The importance of shareholders agreements

The importance of shareholders agreements

A shareholders’ agreement is a written agreement between the shareholders of a company. It sets out the relationship between the company and its shareholders and establishes their rights and obligations as to how the company will be managed and run.

There is no requirement under the Corporations Act 2001 (Cth) for shareholders to enter into a shareholders’ agreement. The Constitution (or, in its absence, replaceable rules under the Corporations Act 2001 (Cth)) provide a basic level of governance and procedure. However, these may not be appropriate or they may not address key issues.

Key elements to be covered in a shareholders’ agreement

1.  Board composition

• Who will be the directors and how will they be appointed and removed? Can ‘outsiders’ be appointed as directors? These are fundamental issues that should be covered in a shareholders’ agreement.
• In circumstances where all of the shareholders (or their associates) work in the company’s business, there is generally an expectation that the directors will be the same people (and not their nominees). This may change where an investor buys into the company or the company is a special purpose vehicle.

2.  Decision making

• A shareholders’ agreement should set out decisions which are to be made at a director level and decisions which are to be made at a shareholder level. This is particularly important in circumstances where the shareholders are not represented at board level. For example, a shareholder holding 5% of the shares in a company would generally not be entitled to appoint a director, so, in the absence of any rights under a shareholders’ agreement, they would have very limited voting rights.

• In circumstances where each shareholder can appoint a director, however, the shareholding is not equal, it is important to think about the number of votes that each director can exercise. For example, in a company with shareholder A holding 50%, shareholder B holding 25% and shareholder C holding 25% of the shares respectively, and each shareholder having the right to appoint a director, shareholder A could be outvoted at board level (ie. 2-1) even though shareholder A owns 50% of the company.

• A shareholders’ agreement should specify the number of votes needed at either level to pass a resolution. The required number of votes for an ordinary resolution is generally a simple majority, whereas the required number of votes required for a special resolution is often 75%. It is important to note that these numbers can be amended in the drafting phase, subject to negotiations between the shareholders. This issue will depend on the perspective of a shareholder. For example, a shareholder with 70% of the shares may expect to singlehandedly carry the vote, so it would want a lower threshold. On the other hand, a shareholder with 15% may expect to be able to veto certain decisions, so it would want a higher threshold.

3.  Exit

• What happens if a shareholder wants to leave the business? How will this happen with minimal disruption to the business? These issues should be addressed in a shareholders’ agreement in order to give the shareholders a framework and avoid a protracted process or legal dispute.
• The shareholders should think about how their shares will be valued and how the purchase price of an exiting shareholder’s shares will be paid. For example, will it be paid over terms? If so, will the seller have a charge over the shares to secure payment? Will the seller be entitled to interest?
• An issue that is often overlooked is how shareholder or director loans will be dealt with. In the absence of any agreement (which is often the case), an exiting shareholder may be able to demand immediate payment and this may cause unexpected cashflow difficulties for the business.
• What happens if a shareholder (or their associate who works in the business) dies or becomes disabled? In the absence of a shareholders’ agreement, the death or disability of a shareholder would result in that shareholder’s personal representative or estate being in control of its interests. This may negatively affect the operation of the business. Again, a procedure should be set out dealing with this.
• Majority shareholders may also want to have ‘drag along’ rights to allow them to force the sale of minority shareholdings in the event of an exit.

4.  Deadlocks

• It is common for issues to emerge in companies whereby decisions cannot be made by agreement. In the absence of a shareholders’ agreement, the parties will have to turn to the courts to resolve a deadlock. This can be very costly and time consuming. The lawyers are usually the only winners in these cases.
• This can severely impact the business and risk the financial interests of not only the shareholders but the employees and external stakeholders.
• Common mechanisms to deal with deadlocks are:
  • A casting vote – on a director level, the chairman or chairwoman may have the decisive vote to resolve a deadlock.
  • Call option – any shareholder may, in the absence of a resolution of the deadlock after a certain time period, offer the other shareholders the first right to buy its shares either at a pre-determined valuation or by way of a valuation. If no sale completes, the selling shareholder could force a sale of the business as a whole.
  • Dispute resolution – the issue may be referred to a certain procedure or to an expert to make a determination.

5.  Finance and access to information

• A shareholder’s agreement should set out the manner in which the company can raise funds, whether that be through equity, debt or hybrid securities (such as convertible notes/loans).
• Business plans and budgets should also be prepared and reviewed periodically in accordance with a shareholders’ agreement.
• A shareholder’s rights to access information and documents about the company should also be covered in a shareholder’s agreement, particularly if a shareholder is not represented at board level.

6.  Issuing and transfer of shares

• The issuing and transfer of shares is normally reserved for approval by shareholder resolution. This gives the shareholders control over the dilution of their shares, incoming shareholders and possible power plays by other shareholders.

Shareholders’ agreements – the Nine Dots way

Do you have a question about your shareholders’ agreement; interpreting it, drafting a new agreement or amending a current agreement? Please contact the team at NDL and we will be happy to assist you.