Insights

Shareholders Agreements: Why Do They Matter?

November 23, 2022

A shareholders’ agreement, in simple terms, manages the relationship between a company and its shareholders.  But what should be in your shareholder’s agreement? What makes them so important? And what are the risks of not having a shareholders’ agreement in place? In this article, we provide the ultimate shareholders’ agreement checklist, from what to include, to what to look for.  

So, let’s start with the basics, what is a shareholders’ agreement?

What is a shareholders’ agreement?

A shareholders’ agreement is a private agreement between the shareholders and the company. This agreement provides a series of functions, from regulating the relationship between shareholders and a company to outlining what actions a company can take and what level of shareholder consent is required to do so. As a private document, shareholders' agreements don’t need to be filed at Companies House and are instead used as an internal document to govern shareholder actions and sits alongside a company’s articles of association.  

Why are shareholders’ agreements so important?

Shareholders are the owners of a limited company (usually made up of the original founders and investors, as the business grows), and therefore are able to exercise certain rights and controls on how a company operates. But, with great power comes great responsibility and, therefore, their decision making powers and rights need to be clearly defined. Without an agreement, decision-making can become unwieldy, powers can become unbalanced, and accountability becomes hard to enforce. Put simply, the contents of a shareholders’ agreement serve to impact the scope of the actions a company can make. This includes how commercially practical these actions are and helps to define the position in the event of a breakdown of relations between the shareholders of a company. This helps the company to same time and cost in the event of a breakdown.

A shareholders’ agreement will cover a broad spectrum of things likely to impact the business itself. For example, what are the “Reserved Matters” that can’t be implemented without the consent of a specified percentage of a company’s shareholders? What happens when a shareholder dies? And how can the business be protected from competitors e.g. in the event of a founder exit?  

A well-drafted shareholders’ agreement will house many of the answers to these questions and many others. Let’s explore some of the areas where a shareholders’ agreement comes into play.

Shareholder fallout

It's certainly not something you want to think about, but at times, relationships will grow sour. Even if your shareholders are close friends, when things go wrong - they can go particularly wrong. This is even more relevant as a company grows and takes on investment (whilst a company undertakes its due diligence on incoming investors it’s important to have a clear plan). It’s wise to “plan for the divorce” from the outset, ensuring that if the worst happens - a plan is in place to protect the company’s interests while minimising potential conflict. This is where your shareholders’ agreement comes in. As the saying goes, prepare for the worst, but of course, hope for the best.

Confidentiality and Restrictive Covenants

For many businesses, protecting the secrets of their trade is paramount. However, that can be a challenge when contending with curious competitors. These can prevent shareholders from revealing confidential information, meant for business eyes only.  

A shareholders’ agreement can place restrictions relating to competitors in the form of restrictive covenants on the shareholders (during their time as a shareholder and for a period of time following their exit) to protect the goodwill of the company.  

What do articles of association have to do with shareholders’ agreements?

Articles of Association can be thought of as a constitution of a company. Articles of Association will include provisions relating to directors, the rights attaching to the shares (e.g. in relation to voting and entitlement to dividends), board decision-making,  pre-emption rights on the issue and transfer of shares, in addition to many other things. But what do they have to do with shareholders’ agreements?  

The articles of association is a publicly available document (filed at Companies House) and a company’s governing document. There is no need for a new shareholder to sign a deed of adherence to a set of articles of association as this automatically binds them by virtue of them being a shareholder (and a company is bound by law to comply with its articles of association).

When drafting your shareholders’ agreement, it’s important that it aligns with your articles of association, thereby strengthening the impact of both documents. In need of support with your articles of association? Check out our all-in-one legal subscription.

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What should be in a shareholders’ agreement? Our top ten

So, we’ve covered what shareholders’ agreements are and why they matter; but what should a shareholders’ agreement include? While there’s plenty to cover, we’ve put together the top ten things your shareholders’ agreement should include. First up…

Company obligations

As an agreement that manages the relationship between shareholders and the company, it makes sense to start firstly with company obligations relating to the agreement. Here, your shareholders’ agreement will want to outline certain things that the company is obligated to do - and not do. This might include things like not making key decisions without certain levels of shareholder consent (“Reserved Matters”). These should be carefully considered to ensure that whilst the appropriate levels of control are there that these also enable a company to operate in its sector and that directors can still carry out the day to day running of the business.

Shareholder obligations

Next up, shareholder obligations! Just as the company is required to abide by a series of rules, so too are shareholders. This part of a shareholders’ agreement would outline the obligations of shareholders to use their powers for their defined purpose. This might include things like ensuring the company elicits consent when required, and exercising their rights for the benefit of the company.  

Directors and the board

Generally, decision-making within a company is driven by directors, rather than shareholders. Your shareholders’ agreement will want to include information relating to your directors, their appointment, who is allowed to appoint a director, and the removal of directors. It will also want to define the responsibility of directors in relation to the business itself, allowing shareholders to hold directors accountable for key decisions.  

Shares

Next up, we have shares! Your shareholders’ agreement will need to include information relating to shares, their issue and transfer, pre-emption rights, and the compulsory transfer of shares. Compulsory transfer of shares would trigger in the instance of a death or bankruptcy, for example.  

Rights

It's crucial that your shareholders’ agreement includes information on the rights and responsibilities of the shareholders. For example, what voting rights do shareholders receive? Do shareholders have any veto rights? When should shareholders be consulted? Your agreement will need to outline these rights in clear terms, to avoid any confusion in the event of a conflict or dispute.  

Dividends

Much of the reward that comes from building a business is tied to its profits. There are many different ways a company’s profits can be distributed to shareholders - and this would need to be outlined in a shareholders’ agreement. For example, what is the dividend policy of the business? Does the shareholder agreement stipulate a minimum amount of profits to be retained each year? These are all considerations you’ll need to clearly outline in your agreement.  

Protection for founder shareholders

Given their importance, you may want to include particular stipulations relating to the protection of founder shareholders. Some agreements will go so far as to address life insurance policies in the event of a founding shareholder’s death - to protect the integrity of the shareholding within the business.  

Confidentiality

Confidentiality is a big, big one in shareholder agreements. Your agreement will need to define what is considered strictly confidential - likely core business matters, trade secrets, and any information that would weaken the company’s positioning. Your confidentiality section will likely include information on restrictive covenants for shareholders, the duration of the covenant, and what it includes.  

Shareholder restrictions

Clearly defining shareholder restrictions will be a really important part of drafting your shareholders’ agreement. Without this section, it will be a real challenge to hold shareholders to account for certain actions, in addition to opening the floodgates for potential risks.  

Here you’ll want to define what actions are, and aren’t permitted on behalf of shareholders - such as working for competitors, poaching core members of staff, or negatively interfering with supplier relationships.  

Termination

What happens if your company winds down? Or if your shareholders simply no longer want to comply with the shareholders’ agreement? In this instance, you’ll need to outline the process for termination, and how this agreement would need to be handled. Simple stuff!

What is a deed of adherence? And when is it used?

So, we’ve covered some of the core components of a shareholders’ agreement. However, you’re likely to have come across the phrase “deed of adherence” while exploring shareholders’ agreements. So, what is a deed of adherence? And what is it used for?

When a company takes on investment in the future this will likely be, at some point, in the form of equity (be it straight up equity of investment with a future conversion right). Therefore when an investor receives equity they become a shareholder of the company and will need to sign a “Deed of Adherence”. A shareholders’ agreement is a contract binding the parties to it (the shareholders and the company) and by signing this deed, the shareholder is consenting to be bound by the terms of a shareholders’ agreement. It’s normally stipulated that shares can’t be issued or transferred without this agreement being signed, which ensures that the terms of a shareholders’ agreement can be enforced on all parties.

What happens if you don’t have a shareholders’ agreement?

Unlike articles of association, shareholders’ agreements are private documents and are not required by law. You might therefore be tempted to save on your hard-earned cash and opt-out of a shareholders’ agreement. Unfortunately, the risks for this are pretty steep, and you can end up with more than financial woes…

Future conflicts

While your relationship with your shareholders may be peaceful, it’s not something you can necessarily bank on. Conflicts invariably arise in business, which is where agreements like shareholders’ agreements can come particularly in handy. Without one, it’s not only likely that conflicts will arise - but it also will be remarkably more difficult to resolve them.  

Damage to majority shareholder powers

Without a shareholders’ agreement, it can be particularly challenging to make big decisions for the business, such as a sale. What happens if the deal faces continuous blockers that could have been rectified in the shareholders’ agreement? Not only have you lost out on time, and money, but you may have also unnecessarily lost out on a deal of a lifetime.  

Lack of minority shareholder protections

Without a shareholders’ agreement in place, minority shareholders can be swept along with the tide for certain decisions. Without the clear voting and veto rights set out in a shareholders’ agreement, minority shareholders can often be forced to accept changes or terms that they don’t approve of.  

Inability to force transfer of shares

What happens when a shareholder-employee leaves your business? With a shareholders’ agreement in place, it’s often a fairly simple process with “good” or “bad” leaver provisions. From example, with the option for the company or remaining shareholders to buy back the shares held by the exiting shareholder. This is where the articles of association and shareholders’ agreement also particularly fit together, as well.  

But what happens without a shareholders’ agreement? Well, anything! Without the terms of a shareholders’ agreement, it can be challenging to stipulate what happens to leavers, and what happens to the shares that go with them as there is no automatic right to force a leaver to sell their shares

Restrictive covenants

One of the many important components of a shareholders’ agreement lies in its capacity to oblige shareholders to keep certain matters confidential. Without it, your shareholders may not be bound to any terms that prevent them from sharing business information with competitors.  

For example, a shareholder may leave the business, and join a competing firm. Without a shareholders’ agreement (for example, if they are an investor that isn’t also a director or employee) or any other restrictive covenants, they are free to share material that could put your business at risk. Worse yet, due to your lack of shareholders’ agreement, you won’t have any legal frameworks with which to hold them to account.  

Put simply, confidentiality terms from the outset can help you much further down the road.  

Destroy investor appetite

As you can see, there are quite a lot of issues to contend with when you lack a shareholders’ agreement - so much so, that it’s often insisted upon by would-be investors. As an agreement that protects your business, your shareholders and your future prospects, it's a no-brainer that a shareholders’ agreement is a must-have for many investors. Not only that, but it’s a negotiated document as part of an investment as investors will want certain rights, for example, rights in relation to certain “Reserved Matters”, board observation rights, a seat at the board, and information rights. This will usually be in the form of a new or amended subscription and shareholders’ agreement/investment agreement.

While the hope is to avoid conflict, the reality is, confusion, disputes, and downright debates are likely to rear their head, and without a shareholders’ agreement in place, you may find certain issues impossible to resolve.  

To avoid exposing your shareholders, and importantly, your company, to risk, make sure you invest in an airtight shareholders’ agreement that supports everyone’s interests in the long run.

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