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When Do You Need A Shareholders’ Agreement?

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Any company that has more than one shareholder needs a shareholder’s agreement, and the sooner the better.

The main reason is that while it’s easy enough to incorporate a company, the hard part is keeping it running smoothly through thick and thin. Enthusiastic entrepreneurs sometimes underestimate the issues and difficulties that may arise during the company’s lifetime. This is where the shareholders’ agreement comes into play.

When setting up a company, the founding shareholders have several basic options:

  • no constitution
  • standard constitution
  • constitution plus shareholders’ agreement.

 

Either of the first 2 options is fine if the company is a subsidiary or has only one shareholder. In other cases the third option is preferable because constitutions are typically generic documents, and one size does not necessarily fit all.  It’s difficult for a standard constitution to be tailored to shareholders’ individual circumstances, the relationship between them, or the planned life-cycle of the company. Also many of the key issues which need to be addressed may involve matters which the shareholders would rather remain private and confidential.

Normally company constitutions are filed with the Companies Office on a public register, as is appropriate to allow the public to review the company’s externally relevant procedures. On the other hand a shareholders’ agreement is the ideal place to target potentially problematical internal  areas in advance, such as :


Company management

Typically, all shareholders in a start-up company will want to be directors. But while this may protect shareholders’ interests to some degree, efficient overall management may require choice of a Managing Director and/or appointment of a CEO. The company may not be able to afford to appoint outsiders to other vital roles and such responsibilities may need to be allocated by formal agreement amongst the shareholders.


Finance

What initial and ongoing financial contributions may be needed from shareholders to keep the company on track? Will contributions be secured, repayable on demand or drip-fed from profits ? Will shareholders be required to guarantee the company’s obligations?


Dividend policy

Are all profits to be paid as dividends, or is a percentage to go to working capital? Should shares carrying differing dividend rights be issued?


Share valuations, transfers and buy-backs

What is the best valuation model for the company, historical, or future earnings and prospects? If a shareholder stops working for the company, can they retain their shareholding? If not, what would buy-back terms be? If a shareholder becomes mentally incapacitated or dies, do their shares pass into their estate or does the company have an option to buy them back? In these situations should the company be entitled to repurchase shares on a time-payment basis?


Confidentiality and intellectual property protection

Most constitutions and employment terms will contain some reference to these highly important areas. But if a shareholder doesn’t have an employment agreement and has not read the constitution (or even seen it), the company’s interests may be at risk. Commercially sensitive or personal issues may be addressed up front and policy formally agreed but kept confidential by way of the company shareholders’ agreement. Shareholders can be contractually bound to confidentiality after exit by covenants under a shareholders’ agreement.


Deadlocks and disputes

If there is potential for disagreements and deadlocks in shareholder decisions, a mechanism for resolution can be included in the shareholders’ agreement, as normally the constitution does not deal with this. A fair shareholder dispute resolution process also promotes consensus and harmony within the company, intended to avoid adversarial outcomes.

 

WHEN IS THE BEST TIME TO ADOPT A SHAREHOLDERS’ AGREEMENT?

It is far easier to put a shareholders’ agreement in place as part of the company incorporation process than to do so later on, when positions may have become entrenched, and parties may not be prepared to forgo any personal advantage.

A simple format that all can agree on (or at least accept) is all you need to start with. Once it is in place it can be updated by agreement as time moves on and circumstances change. Incoming shareholders will need to be added, but this can be made a condition of becoming a shareholder.

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