What is a Shareholders’ Agreement?

Before your company has more than one shareholder, I recommend that you speak to a lawyer about drafting a shareholders’ agreement for your company.  The shareholders’ agreement sets out many of the shareholders’ rights and responsibilties as well as important processes required in the operation of the company – the most important of which I have set out below.

f you are already running a company with co-founders and you don’t have a shareholders’ agreement in place, it is likely that your company will be run by the rules in you company constitution and the replaceable rules under the Corporations Act 2001 (Cth). These rules are a ‘one size fits all’ solution to run companies and are not often suitable for most companies.  A company that wishes to adopt a shareholders’ agreement will need to check it’s consititution, which often requires a special resolution of 75% of shareholder votes to modify.  This is reflected in section 136(2) of the Corporations Act 2001 (Cth).

Preemptive Rights

Shareholders must consider how they would like shares dealt with. If a shareholder is freely able to sell their shares, they may sell to someone the other members don’t know or don’t want to be associated with. Shareholders’ agreements often have clauses that force shareholders not to sell their shares without first offering them to existing shareholders. Such rights are known as preemptive rights.  Further, a period may be stipulated in which the shares may not be sold to anyone.

Voting Rights of Shareholders

The shareholders’ agreement must also deal with voting rights. You must decide what decisions are made by the board of directors, the (non-director) shareholders and the managers. It is impractical to take every company decision to a vote. For example, the decision to hire a new employee can be made by the General Manager, rather than calling a shareholder meeting to vote on such decisions.

It is best to have the board of directors make the decisions on important operational, business and strategic matters in which they have expertise. What about appointing a new CFO? Should that be a board decision? More than likely.

While directors who are also shareholders will make the important decisions relating to the running of the company, the non-director shareholders may vote on matters such as appointment and removing directors or whether to take the company public.

Decisions that are required to be made by voting are called resolutions. The most common types of resolution are: ordinary resolution, which requires more than 50% of the votes, a special resolution – which usually requries 75% of the vote and a unanimous resolution which requires 100% of the votes.

Once you decide who makes what decisions, you must then determine the percentage of votes required to make those decisions – or to pass those resolutions.

For example; a unanimous resolution may be required to change the shareholder agreement, a special resolution (over 75% of votes) may be required to hire and fire a general manager, and a majority decision (over 50% of votes) of the board is required to hire a new C-Suite executive.

It is therefore critical to speak to your lawyer about who makes what decisions in your company.

shareholders' agreement

Disputes

It is best to plan for the worst. Your shareholders’ agreement can provide a dispute resolution mechanism which requires other methods of dispute resolution to be carried out, before commencing legal action through the Courts. There are two types of alternate dispute resolution (ADR) processes that I recommend considering – they are mediation and arbitration.

Where a shareholders’ agreement requires mediation in the event of a dispute, the parties must negotiate to resolve the dispute before a  mediator, where the parties are encouraged to come to an agreement between themselves. An arbitration clause requires parties to meet before an arbitrator, where each party puts their case forward and the arbitrator decides the outcome.

Be sure to consider including an ADR process in your shareholders’ agreement to help resolve costly disputes outside of Court.

Enforcing Shareholders’ Promises

In the early stage of your company, co-founders provide different forms of value. Some provide cash, some provide skills, while others provide industry connections. Whatever is promised to be provided, must be identified and measured.

Each co-founder should have an employment agreement that is separate from the shareholders’ agreement. The shareholders’ agreement may then require that employee shareholder fulfill their employment obligations and failing to fulfill their responsibilities may cause a breach of the shareholders’ agreement.  These clauses ensure that everyone pulls their own weight and to otherwise provide what they promised.

However, many companies don’t start with PAYG employment, right away. So shareholders who are working in the company employment, then record roles and responsibilities in the shareholders agreement.

You should also stipulate what occurs if a shareholder breaches the agreement and what constitutes a material (serious) breach and which are non-material breaches.  I usually also advise bad leaver provisions to those who don’t provide what they promised.  I have discussed bad leaver provisions below.

Employees and Shares

For employees who are to receive shares under an employee share scheme (ESS) as part of their employment package shareholder agreements must stipulate how shares are handled.

Imagine what would happen if you found the best coder on the planet. He accepted 2% of your company in exchange to work for your company. You assigned the shares. He stretched the truth and he isn’t as good as you thought. They are his shares now. You can’t get them back – he can retire on a beach while you do all the work – unless you have planned for these types of circumstances in the shareholders’ agreement.

Instead of outlaying the shares immediately, shares for employees can vest. This means they are assigned incrementally over time or upon reaching a particular milestone or point in time.  For example, 10 shares for every month of full-time work.  For added protection you should also consider having bad leaver provisions, discussed below.

Good Leaver and Bad Leaver

A good shareholder agreement will address shareholding employees who leave the company early and may deem that employees who leave your company to work for a competitor, are ‘bad leavers’. In which case, they must sell their shares back to the company at a predetermined, nominal value.

On the other hand, if an employee has worked their heart out for 3 months, but must resign due to illness, the shareholders’ agreement may determine that shareholder to be a good leaver. In which case the employees’ shares are purchased back for market value – or sometimes less, depending on the shareholders’ agreement.

There are many different ways to handle good leavers and bad leavers. A good lawyer experienced in company law can talk you through these provisions.

shareholder agreement

The Exit

You need to consider what happens if a larger company offers to buy your company out and half the shareholders want to sell, and the other half don’t. This can be very problematic unless the shareholders’ agreement deals with such circumstances. This is why you should consider having ‘drag-along’ and ‘tag-along’ rights in your shareholders’ agreement.

Drag-along provisions force minority shareholders to sell their shares, along with the majority shareholders. Whereas, tag-along rights provide minority shareholders the option to sell their shares in the same proportion to majority shareholders. For example, majority shareholders A, B and C vote to sell 20 per cent of their shares, therefore, shareholder D also has the right to sell their shares in the same proportion.

Finances

A good shareholders’ agreement must also contemplate financial issues, such as who decides to pay out dividends, what are the spending limits, emplloyee remunersation, etc.

There should also be terms that force the board to make financial statements available to the shareholders each quarter.

As you can imagine, there are many issues regarding money that need to be addressed.  Above are just some of the things that you need to be discussed before creating your shareholders’ agreement.

Important things to remember:

  • Shareholders’ agreements are important to establish shareholders’ rights and responsibilities and to set out the rules of how the company will be run.
  • If you have more than one shareholder in your company and you want to adopt a shareholders’ agreement you will need to review your company’s constitution and perhaps the Corporations Act, for those requirements.
  • Consider voting rights of board members, shareholding employees and ordinary shareholders.
  • Start with the end in mind – consider how shareholders will exit the company.
  • Be careful about allocating shares before value is provided.
  • Consider pre-emptive rights so that the current shareholders have first right of refusal of shares that a shareholder wants to sell.

Related article:  Read about a deed of accession that usually accompanies a shareholders’ agreement.

Related article: Key Aspects to a Shareholders’ Agreement for a Startup Company.

Also see the Technology Law Guide.