What is a Shareholders Agreement?
Before your company has more than one shareholder, I recommend you speak to a lawyer about drafting a shareholder agreement.
A shareholders agreement sets out many of the shareholders’ rights and responsibilities and essential processes required in the company’s operation – the most important of which I have listed below.
If you currently operate your company without a shareholders agreement, your company constitution and the replaceable rules under the Corporations Act 2001 (Cth) will likely govern your company. The replaceable rules are a one-size-fits-all solution to governing the operation of companies and are therefore not suited to all.
Directors who wish to adopt a shareholders’ agreement must check the company constitution, which often requires a special resolution of 75% of shareholder votes to modify. Section 136(2) of the Corporations Act 2001 (Cth) reflects this requirement.
Preemptive Rights
Shareholders must consider how they would like shares dealt with. If a shareholder can freely 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 to only sell their shares after 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. It would be best to decide what decisions the board of directors, the (non-director) shareholders and the managers make. It is impractical to take every company decision to a vote. For example, the General Manager can decide to hire a new employee rather than calling a shareholder meeting to vote on such decisions.
It is best to have the board of directors make the decisions on critical operational, business and strategic matters in which they have expertise. What do you think about appointing a new CFO? Should that be a board decision? More than likely.
While directors who are also shareholders will make the critical decisions relating to the company’s running, the non-director shareholders may vote on matters such as appointment and removal of 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 requires 75% of the vote; and a unanimous resolution, which requires 100% of the votes.
Once you decide who makes what decisions, you must 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.
So, speaking with your lawyer about who makes what decisions in your company is critical.
Disputes
It is best to plan for the worst. Your shareholders’ agreement can provide a dispute resolution mechanism that 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 agree 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.
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. So that you know, whatever is promised to be provided must be identified and measured.
Each co-founder should have an employment agreement separate from the shareholders’ agreement. The shareholders’ agreement may then require that employee shareholder fulfil their employment obligations, and failing to fulfil their responsibilities may cause a breach of the shareholders’ agreement. These clauses ensure that everyone pulls their weight and provides what they promised.
However, many companies need to start with PAYG employment right away. So, shareholders working in the company employment record roles and responsibilities in the shareholders’ agreement.
I would also like to point out what happens if a shareholder breaches the agreement, what is a material (serious) breach, and which are non-material breaches. I usually 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 for working for your company. So that you know, you assigned the shares. He stretched the truth and 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 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, ten shares for every month of full-time work. For added protection, you should consider having bad leaver provisions, as discussed below.
Good Leaver and Bad Leaver
A good shareholder agreement will address shareholding employees who leave the company early and may deem employees who leave your company to work for a competitor as ‘bad leavers’. In this case, they must return their shares to the company at a predetermined, nominal value.
On the other hand, if an employee has worked their heart out for three months but must resign due to illness, the shareholders’ agreement may determine that the shareholder is a good leaver. In this 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.
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 problematic unless the shareholders’ agreement deals with such circumstances. It would be best to consider having ‘drag-along’ rights and ‘tag-along’ rights in your shareholders’ agreement.
Drag-along provisions force minority shareholders to sell their shares and the majority shareholders. At the same time, tag-along rights provide minority shareholders with the option to sell their shares in the same proportion as 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, employee remuneration, 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 some things you must discuss before creating your shareholders’ agreement.
Important things to remember:
- Shareholders agreements are essential to establish shareholders’ rights and responsibilities and set the company’s rules.
- If you have more than one shareholder in your company and want to adopt a shareholders agreement, you must review your company’s constitution and perhaps the Corporations Act for those requirements.
- Consider the 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 the value is provided.
- Consider pre-emptive rights so that the current shareholders have the first right of refusal of shares that a shareholder wants to sell.
