Using a shareholder agreement to avoid conflict, delays and costly mistakes

If the last few years have taught us anything, it’s how unpredictable the world can be and the importance of planning ahead for challenging circumstances.

Here, I’ll discusses the importance of a shareholders’ agreement, particularly when it comes to difficult scenarios.

A shareholders’ agreement is an essential tool recommended for any company with two or more shareholders to regulate conduct between each person and put provisions in place for potentially difficult or significant decisions. There is certainly much more awareness of these agreements now than in the past, but there is still sometimes a reluctance and a lack of appreciation of their value. This is particularly true where there are family ties or other close relationships and therefore often a belief that these agreements won’t be needed – but most legal professionals would argue it’s better to have the rules laid out to aid transparency and potentially defer or resolve any future conflict.

Ultimately, a shareholders’ agreement allows decisions to be made at the outset and to ensure the shareholders are on the same page before the business becomes successful.

Understanding roles

It’s important to understand the distinction between shareholders as the owners of the business and how this differentiates them from other members of the business. For example, directors run the company but do not have to be shareholders. Employees work in the company – but this doesn’t mean they can’t be shareholders.

The lines can become blurred, particularly in smaller businesses when often, there are people participating in all three roles. Putting these clear boundaries in place can help to understand who is responsible for what and keep the company running successfully even if obstacles arise.

Putting pen to paper

Perhaps one of the most serious questions businesses should ask themselves is what happens if a shareholder dies. Many times, shareholders will say they ‘have an idea’ or perhaps have even discussed their plans on an informal basis. However, if these plans have not been committed to a formal agreement, the shares may ‘accidentally’ pass in accordance with the deceased’s Will (or worse, in the absence of a Will, by the rules of intestacy). This could mean that the shares end up with a deceased shareholder’s spouse, children or other family members. The question to ask in this particular scenario is, will we get along against the backdrop of a very emotional period of time?

I have experienced variations of this scenario many times. In one example, a spouse took ownership of shares and the surviving business owners found it very difficult to navigate, particularly around financial decisions. In the end, legal action was taken to buy the shares back. It’s important to remember that in circumstances like this, which can be very emotional, people may say and do things out of the ordinary and once harsh words are spoken, they’re difficult to take back.

Dealing with the fall out

At some point during the business life cycle, shareholders will disagree on commercial decisions. It’s just a matter of how serious the disagreement is. Setting out how to resolve disputes will allow the shareholders to follow a procedure to achieve a resolution. A ‘Russian Roulette’ provision is particularly useful for 50/50 partners facing a situation where the dispute is so serious that one or more of the parties cannot see a way to continue working together. The premise behind this very aggressive measure is that one party offers to buy the shares of the other party for a specified price. The party in receipt of the offer can either accept the offer and sell their shares or reverse the offer and buy the shares of the party which made the offer, at the same price. The parties won’t make a low offer (in case they end up selling) and they won’t make too high an offer (as they will have to pay for it).

It’s not working out

When it comes to owner managed businesses, there may come a time when a shareholder wants to leave the business.

A right of first refusal (also known as a preemption right) ensures that any shareholder wanting to leave must offer their shares to the remaining shareholders first. The price can be determined by whether they are considered to be a ‘Good Leaver’, ‘Early Leaver’ or a ‘Bad Leaver’.

An example of a ‘Bad Leaver’ could be someone who has been stealing trade secrets and selling them on to the highest bidder. In this case, they are likely to receive the lower of nominal value and market value for their shares.

A ‘Good Leaver’ is usually when a shareholder leaves the company on good terms, such as retirement in which case they are likely to receive market value for their shares.

Selling up

Where there is an imbalance of shareholdings, there can be protections for majority and minority shareholders’ interests. If a majority shareholder wants to sell their shares, a minority shareholder is under no obligation to join in the sale. This could cause critical delays in situations where the company is up for sale, and in serious situations, majority shareholders can be forced to pay ransom fees.

‘Drag Along’ provisions can allow majority shareholders to force minority shareholders to sell their shares along with majority shareholders if the majority have accepted an offer for their shares.

Final thoughts

Putting a shareholders’ agreement in place can be done quickly and easily – all it takes is decisiveness. The terms are largely confidential and don’t need to involve many people. Every company which has multiple shareholders should have some protection as you simply never know when it might be needed, and it’s largely agreed that most people want to protect their businesses from the unpredictable.

It’s often a much simpler process to get shareholders together and work on an agreement at the start of a new venture when everyone is likely to be on the same page and feeling optimistic about the future.

A shareholders’ agreement is just one of the many tools a legal professional can discuss to support your business’ wider planning and succession goals, enabling better control and peace of mind for whatever challenges may arise.