Shareholders' agreements

What is a shareholders' agreement?

A shareholders' agreement is a private contract between those shareholders who sign up to it or who later agree to be bound by it. It sets out the shareholders' rights and obligations.

Why shareholders' agreements matter

Familiarity can breed contempt, and in the case of shareholders' agreements there may be a temptation for advisors and their clients to ignore the real value that a carefully considered and tailored shareholders' agreement can provide, particularly for an owner bringing in co-shareholders for the first time.

In this, the first in a series of articles, Weightmans' Owner Managed Business group explore the ways in which business owners can protect themselves against the risks arising whenever ownership is shared. What rights should be given to the shareholders? Should they be free to transfer the shares to a third party or to family? What should happen if they leave the company? What happens if a shareholder dies? How can you be sure that they will not frustrate a sale?

What is the legal status of a shareholders' agreement?

As outlined above, a shareholders' agreement is a private contract. Contrast this with the articles of association of a company which are a matter of public record filed at Companies House.

Any private or commercially sensitive arrangements which the shareholders may want to keep confidential should be set out in the shareholders' agreement, leaving the articles to deal with matters where it may be seen as helpful to have the position made clear to any third party, such as restrictions on share transfers or drag and tag provisions.

However, take care to consider the tax position. For tax purposes, it's often important to ensure that certain provisions are included in the articles rather than just a shareholders' agreement, so that the rights are intrinsic and attach to the shares rather than being provided by way of an extrinsic personal contract between the shareholders and which may or may not be recognised for tax purposes.

In one leading tax case, the managing director of a company acquired 6% of the ordinary share capital but, in a separate subscription agreement with the other shareholders, it was agreed that on a sale he would effectively receive 33% of the sale proceeds. It was held that because the rights under the subscription agreement were personal to the managing director and did not actually attach to the shares, the extra proportion of the sale proceeds he received under the terms of the subscription agreement was subject to income tax rather than capital gains tax.

What is a family charter?

In a family business, which includes multi-generations and sides of the family, an alternative to a shareholders' agreement is a family charter.

A family charter is a slightly less legalistic document that sets out the rules of operation of the family business, goals and long-term strategies, and how the various family members should behave towards each other in relation to the business.

We've written an article on family shareholders in which we look at family charters in more detail.

Decision making

The day to day running of a company is generally left to the board of directors. Under a shareholders' agreement, the parties can provide that certain matters require shareholder approval in any number of possible variants (so by a majority, a specified percentage or unanimity). These matters are often referred to as reserved matters.

Care should be taken to ensure that a standard, and often lengthy, list of reserved matters is not simply included by default, as the provisions may not be relevant or provide the required protection. We would recommend that a controlling shareholder should think carefully about what restrictions on his or her decision-making are acceptable, if any. Obtaining consent from shareholders can impact on the ability to make decisions quickly, so care needs to be taken to balance a willingness to provide protection to shareholders with the ability to operate the business effectively.

Dispute resolution

At board level, decisions are made by majority. At shareholder level, voting is linked to the number of shares held. Where a shareholders' agreement includes reserved matters, then as a matter of contract the decision making on these issues will be dictated by what the shareholders' agreement says.

What should be the solution when deadlock arises?

If there are two equal shareholders they may be happy that, in the event that they cannot agree on a course of action, they will not proceed — leave the deadlock in place.

Alternatively, the chairperson could have a second or casting vote in the case of an equality of votes, and this might be acceptable where there are multiple shareholders as opposed to two 50/50 shareholders. If this is proposed, care should be taken as to the terms of appointment of the chairperson so that this element of control does not pass to another shareholder.

The matter in dispute could be referred to the company's accountants or a nominated third party such as an independent firm of accountants to resolve the matter in dispute, or be referred for adjudication or mediation. But are the shareholders willing to agree that a third party make the decision for them, or might they prefer to leave the matter deadlocked and let commercial pragmatism drive an eventual resolution?

In an extreme case, the answer may be to resolve the impasse by share purchase to buy out one of the parties.

Controlling share transfers

General veto or pre-emption rights?

Unless specifically stated in the articles of association or in a shareholders' agreement, there are no restrictions on the transfer of shares to third parties.

The more usual default position in articles is a provision that bluntly provides that no share transfer can take place unless the board approves it, a rather simplistic approach and which also of course then gives rise to the question of who controls the board — ultimately the majority shareholder.

A shareholders' agreement can enable the majority owner to prevent share transfer absolutely or to permit transfers but only after the shares have first been offered to the other shareholders as a whole or perhaps more narrowly offered simply to the majority shareholder.

Family transfers

Should transfers to family members or family trusts be permitted? That's a matter of individual choice of course, but majority shareholders need to consider the pros and cons. Yes, this offers flexibility in estate and tax planning to the new co-shareholder in question, but is worth the risk for the majority shareholder of potentially having a family member as co-shareholder, leaving aside the complications arising should there be subsequent family breakdown?

We would recommend that any family transfer provisions are considered in conjunction with proper will planning and, where appropriate, pre-nuptial agreements are considered, in order to ensure that the various documents dovetail together and do not conflict with each other.

For further detail on these aspects, please look out for our upcoming articles on will and estate planning and prenuptial agreements.

'Drag and tag' rights

In addition to the above controls and protections, the shareholders' agreement could include drag and tag provisions. These provisions would apply where an offer is made by a third party to acquire the entire issued share capital of the company and the majority of the shareholders wish to accept that offer. The drag provisions would allow the majority to force the remaining shareholders to sell their shares on the same terms as is offered to the majority so that they do not lose the deal. The flip side of these rights is tag-along rights where the minority can compel the majority to only sell when the offer they have received is extended to all the shareholders on the same terms.

Ideally, these provisions should be placed in the articles of association in order in effect to put on notice any third party purchaser of the shares that these rights exist.

It may be open to doubt whether a drag-along provision would be effective to compel a minority not simply to sell their shares on the same terms (as they could do by signing a stock transfer form or short form sale agreement) but to go further and compel them to join in an extended share purchase agreement with extensive warranties and indemnities. Consideration should be given to including power of attorney in favour of a person nominated by the board to execute the paperwork on behalf of any minority shareholder who might object to being dragged.

Valuation

Specific provisions can be included in the shareholders' agreement or articles as to how shares are to be valued on transfer, together with the mechanism and timing of payments.

The common default position is that on a transfer of shares, shares are often stated to be valued at their fair market value. This could be specified as being the price agreed between the seller and the board of directors or failing agreement, determined by the company's accountants or a third party independent valuer. Provisions can also be included to specify the assumptions and bases upon which the fair market value will be calculated, such as:

1. Valuing the shares as on an arm's length basis between a willing seller and a willing buyer; 
2. The business being carried on as a going concern and on the assumption it will continue as such;
3. The shares are capable of being transferred without restriction;
4. Whether a minority discount should apply to a minority shareholding or whether the shares should be valued as a proportion of the total shares in issue without a premium or discount being attributable; and 
5. Any other factors that the shareholders believe should be taken into account.

The valuation of the shares (and the assumptions and bases upon with the valuation is to be calculated) can have potential tax implications, particularly in relation to officers and employees who are subject to a special set of tax rules, and specialist valuation and tax advice should be obtained as necessary.

Compulsory share transfers

In certain circumstances, the shareholders' agreement can provide for the board of directors of the company to have a right to require the transfer of shares held by a shareholder. These circumstances can include:

Death of a shareholder

In the unfortunate event of the death of a shareholder, in the absence of a shareholders' agreement, their shares would transfer through their estate to a family member. A shareholders' agreement can prevent this by setting out terms for the remaining shareholders (or the company, subject to it having distributable reserves) to buy the shares of the deceased shareholder. Similar provisions can also be included in cases of mental incapacity of shareholders.

The company and its shareholders may also want to consider putting in place a cross option agreement, which is a standalone document often backed by an insurance policy and trust deed that in the event of the death of a shareholder (whose life was insured) the proceeds of the insurance policy would be paid out to enable the survivors to fund the purchase of the shares.

Shares linked to employment

Compulsory transfer provisions can also be used where shares are issued to employees or consultants to a company by way of incentivisation. In the event that the employee/consultant shareholder ceases to be an employee or consultant to the company, provisions could again be included to enable the board of directors to require the transfer of the shares. Typically a distinction is drawn between shareholders who leave in 'good leaver' as opposed to 'bad leaver' circumstances.

Good leaver/bad leaver

The shareholders' agreement may go further in relation to the compulsory transfer provisions and specify different valuation mechanisms that would apply to the share transfers depending upon the leaver circumstances. Typical good leaver definitions include death and permanent incapacity and typical bad leaver definitions include dismissal and resignation, (sometimes only if this is an 'early leaver' situation i.e. resignation within a couple of years of receiving the shares). The consequences of being classed as a good or bad leaver are normally that the company or other shareholders have the option to buy back the shares either at full or some high percentage of the market price, (good leaver), or at a heavily discounted or even par valuation, (bad leaver).

For more information on the issues to consider if releasing equity to employees, see our article on employee shareholders and share options.

Dividends

Consideration should also be given to whether or not there should be a formal dividend policy or, if not, should the matter simply be left for the board to determine from time to time. It may also be helpful to consider, when minority shareholders are being brought into equity, whether they should have any dividend rights or just receive shares for their capital value, (in which event they should be issued shares with class rights giving them no rights to dividends).