Reasons for a shareholders’ agreement

Where a company has more than one shareholder, it is recommended that the shareholders enter into a written shareholders’ agreement to manage their expectations and to provide for when any disagreements may arise between the parties to the shareholders’ agreement. It is also common for the company to be a party to the shareholders’ agreement.

Reasons for a shareholders’ agreement include the following:

1. Management and right to be a director The directors of a company (not the shareholders) manage the company’s day to day business, and, unless otherwise provided in the articles of association or a shareholders agreement, there is no automatic right for a shareholder to be appointed as a director. If a shareholder wants the right to be appointed as a director and therefore be involved in the management of the company, or to nominate a director, this should be stipulated in the shareholders’ agreement.

2. Information rights Generally, a director of a company, in his/her capacity as a director, has a right to see all information of the company, whilst a shareholder is entitled to only a limited amount of information relating to the company. It is important, especially for shareholders who are not also directors, to include in a shareholders agreement an obligation on the company to provide such information about the company as a shareholder may request.

3. Minority protection If a shareholder holds a minority interest in a company, he/she may wish to include in a shareholders agreement details of certain decisions that should not be left to the discretion of the directors but which should be approved by the shareholders before such decisions are given effect to.In addition, a shareholder who holds a minority interest in the company may wish to include “tag along” rights. If a majority shareholder, having the right to transfer his/her shares to a third party, seeks to sell his/her shares to a third party buyer, “tag along” rights enable a minority shareholder to insist that the buyer also acquires the minority shareholder’s interest in the company.

4. Majority protection It is not uncommon for the founder(s) of a company to retain a majority of the shareholding in the company, and if a third party buyer makes a very favourable offer for the company, such majority shareholder(s) may wish to accept the offer. In such circumstances, “drag along” rights would enable the majority shareholder(s) to force the minority shareholders to also sell their interests in the company to the buyer thus enabling the deal to be completed.

5. Transfer of shares In many cases, the shareholders of a company have come together to form a company with the view that they each also take part in the management of the company’s business, and work together for the benefit of the company. In such circumstances, if a shareholder was to exit the company, the other remaining shareholders may not want the exiting shareholder to transfer his/her shares in the company to any third party he/she so desired. It is common to include provisions in a shareholders’ agreement to provide that any exiting shareholder must first offer his/her shares to the other remaining shareholders at a certain price. The price may be, for example, agreed between the shareholders, or determined by applying a pre-agreed formula or by an independent expert. Only after going through the process provided for in the shareholders’ agreement may the exiting shareholder then offer his/her shares to a third party.

6. Default If a shareholder is in default of any provision of the shareholders’ agreement or the articles of association, or he/she becomes insolvent or commits any crime, the other shareholders may not want the defaulting shareholder to remain in the company. In such circumstances, the shareholders agreement could provide that in the event of default the defaulting shareholder’s shares are deemed to have been offered for sale to the other shareholders. Such provisions are very useful for the other shareholders especially if the continued participation of a defaulting shareholder in the company is prejudicial to the company’s reputation and therefore business.

7. Deadlock In the absence of a shareholders agreement which also deals with deadlock situations, if shareholders are unable to agree on an important decision in relation to the company, it may be that the only option is to liquidate the company. It is always a shame to liquidate a company that is successful and not otherwise in financial difficulties.Deadlock situations may be provided for in a shareholders agreement whereby in the event of a deadlock, the shareholders must try to resolve the deadlock within a short period of time, and if they fail to do so then either may commence a process which leads to a shareholder buying out the other.

8. Confidentiality Whilst directors owe directors’ duties to the company, shareholders do not. Therefore, it is recommended to include confidentiality provisions in a shareholders’ agreement to provide that shareholders who receive confidential information about the company keep such information confidential, and to provide that they cannot use the information for any purpose that may be prejudicial to the company or the other shareholders.

9. Restrictive Covenants As mentioned above, in many cases, the shareholders have come together to form a company with the view that they each also take part in the management of the company’s business. It would be unfair to the company and other shareholders if a shareholder was able to own and operate whether directly or indirectly any other business that competed with the company’s business.A shareholders’ agreement may include restrictive covenants whereby the shareholders agree not to, amongst other things, be interested in any other competing business. Such covenants may apply during the period which a shareholder holds shares in the company and for a period after he/she ceases to hold such shares. Such provisions would help protect the company’s business that the shareholders have come together to build.

10. Dispute resolution A shareholders’ agreement should set out the process for the resolution of any disputes between the parties to the shareholder’s agreement. This could be simply that disputes are referred to the courts. Alternatively, parties may agree in the shareholder’s agreement that disputes are to be resolved by mediation or arbitration which might result in a quicker and more effective resolution of the dispute in certain circumstances (not all circumstances). In the absence of such an agreement, shareholders may have little option than to just proceed through the courts. This process may take time and take up significant resources of the parties.Whilst the above are some of the reasons to have a shareholders’ agreement, they are not the only reasons. There are many other good reasons to have a shareholders’ agreement. Further, it is important to ensure that the provisions of a shareholders’ agreement are properly drafted to reflect what the parties want in the shareholders’ agreement and to ensure that the provisions actually work in practice.

For further information, please contact:

Edmond Leung
Partner | Email

Disclaimer: This publication is general in nature and is not intended to constitute legal advice. You should seek professional advice before taking any action in relation to the matters dealt with in this publication.