Of the hundreds of thousands of businesses operating in Australia as partnerships or companies, less than 5% would have shareholders or partnership agreements. This is really living dangerously because so many business owners and their associates start off full of enthusiasm and energy and with great intentions but then fail because of changing circumstances, a clash of personalities, sickness or death.
The break up of any relationship is stressful and debilitating. It absorbs you and prevents you from moving on until it is resolved. It can be very expensive through legal costs and/or the absorption of your time in endeavouring to sort out your differences. Some have to resort to the court system which can be very time consuming and expensive. Documenting your arrangements with your business partners reduces the down side of a break up -you have already agreed on the outcome Those documents take the form of a shareholders or partnership agreement.
Why have Shareholders' Agreements?
The most common answer is to provide a mechanism for resolving issues and/or disputes that arise in the operation of a company/business. (If your business operates via a company you need a shareholders' agreement and if you operate as a partnership you should have a partnership agreement.)
If you set up such an agreement when you start out in business and "the going is good", you probably won't have a problem. If you put off documenting such an agreement until there is a problem or the sign of a problem, you most likely will have a bigger problem. It is much easier to agree on exit strategies when everything is running smoothly rather than trying to work out issues in a crisis mode.
All companies have a constitution (formerly called Memorandum and Articles of Association). That constitution is adopted when a company is incorporated and it sets out the objectives of the company, although these days, these objectives are extremely wide and the company can virtually do anything. It sets out the rights and obligations of shareholders often with different classes of shares and the procedure for meetings of members, meetings of directors, the board of directors, and many other matters. However a shareholders' agreement is more specialised and tailored to the particular purposes of the company, the nature of its business and the aims and wishes of its shareholders.
Let's look at some of the issues usually addressed in such agreements.
Aim of the Company
The shareholders' agreement usually states the specific aim or purpose of the company's business, for example to develop software for the accounting industry or to run a building project management company. The shareholders can agree on other activities but unless they do the shareholders can gain comfort from the fact that their investment will only be used for something they agree to.
Who will play what role in the company and what remuneration will they receive for their efforts? It is a good idea to define the areas of responsibility for each shareholder and specify what remuneration they will receive by way of a salary or other benefits. This can always be altered by agreement but what we are trying to set up is a default mechanism so there is a clear way of resolving issues should the parties not agree.
Some decisions might need to be unanimous, eg selling the main business of the company; others may need to be a simple majority. Who is responsible for preparing budgets, who is responsible for sales?
How often will you have Board meetings? What will constitute a quorum? Will the chairman have a casting vote? It is appropriate to keep minutes of all Board meetings.
What is the company's dividend policy? Some shareholders may want to reinvest all the profits back into the company to build it up but other shareholders might want the cash. Maybe there is a minimum dividend policy of 20% per annum and maybe this doesn't apply for the first two years of operation. If you specify a particular policy, it can always be varied but again if there is disagreement, there is a fall back position.
What happens if a shareholder wants out? (share transfers)
How does he get out? To whom can he sell his shares? Must he offer his shares to the remaining shareholders and at what price? You need to build into the agreement a mechanism for establishing a fair market value. Do all shareholders get an equal chance to buy the exiting shareholder's shares? Do they have to purchase all the shares for cash or can they pay those shares off over a period of time? If so, what period of time? Often there is a provision that shares must be divided pro rata amongst existing shareholders. Is this appropriate or should the founding shareholders have the right to buy the exiting shareholder's shares?
What if there is a "great" take over offer to buy all the shares in the company and a minority shareholder wants to hold out for more money for his shares? You might want to build in a provision whereby a minority shareholder cannot hold out and must sell his shares if the majority of the shareholders decide that's what should happen?
What happens if a majority want a minority out?
Can a shareholder be forced to sell out and if so on what terms? What majority might be required to force a sale? How do you deal with a shareholder/ employee who is not contributing to the enterprise?
How is the company to be funded if it needs more working capital? Should existing shareholders be required to put in more equity capital or should the company simply borrow? If it borrows from individual shareholders, what security do they get, or do they get the right to acquire more shares? There are various ways of building into an agreement what the various options are and who can be compelled to do what. Do they get security? If so what form of security and what interest is payable? When is that interest payable?
Death of a Shareholder
If a shareholder dies, do you want that shareholder's spouse or children to have a say in the governance of the business? Should his or her estate and beneficiaries remain shareholders? You might be happy to have them as shareholders but not as directors. You may want to build into the agreement a mechanism for the shares to be sold to existing shareholders. If so, what should be the sale price and should it happen over a period of time? There are various ways of dealing with this issue and each depends very much on the circumstances of the particular company and the nature of its business.
Restraint of Trade
Should shareholders be restrained from having interests in other similar businesses or even from having another role in a different business? If two parties have got together in a particular industry and operate as a company, do you want to stop them breaking away from this company and forming another company in opposition? What penalties or restrictions can you impose, if any?
Has any party brought intellectual property into the business? If so, is it licensed to the company or does the new company own it? What should happen if that person leaves the company?
If there is a disagreement in the company, how is such a disagreement to be resolved? Often a dispute resolution procedure is inserted in a shareholders' agreement providing for there to be mediation or an independent expert to determine an outcome. This can often be far simpler and less expensive than resorting to the court system.
How Long Will the Agreement Last?
This is often one of the most important clauses in the agreement. If it was for one particular project you might say the shareholders' agreement would only go for one or two years or until the development was complete, but normally it will continue while there are two shareholders in the company.
How Can the Relationship be Terminated?
The purpose of this clause is to have a formal procedure whereby one shareholder will definitely be able to buy out another shareholder, thus severing their relationship. Sometimes you might have what is often referred to as a Mexican Standoff clause or Russian Roulette. This is a provision that any shareholder can serve notice on another shareholder that they would like to purchase that other shareholder's shares and stating the price they are prepared to pay for them. The other shareholder must take some action, but if no action is taken, then at the expiry of the 30 days there will exist an enforceable agreement whereby the shares must be transferred to the original shareholder at the offer price made. If the 2nd shareholder does not wish this to happen, they must make a counter offer within the 30 days. If they make a counter offer there will exist an enforceable agreement whereby they can buy the shares for the sum set out in the counter offer.
This is a "sudden death" procedure, because if the person who makes the first move makes an offer that is too low the other shareholder will be in a position to acquire the company for marginally more than that price and there is nothing the initiating shareholder can do about it. It is a deadlock breaking procedure if the parties cannot agree on who is going to stay in the business.
Key Man Insurance
The words "key man" insurance are used in a variety of ways but there are two principal meanings:
Firstly, it can refer to a situation whereby a company takes out an insurance policy on the life or health of its directors to provide funds to the company to employ someone to replace that director should he or she die or fall ill. This is normally some type of term insurance, the proceeds of which go to the company.
The other type of "key man" insurance often referred to is cross insurance on the lives of various directors/shareholders so that should they die or become ill there are funds available to the other shareholders to purchase the dying/sick shareholder's interest in the company.
Both have different functions in different companies. You may need both or you may need none.
What professional advisers will you use and which bank? You often want to nominate a bank, an accountant, auditor or solicitor so they are the people you will be using unless you agree otherwise.
The agreement often sets out the duties of shareholders to respect the confidentiality of the company's information and intellectual property.
As well as the above, shareholders' agreements often cover many other matters but are tailored to reflect the future plans of the company, having regard to the age, financial position, expertise and personalities of the shareholders. Remember the aim of a shareholders' agreement is to bring some certainty to the business relationship so that shareholders can work with some confidence as to how the company will be run and, if there is a falling out, to provide a mechanism for that falling out to be dealt with, as painlessly as possible.
Having a shareholders' agreement:
- Makes the partners think about and address issues at the right time, earlier rather than later
- Can create confidence between partners
- Can help avoid disagreements becoming expensive arguments.