How do Shareholder Agreements Work

How do Shareholder Agreements Work?

When your business issues shares, those owning them become shareholders, giving them partial ownership of your company. With that comes the potential for them to be rewarded when and if the company’s shares increase in value, and to potentially participate in decisions made by the company (eg via voting rights that shareholders may have). They also share liability if the company owes money or goes into liquidation.

What is a shareholder agreement?

A shareholders agreement is a contract between those who own shares, and the company who has issued them. The contract regulates the rights and duties of shareholders with regards to their ownership of those shares.

The agreement’s purpose is to deal with the issues that may arise between shareholders during the course of a business, by determining in advance and providing guidelines concerning how such issues should be handled. Generally, a shareholder agreement regulates matters that are not covered by the companies constitution, setting out the shareholders rights, responsibilities, liabilities and obligations.

There is no standard form of shareholders agreements as the contents of the contract will differ according to what the shareholders agree but the agreement must be drafted to ensure it is valid and enforceable. On top of this, the agreement must have the consent of all shareholders and all existing shareholder’s consent is required to appropriately make any changes.  

Why should you have a shareholder agreement?

Shareholder agreements are not compulsory but are important to protecting the interest of the company and shareholders. It provides security for the company as the agreement addresses issues concerning resolving disputes between shareholders or between shareholders and management, how shares may be dealt with, and how a shareholder may sell/transfer its shares. These issues are usually not covered in the company’s constitution.

Without a shareholder agreement in place, the company open itself to risk in the event of a dispute with shareholders. With smaller companies and startups where there is a close relationship between shareholders and management the shareholder agreement will provide clarity. 

What should a shareholders agreement include?

While shareholder agreements need to be customised to their parties needs, there are some common issues that most agreements address: 

  • Dispute resolution procedures
    providing options for alternative dispute resolution and mediation before any litigation can be commenced. 
  • Addressing Inconsistencies
    A clear mechanism for dealing with how inconsistencies between the shareholder agreement and the company constitution will be dealt with. This is referred to as the supremacy clause as it will define one of these documents as having supremacy in the context of a conflict.  
  • Dividends
    Outlining the procedure for how and when dividends are to be distributed, aka the dividend distribution policy.
  • Termination
    There should be provisions for the management of shares in the event of certain actions – death, trade sale, an initial public offering etc.
  • Drag along rights
    Allowing majority shareholders to compel a minority shareholder to join in the sale of shares in the company.
  • Tag along rights
    Allowing a minority shareholder to join a majority shareholder in a transaction, where a majority shareholder is selling shares in the company.  
  • Pre-emptive rights
    Allowing shareholders to acquire another members shares in the event that one Member wishes to sell. 
  • Deadlock breaker provisions
    Outlining what should happen in circumstances where shareholders cannot agree on the management of the company.
  • Confidentiality
    Creating an obligation of confidence for Shareholders.
  • Voting
    Governing the voting procedure of the Board and the weight of various votes – eg are one vote per Director or proportionate according to the percentage of shares held in the company.

Enforcing a shareholder agreement

As a legally enforceable contract, the normal rules of contract law will apply to the enforceability of the agreement and the remedies available in the event of a breach. 

How to terminate a shareholder agreement?

The terms of the shareholder agreement should provide for when and how the contact can be terminated. Thus, the utmost care should be taken with the drafting of every provision in a shareholder agreement to ensure your company’s interests are protected.

The terms setting out the relationship between shareholders and the company are critical considering shareholders are being given partial ownership. Thus, it is critical to ensure the existence of a shareholder agreement which will provide clarity to all aspects of the relationship. As always, the most effective agreements are those with clear drafting and mechanisms that direct for the quick resolution of disputes with certainty.

About Raymond Chbib

Raymond ChbibRaymond is a legal intern at OpenLegal, working with our legal content team. He is currently a penultimate student at the University of Technology Sydney, studying a Juris Doctor degree with an undergraduate Bachelor of Global Studies. He is particularly interested in Intellectual Property law and the increasing internationalisation of that area of business.