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The need for a Shareholders' Agreement

The following article was written by Robin Standage.

Wherever a small to medium sized company has more than one shareholder, even if they are different members of the same family, consideration should be given to the signing of a Shareholders’ Agreement.

The principal means for regulating the affairs of a company and the relationship between shareholders is the adoption of a Company Constitution. This is a document which governs the way in which a company is run in a manner which is appropriate to the particular circumstances of the company concerned. It is possible to set up and operate a company without a Constitution. The Companies Act 1993 (“the Act”) has default provisions that apply when no Constitution has been registered, but it is generally accepted amongst professionals that all companies where there are multiple shareholders should agree upon and file a Constitution. This is because some of the provisions of the Act are likely to prove most unsuitable if left unmodified.

It is surprising how many companies are formed and are operating without having adopted a Constitution. Such companies run a high degree of risk that they will strike trouble down the track because there has been a failure to identify and deal with the “what if...?” eventualities which can arise.

In addition to a Constitution which modifies or augments the rules set out in the Act, a Shareholders’ Agreement is to be recommended as an additional tool that can be used with great advantage where there is more than one shareholder.

Some of the reasons why most lawyers dealing with the affairs of small companies recommend a Shareholders’ Agreement are:

  • Such agreements can deal with matters that need to be decided prior to a company being incorporated. A Constitution takes effect only after incorporation.
  • It reduces or overcomes the risk of misconceptions between shareholders by setting out the intended purpose and scope of the company’s activities and the way in which the company will be managed.
  • It is not a document that requires to be registered and therefore available to the public. Accordingly, matters which shareholders might desire to be kept private can be protected from public scrutiny.
  • It can entrench, as between the shareholders who have signed the agreement, fundamental matters which the shareholders agree shall not be subject to change. By contrast, anything contained in a Constitution may be altered by a special resolution (75% majority) of shareholders.

The setting up of a Shareholders’ Agreement and the discussions which will necessarily be part of deciding upon its contents will have the effect of making shareholders address potentially significant issues that might otherwise have been overlooked. Such things might include:

  1. An exit strategy. Very few things last forever. Most shareholders would regard their participation in a company and its business as an investment and like all investments there will come a time where it is desirable that it can be cashed up. There are quite a number of possibilities here and discussion with legal and accounting advisors can help identify provisions that might suit the individuals concerned.
  2. The question of funding the company’s activities. The parties need to agree on what contributions they will make to the capital of the company and whether the contributions be by way of purchasing shares or making loan advances and in the case of the latter, restricting the ability to call for advances to be repaid in circumstances where the company could be placed in jeopardy as a consequence. Often additional funding will be sought by way of bank borrowing and there need to be rules about how this is achieved, including what obligations shareholders may have in the giving of personal guarantees.
  3. While it is possible to put such matters in the Constitution, it is generally thought to be preferable that agreements as to how a company will be managed and how the directors will be appointed and what responsibilities each shareholder will have are things which are best dealt with in a Shareholders’ Agreement.
  4. There are certain things in the Act which could give rise to dangerous consequences. For instance, Section 110 of the Act provides that a shareholder that has voted against a special resolution can, if the resolution is passed, require the company to purchase that shareholder’s shares. This could cause a real problem if the company concerned did not have readily available means to make that purchase. A Shareholders’ Agreement can contain covenants that shareholders will not resort to invoking the provisions of this section.
  5. It is generally thought appropriate that shareholders should covenant to be loyal to the company and supportive of its endeavours. Similarly, shareholders should agree that they will not compete with the company in a defined area, both as to the nature of the business and geographically.
  6. Problems can arise where one shareholder, holding a significant parcel of shares, wishes to sell to an outsider. There are provisions known as “drag along” and “tag along” rights which are designed to ensure that all shareholders are treated fairly in these circumstances.
  7. A company may have what the income tax regime refers to as imputation credits. It may also have some accumulated losses. A Shareholders’ Agreement should have provisions which are designed to promote the necessary continuity of shareholding so that these credits or losses can be preserved for the company’s future benefit.
  8. Dispute resolution. Disagreements can arise. A shareholders’ agreement should identify and detail the manner in which disagreements and deadlocks can be resolved.

There are other issues which can be the subject of provisions in a Shareholders’ Agreement. It would not be feasible for this article to attempt to identify them all. Persons looking at forming a company, or even persons involved in a company that is already underway, should consult their lawyer regarding the adoption of a Shareholders’ Agreement (and, if none exists, a Constitution). At Harmans, we have checklists available which can assist in identifying what subject matter might be considered for inclusion in an Agreement.

 

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