What are the contents of a shareholder agreement?

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New businesses are often formed on a relatively informal and intimate basis. Like any good romance, a business relationship starts with some innocence and chemistry, but the day-to-day stresses and strains of running a company together can have the effect of turning endearing foibles into irritating habits. The shareholder agreement can act like a pre-nup or a room-mate agreement.

When Clara and Adam set up Equality IT Ltd together, they both invest the same time and capital, and it’s fairly obvious that they will have equal shares and equal rights. They award themselves 50 shares each. But wait… business relationships have the potential to be even more complicated than marriages.

Funds are tight, so when a third friend, Victor, offers to set up the IT system in return for shares in the company instead of cash payment, it seems too good a deal to decline. Clara and Adam each sign over five of their shares to Victor.

Friend Four, Emma, who works for a top PR company, comes along and offers her marketing expertise. She knows cash flow is a problem at the moment, so offers to put in a few weekend hours for free… as a thank you, the partners decide to give her a present of a couple of shares, issuing new ones this time, it’s just a token, but…

The original romance now feels a bit crowded. Suddenly, nothing is as straightforward as it once seemed.

The Shareholder Agreement is a means of keeping track of each of these changes. Yes, they may be recorded in the minutes of board meetings (if you actually take minutes), but the board minutes are unlikely to go into as much detail, particularly concerning future eventualities, such as what happens if Victor or Emma decide to sell their shares. Add to that, board minutes are not usually legally binding on the parties in any event.

The Shareholder Agreement also clearly lays out what these share allocations mean – Victor may think that he can now cast the deciding vote in any dispute, but the original partners may have intended his shares to be non-voting, that is, allowing Victor a share of the profits, but not a say in the company’s day-to-day business. A Shareholder Agreement can make all of this clear, preventing future discord.

In a proverbial nutshell, a Shareholder Agreement can set out: who owns what; when and why (if relevant) it was allocated to them; what the allocation means (the individual rights of the shareholders); and act as an aide-memoire, in the event that shares were agreed but not actually officially issued for any reason.

DIRECTORS AND DECISION MAKING

Why it pays to control the powers of directors?

During the course of its life, every company is bound by any contract made by one of the directors. It doesn’t matter if the other directors didn’t agree to it. Nor does it matter if there is an agreement between the directors that no one of them has authority to sign on behalf of the company. The company is still committed.

The ability of a director to ‘go rogue’ means that the company could find itself the proud owner of such non-essential items as a pool table for the reception area, or hospitality tickets for a football match (that coincidentally involves the director’s favourite team), or even a sports car (euphemistically referred to in one company’s accounts as an “emergency response vehicle”). Alternatively, directors have not infrequently been known to employ their children or romantic partners on an inflated salary.

The way to counter the problem of rogue decisions by a single director is to make a list in the Shareholder Agreement of decisions where a single director must seek the permission of the shareholders first.

While no company could survive if a meeting of the shareholders was needed for every single decision, the Shareholder Agreement can clearly lay out decision making powers, as well as their limitations.

For example, the circumstances where wider shareholder permission is needed might include employing a family member, engaging any person on a salary greater than a specified amount or purchasing any item outside the normal course of business.

Remember that the company would likely still be committed in the event of an unauthorised purchase, as every company is bound by any contract made by one of the directors. However, if the offending director is also a shareholder then the Shareholder Agreement can include a sanction against him that would otherwise not be available. For example, shares could be removed or the director might be required to compensate the company personally. Or even that he must exit the company entirely and return his shares.

If the sanction is tough enough then it should act as a deterrent to pool tables, football tickets, luxury cars and highly paid mistresses becoming entangled in the affairs of your company.

What key decisions should rest with the shareholders?

The directors of a company are in control of the day to day decisions, for example hiring and firing and spending money, whereas big ‘life events’, such as selling the company or inviting a new shareholder into the company, are reserved for the shareholders. These decisions are generally internal ownership ones and, as such, the risk for the company being legally bound by them behind its back is different to the outward facing decisions of rogue directors described above.

A Shareholder Agreement can prevent these ‘big’ decisions being taken without the unanimous consent of all of the Shareholders. The Agreement can also set out the consequences for a shareholder, should they attempt to circumvent these rules.

Why it pays to protect the directors?

As well as providing the rules of the game, the Shareholder Agreement can also help to ensure that participants ‘play nicely’.

It takes anything greater than 50% of the voting power to remove a director from office, unless a Shareholder Agreement states otherwise. A Shareholder Agreement can therefore increase the voting percentage needed, or reduce it. Where there are three minority shareholders, such as Jocelyn, Daphne and Oscar in Multi Comms Ltd it creates the ability, in the event of a disagreement, for two shareholders to ‘gang up’ against one, removing her from the board.

A Shareholder Agreement can protect against this. Created in a time of unity, the Shareholder Agreement can state that that directors (who are also shareholders) cannot be removed without their consent.

SHARING PROFITS/DIVIDENDS

In company law, the profits of a company (i.e. what is left after overheads and salaries have been paid) can be distributed between the shareholders in proportion to the shares that they hold. This is called “dividends”.

The Shareholder Agreement can specify how the dividends are to be paid in certain scenarios – for example, if the directors cannot otherwise agree on whether to pay out or to invest.

There is no automatic duty on the directors to issue dividends to the shareholders. By the same token, there is no duty to keep anything back to re-invest in the business. While a degree of flexibility is essential to the success of a business, dithering is of no use to anyone, so having a settled accounting basis in the Shareholder Agreement can help resolve any hesitations. One such point of indecision could stem from something as simple as defining what the net profit is, in order to work out what is distributable.

A common scenario is that a Shareholder Agreement will be used to ensure that a percentage of net profits (e.g. 25%) will always be distributed, regardless of what else is happening within the business. This is most relevant in companies where there is a 50/50 split and where disagreement will lead to deadlock and the default position that nothing is decided and no course of action taken. A clause to ensure that at least some of the profit is distributed will ensure that the most solvent party does not force the other into accepting a lower exit settlement by preventing money from leaving the company during the negotiation period as a hard-ball negotiating tactic.

If you’re looking for more flexibility in issuing dividends, you may again turn to alphabet shares, where different categories of shareholders may receive different amounts in different circumstances. This may be useful in a situation where remuneration is linked to the amount of fees earned by the director-shareholders – in a recruitment consultancy or other ‘individual sales’ type business.

Another useful clause could be that if shareholders have made loans to the company then no dividends will be paid until all loans have been paid in full. This ensures that the shareholders who bankrolled the company in the early days are repaid in full before the profits are shared amongst the other shareholders, who perhaps didn’t contribute when the risk of non-repayment was greatest.

Remember, of course, that corporation tax needs to be paid on company profits before the dividends are dished out. The Shareholder Agreement should include a note that provision will be made for corporation tax before dividends are paid.

INVESTOR-SHAREHOLDER RIGHTS

In most small private companies an individual will fulfil a number of roles: shareholder, director and also work full time in the company. However, a silent investor, who is not also a director, will not have a legal right to attend directors’ meetings and see the monthly management accounts to check on the progress of his investment. A Shareholder Agreement can correct this and ensure that the investor is kept fully informed, as well as making the ‘full time’ shareholder/director(s) accountable to the silent investor.

The rights given to an investor who is not a director could extend to involvement in the monthly management of accounts, cash flow projections, setting sales targets or preparing the annual business plan.