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Why should you have a shareholder's agreement?

View profile for Aaron O'Brien
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Whether you are a new business or have been trading for decades a shareholder’s agreement is an ideal way to ensure that both you as a shareholder, and the business as a whole, are prepared for unforeseen challenges the future may bring. It provides peace of mind that there are processes in place when situations arise which the company would otherwise be unprepared to deal with.

A shareholder’s agreement sets out some key points to help the day to day running of your company including topics such as: how the company is run; the relationship between shareholders; and the rights of shareholders. It is easy to put off creating an agreement but below are five examples of why you need to create a shareholder’s agreement.

Proposed sale of company

In any company with several shareholders, if just one shareholder decides that they do not wish to sell their shares this can prevent a sale from happening, even if it is a minority shareholder.  If the shareholders have received an attractive offer to sell their shares but one shareholder does not want to sell, a buyer is unlikely to be interested in only buying the shares of those willing to sell, so what happens next?

A drag along clause in a shareholders agreement can ensure that a minority shareholder who does not want to sell must sell their shares alongside the other shareholders. They will be served a drag along notice and will receive the value of their shares at the same value as all other shareholders.

The shareholder’s agreement will set out what percentage of shareholders and/or shares are needed to agree to the sale before the drag along can come into effect and will be agreed between the shareholders. This is a key example of how a shareholder’s agreement can be of benefit as you don’t want the sale of your business to fall through because of one minority shareholder.

Proposed sale of shareholder’s shares

If a shareholder wishes to sell their shares, and received an offer from someone outside the business for their shares what would happen now?

The other shareholders may not want someone new coming into the business especially one who may hold a significant stake in it. The existing shareholders will be worried about the future of the company with a new shareholder. Therefore, a clause on transfer of shares will help alleviate some concerns.

This clause sets out what will happen if a shareholder receives an offer for their shares from a third party. Under this a transfer notice will be issued and the other shareholders will be given the chance to buy some, or all, of the shares first as is their right under a shareholder’s agreement. This clause is different to the transfer of some of a shareholder’s shares, and does not affect the validity of this, but instead, this clause is all about ensuring that the remaining shareholders can maintain control of the company whilst providing the seller with the fair value of their shares.

Death of a shareholder

What happens to the share if a shareholder dies?

This is a common concern for shareholders as they want some assurance that the deaths of any shareholders will not have a negative impact on the business of the company. The continuance of the business is important to ensure that the company can continue to trade and the deceased’s estate is not prejudiced in any way.

This is where the shareholder’s agreement can help. Without provisions relating to this matter shares would pass along with the rest of the estate as set out in the deceased shareholder’s Will.  However in many circumstances the shareholders family will not be experienced in the business and do not want to be involved in it. Often the remaining shareholders do not want a family member to become involved in the business also. It may be more beneficial for the deceased’s family to receive payment for the shares value instead.

A compulsory transfer clause can help deal with this. This would mean that a transfer notice will have been deemed to be made on the death of the shareholder. Therefore, the shareholders can buy the shares and allow the company to continue to run as normal and give the deceased shareholder’s estate the value of their shares. Life insurance can be a key part of this clause and getting the insurance to pay the value of the shares means that both your family and your business can have peace of mind at a difficult time.

Becoming a sole minority shareholder

Similar to the drag along clause above, if after a sale of shares one shareholder becomes a majority shareholder leaving the remaining shareholder with a small minority, a tag along clause can be activated. This means that the minority shareholder can request that their shares are also purchased at the same time.

This clause can help ensure that all shareholders get what they want out of the business, each shareholder should be able to make an informed decision on how they want to act with regards to the company and their shares. A shareholder’s agreement facilitates this and ensures that all shareholders are aware of the rules and follow the processes laid out within them.

Shares of former employees

If a shareholder is now a former employee, what happens to their shares?

This is something that all companies should think about if the shareholders are also employees in the company. Not all employees leave the company for the same reasons, some may be due to retirement but others may be due to being sacked for things such as gross misconduct. Therefore, the shareholder’s agreement will set out what constitutes a good leaver and a bad leaver.

A good leaver is simply an employee who has not left for ‘bad reasons’. Good leavers will be those that leave the business due to examples such as; retiring, ill-health, or redundancy.

Whereas a bad leaver is someone who have left for reasons such as; being sacked for gross misconduct, fraud, or bankruptcy.

Both types of leavers may have to automatically transfer their shares once departing from the company, but the way in which this is done will differ. For good leavers, they will receive the fair value for their shares, these employees have not acted in a way untoward to the company and so deserve the full value of their shares. For bad leavers however, they will only receive a nominal value for their shares.

This means that an employee who has been stealing from the company does not need to be given what could be a significant financial amount in order to remove them from the business, especially when they could have already caused large issues to the running of the company as a consequence of their actions..

Bringing in new shareholders

If the shareholders decide to sell some shares to new shareholders or allot new shares, what happens next?

First, a shareholder’s agreement will have a clause stating all new shareholders must sign the agreement and will be bound to the same rules as the existing shareholders.

If new shares are to be allotted consideration can be given to using shares of different classes apportioned different things such as fewer voting rights, no right to appoint a director and so on. When any new shareholder is brought in a review of the shareholders agreement should take place.

The scenarios above are just a few examples of how a shareholder’s agreement can help the running of a business and protect the shareholders. They may seem extreme, but a company must be prepared for the challenges that may appear in the future and a shareholder’s agreement is a simple way to mitigate these risks and provide the shareholders with peace of mind.

If you would like further information on how a shareholder’s agreement can benefit you and your company, and how to go about creating one. Please contact our commercial and corporate law specialists on 0161 696 6170 and we will be happy to assist you with the process.