there is much money involved, it can end in legal proceedings and a court will (in the absence of a shareholders’ agreement) order the company to be wound up. Everybody loses.

Alternatively, the disgruntled shareholder who is unable to sell for a fair price is “locked-in” which causes more friction and more problems, such as the shareholder setting up the same type of business in competition – see below.

Another problem which can arise without a shareholders’ agreement is that the majority shareholders can issue more shares to themselves and increase their percentage ownership for little outlay at the expense of a minority shareholder.

I can give you a long list of problems (and I will if you request one) but it’s more productive to look at the underlying causes so that steps can be taken to provide mechanisms in a shareholders’ agreement to address the causes, rather than the symptoms. But before I do, you may be thinking …

“If a problem occurs, we’ll be able to work it out”

When people go into business together, they are confident that they will be able to work together harmoniously. This is usually because they only go into business with people they know, respect and trust.

People also believe their interests will remain aligned because they have a common objective of making the business successful.

As a result, they make the mistake of thinking that common sense will apply and they will be able to sort out any problem by discussion and agreement. Mmmm!

Long experience on both sides of the fence (as a lawyer who regularly deals with problems between shareholders and as a shareholder in companies with more than one shareholder) has proven to me that such confidence is usually not warranted. And, although a successful business helps, problems still occur no matter how successful it is.

What are the causes of these problems?

One of the most common causes is that the business and/or the behaviour of fellow shareholders does not live up to the expectations of one or more shareholders.

But it may surprise you that, even when performance exceeds expectation, problems still occur. For example, people’s priorities change for a lot of reasons unrelated to the success of the business – family problems, health, personal financial issues, etc.

Any such change can result in the shareholders’ objectives no longer being aligned which increases the chances of disagreements and other problems. For example, a shareholder may need to sell his/her shares which, as mentioned above, can lead to disagreements and problems.

Without a shareholders’ agreement which provides a fall-back mechanism (i.e. a way to resolve a disagreement if you can’t agree to a solution), a disagreement can become a disaster.

Actually, a shareholders’ agreement should do more than provide a fall-back. It should prevent problems occurring.

How does a shareholders’ agreement prevent a problem occurring?

1. The process alerts shareholders to potential problems that they are usually unaware of. Forewarned is forearmed!
2. The discussion which occurs between shareholders in deciding upon the provisions to go in their shareholders’ agreement raises issues which are otherwise not discussed. This results in greater understanding and clarity about the expectations and commitment of each shareholder, which minimises the likelihood of a misunderstanding – the cause of many problems.
3. A customised shareholders’ agreement will provide a mechanism for dealing with various issues which could otherwise cause a problem. Knowing that such a mechanism is binding in the absence of everyone agreeing to a solution has the effect of stopping an issue from becoming a problem.

Let’s look at a specific example. The disgruntled shareholder referred to above, whether he is locked-in or sells for a price he is not happy with, decides to set up the same type of business in competition. I hear you say “What? How can he do that?” The answer is that there is usually nothing to prevent a shareholder setting up a competing business if you don’t have a shareholders’ agreement with a non-competition clause.

How does it contain the damage if a problem can’t be prevented?

A shareholders’ agreement should provide a clear set of rules about how the company will operate and what needs to be done if certain things happen. For example, the non-competition clause referred to above will prevent a shareholder from competing against the company but it won’t prevent the underlying problem – an unrealised expectation resulting in a disagreement.

There needs to be a mechanism which will avoid the disagreement escalating, which can end in court. For some businesses, this can mean the end of the road.

One solution is for the shareholders’ agreement to provide a process for a disgruntled shareholder to be able to sell at “fair value”. But this often results in another problem – the parties disagreeing about the valuation. This should also be dealt with in a customised shareholders’ agreement.

Is it too late after the business starts?

Even if you have been operating smoothly for some time, and trust your business partners and other shareholders implicitly, things can still change.

What usually happens is, if a shareholders’ agreement is not entered into at the start, it tends to get put off and then, when a problem arises, it’s too late.

Will a cheap online solution do the job?

No.

The general rule is that you get what you pay for. However, in the case of an online shareholders’ agreement which is created automatically when you complete a limited electronic form, there are compelling reasons why anything you pay is a waste of money.

This is partly because such template agreements don’t contain some of the provisions which are important to protect you against the type of problems which occur. For example, I have never seen one which contains a mechanism which will enable a disgruntled shareholder to exit in a way which will avoid problems. Nor have I seen one which contains a clause to resolve a disagreement about a valuation of shares.

Just as importantly, a shareholders’ agreement must be specifically customised for your particular circumstances, not just details such as names, addresses, number of shares, how many directors you want, etc. Otherwise you are letting someone else decide what provisions or mechanisms will work for you without you providing any information which would enable them to make that decision.

For example, some templates give the chairperson a casting vote without you having any choice. But the consequences of this can be significant so it is not something which should not be decided by anyone other than the shareholders [after the significance of how this changes the balance of voting power is understood].

The bottom line is that it is critically important for a shareholders’ agreement to be put together by a lawyer with a lot of experience in this area of the law.

Systems which enable gaps in a template to be completed by a computer cannot do this.

The killer

On top of all the other problems with website created agreements, here is the killer – even the online providers don’t have confidence in their own shareholders’ agreements. If you read the fine print, you are likely to find that they exclude any liability and there is a disclaimer that they do not provide legal advice. That’s because they are not lawyers!

This means that you don’t get the protection of a lawyer’s professional indemnity insurance, which itself is a good enough reason to use a qualified lawyer to prepare such an agreement.

Why use our shareholders’ agreement?

I could tell you that our agreement represents great value for money because of its quality and because it is far less expensive than similar agreements.

But that is easy to say, so we will offer you a guarantee – if  you believe it doesn’t represent good value for money, we will reduce our fee to meet the price of any comparable shareholders’ agreement PLUS we will give you a further 10% rebate.

Further information? Quotation?

Please complete the Contact page if you would like a quotation or more information, such as why a majority shareholder needs protection.