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7 things to consider when drafting a shareholders’ agreement

No matter the size of the business, if you are a founder setting up a new business or you are investing in a private business, it is essential that the shareholders enter into a shareholders’ agreement (SHA).

Unlike articles of association (Articles), which are a public document published on Companies House that bind the company, an SHA is a private contract between its shareholders that sets out their rights and responsibilities in relation to the company.
A key aim of an SHA is to prevent future conflict, the idea being that whilst relations between shareholders are amicable, they should agree the terms on which they will deal with potential areas of disagreement in the future, for example, if relationships should sour or a shareholder seeks to step away from a business. This article sets out seven things to consider when putting together an SHA.

1. Should there be a right of first refusal (known as pre-emption)?
Existing shareholders are often given a right of first refusal (i) on the issue of new shares by a company or (ii) for shares being offered for sale by a departing shareholder before a third party can receive them. Generally speaking, this is in proportion to their existing shareholding. There is no automatic right of pre-emption under company law for transfers to third parties, so it must be expressly provided for in an SHA or Articles for such a right to exist. Not including pre-emption rights in an SHA (or Articles) risks existing shareholders selling or transferring their shares to unknown individuals whose interests may not be aligned with the remaining shareholders.

2. Permitted, prohibited and compulsory transfers
An SHA may provide for transfers from a shareholder to affiliates/connected persons (for example, a transfer to a shareholder’s spouse or children) that will fall outside of the SHA’s pre-emption provisions, these are known as permitted transfers. Conversely, an SHA can dictate which transfers are prohibited (for example, a transfer to a competitor), referred to as prohibited transfers. SHAs may also specify that a shareholder is compelled to sell their shares on the occurrence of certain events (e.g. on death or bankruptcy), these are known as compulsory transfers. These provisions are sometimes included in the Articles.

3. Restrictions on the shareholders
Restrictive covenants are important in industries which depend on know-how or contacts. They protect the investment of shareholders by preventing a business from being undermined. An SHA can restrict each shareholder from starting competing a business or dealing with customers of the company (including prospective customers) for the period they are a shareholder and for a specified period after they cease to be a shareholder (which can be as little as 12 months). It is useful to include restrictive covenants in the SHA as opposed to simply in an employment contract because courts tend to view restrictive covenants in commercial agreements more favourably.

4. Provisions relating to the management of the company
Shareholders usually have little say in the day-to-day running of a business unless they are also directors. If shareholders wish to retain some control over the running of the company, they can provide for this in the SHA. In addition to requirements regarding quorum and voting, shareholders might include provisions around: certain decisions requiring unanimous shareholder consent (e.g. borrowing over a certain limit), certain shareholders having the right to appoint (more) directors, a requirement for shareholders to participate in discussions regarding dividends, receiving copies of a business plan, etc.

5. Tag-along/drag-along provisions
Companies with minority shareholders often have ‘drag and tag’ provisions in either their Articles or an SHA in order to protect both the company’s and the shareholders’ interests. A ‘tag-along’ provision permits a minority shareholder to join a transaction where a majority shareholder is selling their stake in a company so the minority shareholder can be a part of sale negotiations. A ‘drag-along’ provision allows the majority shareholder to force a minority shareholder to join in the sale of a company and can stop a minor shareholder being able to block a deal going ahead. Tag along rights are more beneficial for minority shareholders and drag along rights favour the majority shareholder.

6. Manage deadlock and prepare for potential disputes
Shareholder disagreements can paralyse a company and prevent decision making (especially where shares are owned equally). An SHA can formalise the dispute resolution procedure to be followed if there is an inability to reach a consensus or a dispute thereby reducing the time and cost spent seeking resolution (e.g. requiring the shareholders to escalate a matter to senior management and to agree to mediation if no resolution is reached). Such a provision may also set out how a shareholder may exit a company if a dispute is not resolved.

7. Death of a shareholder
Where individuals are not the sole owner of a company, consideration should be given as to how a Will interacts with an SHA, how to protect the value of shares on death and the possibility that the views of a person inheriting shares might not align with those of existing shareholders. It is also common for SHAs to provide for automatic transfers on death. Our Wealth Preservation team can advise on how your Will interacts with an SHA and help you to put a Will in place or amend your Will (if required).

If you have a question regarding an existing SHA or require support drafting one, please get in touch with Claire or Francesca .

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