It is easy to presume that nothing can go wrong when setting up a business with family or friends. You might presume that as you have faith in one another, no need to have shareholders’ agreements. Asking for shareholders’ agreement will feature like you do not have trust or respect for your new affiliation. Optimistically nothing will go wrong, but even family persons and best buddies get into conflict, if the worst should happen, you could end up losing everything, or might loosing of relationship or friendship. While the company’s articles of association and company law will assist comparatively, but entirely well-drafted and studied shareholders’ agreement can help as protection and shield against these types of developments.
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A shareholder is somebody who invests money cash into the organization. In return for his cash, he is given a certain number of shares in the organization. These shares qualify him for becoming one of the proprietors of the organization and enable a shareholder with the option to decide on a specific issue related to the organization.
Shareholder’s Agreement Explained
Shareholders are considered to be the true owners of the company.
A shareholder’s agreement is a contract between the company and its shareholders. It outlines the rights, obligations of the shareholders, and provisions related to the management and the authorities of the company. The purpose of the agreement is to secure the interests of the shareholders; especially minority shareholders i.e. the ones holding less than 50% of shares in the organization.
Before jumping into a shareholders’ agreement, some very careful thought must be given to the share ownership. Who owns how many shares (and for what contribution – cash? time? intellectual property, etc)? And how are these shares held? This is the time to talk to tax experts about some serious personal tax planning. Too many entrepreneurs ignore this important facet of owning shares only to find that when they “cash in”, they have a major tax headache. One should consider the merits of using Family trusts or issuing shares to one’s spouse and children. How is share ownership (and subsequent selling) treated by the tax authorities? Is there a disadvantage to granting stock options to employees versus giving shares (with possible vesting provisions) to them instead?
Basics of a Shareholder’s Agreement
The shareholders’ agreement is planned to ensure that shareholders are dealt with reasonably and their rights are secured. The agreement includes sections laying out the reasonable and authentic valuing of shares (especially when sold). It also allows shareholders to settle on decisions about what outside parties may become future shareholders and provides safeguards for minority positions.
A shareholders’ agreement includes a date; regularly the number of shares issued; a capitalization table that outlines shareholders and their rate ownership; any restrictions on transferring shares; pre-emptive rights for current shareholders to purchase shares to keep up ownership percentages (for instance, in case of new issue); and details on payments in case of an organization sale.
Shareholder agreements contrast with the organization’s bylaws. Bylaw’s work related to an organization’s articles of incorporation to shape the lawful spine of the business and administer its operations. A shareholder agreement, on the other hand, is optional. This document is frequently by and for shareholders, laying out specific rights and obligations. It very well may be most useful when an enterprise has a small number of dynamic shareholders.
The What and Why of Shareholder’s Agreement
A shareholder’s agreement is entered in order to dissolve any dispute between the shareholders and the company. We can’t be sure that nothing will ever go wrong and, in such cases, where nothing is certain, such agreements help us in dissolving the disputes if it occurs and to maintain a healthy relationship between the shareholders and the company.
It modulates the relationship between the shareholders, the administrator of the company, the right of possession of the shares, and the safeguarding of the shareholders. They also guide the way in which the company is run. It may be common to combine the use of shareholders’ agreements with a circumstantially drafted set of articles of association for the company.
Shareholders’ agreements are frequently shielding and protecting shareholders since they can assist if things go wrong amongst other things. An agreement can furnish for many possibilities including the financing of the company, the management of the company, the dividend policy, valuation of shares, followed the procedure for transfer of shares, deadlock situation.
It also helps to protect the investment made by a shareholder and lays down the rules & regulations for the shareholders and any other party related to the company. It protects the interests of current shareholders from cases of abuse by future management. If there is new management or the company is acquired by another entity, the agreement helps safeguard certain decisions such as dividend distribution and issuing of new stock or debt.
Some of the issues covered in the shareholder agreement include dealing with shareholders’ issues, corporate distributions, the management team of the company and limitation on authority, rights of minority shareholders, valuation of shares, voting of shares of stock, restrictions on the transfer of shares, allotment of additional shares, etc. The agreement protects shareholders, and it can be used as a reference document if there are disputes in the future.
It is essential to regulate a shareholder’s agreement because not every shareholder is the same. An agreement has to be drafted keeping in mind that every person is different and has a different opinion on the subjects or matter concerned. And that they may or may not agree with each other.
Contents of a Shareholders Agreement
Shareholder’s agreement generally consists of the provisions related to the shareholder’s rights with respect to the following matters:
1. Rights of a shareholder
As a shareholder, a person is entitled to certain rights with respect to the company. Some of them are:-
- Right to vote
- Right to call for a General Meeting
- Right to appoint directors
- Right to appoint the company auditor
- Right to copies of the financial statements of the company
- Right to inspect the registers and books of the company
2. Regulations with regard to sale and transfer of the share of the company
With regards to the issue of transfer of shares, to secure the interest of the shareholders, there are certain rules set up so as to ensure that such transfer happens just after accepting the consent of the parties involved.
3. Financial needs of the company
As the shareholders are given copies of the financial statements or budget summaries, they can track and follow the progress and the needs of the organization. In case, where the shareholders think of the requirement for an influx of funds that they think will be helpful to the development of the organization, they will discuss that point in the most worthwhile source of funding and afterward continue towards getting it. The procedure for acquiring such finances is set down in the Shareholders Agreement.
4. Requirements with respect to a quorum
A quorum refers to the base number of members needed for a gathering to be considered as a valid meeting. The requirements with respect to a quorum will be obviously referenced in the Shareholders’ Agreement.
5. Valuation methods for the shares of the company
As the market is prone to constant fluctuation, the value of the company shares varies too. However, in order to aid in the proper preparation of the financial statements, the method of valuing the company’s shares also plays a significant part and has a material impact on the financial statements. The methods of valuation include: –
- Assets Approach
- Income Approach
- Market Approach
6. The manner in which the company will be run
With the end goal for smooth and free-streaming operations, there must be sure policies and procedures set up. The Shareholders’ Agreement contains the guidelines with respect to how the organization will be run on an everyday basis so as to ensure a consistent and uninhibited work process.
7. Liabilities of a shareholder
- Shareholders are not liable for the acts of the company
- Shareholders are held liable only to the extent of the unpaid amount of share capital with regard to the share held by them
- Where it is a company limited by guarantee, the shareholder is liable only to the extent of the amount guaranteed by him
The reason behind the limited liability of the shareholders boils down to the fact that the company is a separate legal entity, hence separate from the shareholders.
8. Protection of minority shareholders
Minority shareholders are those who do not enjoy much in terms of powers when it comes to the management of the company. Since the introduction of the Companies Act, 2013, the rights of the minority shareholders have been given importance.
- Right to apply to the Board in case of oppression or mismanagement
- Right to institute a class action suit against the company and the auditors
- The requirement to appoint Small Shareholder Director
- Where the majority of shareholders sell their shares, then the minority right must also be included. This concept is termed Piggy Backing.
WHAT IS INCLUDED IN THE SHAREHOLDER’S AGREEMENT?
The contents of a shareholder agreement may vary across companies. Some of the contents of a shareholder agreement include:
The first section of a shareholder agreement identifies the corporation as one party that is different from the shareholders (another party).
2. Board of Directors and Board meetings
The shareholder agreement describes the job of the board of directors in the organization and the necessity that decisions of the board should be affirmed by the majority. It also states how habitually the top managerial staff should hold meetings and how directors are selected and replaced.
3. Reserved Matters
It set out issues that can’t be passed without getting the approval of all signatories, all things considered, not just the majority support. By making a list of reserved matters, all shareholders are allowed the opportunity to vet certain transactions to decide whether they are biased to their investment.
Some of the ordinarily reserved matters incorporate changing share capital, procuring or disposing of specific assets, taking on new debt, paying dividends, and changing the articles of association, and updating the memorandum.
4. Shareholder Information and Meetings
The shareholder agreement should incorporate a necessity that shareholders are qualified for regular updates on the organization’s presentation through quarterly reports and a yearly report. It should state the specific time frame when the reports should be sent out to shareholders. The agreement should also state when shareholder meetings will be held and the time, date, and place of the meetings.
5. Share Capital and Share Transfers
The shareholder agreement should record the corporation’s share capital at the date when it is signed. Since changing share capital is one of the reserved matters, the directors are prohibited from issuing new shares or changing existing shares into a new share class without the signatories approving the changes.
The shareholder agreement also contains provisions relating to share transfer, such as preventing share transfer to unwanted parties, transferring shares to a new party, what happens if a director or shareholder dies, as well as drag and tag provisions.
6. Amendment and Termination
The process of correcting or ending the shareholder agreement should be given in the agreement. For instance, the shareholder agreement might be ended upon the dissolution of the organization, based on a composed agreement, or after the lapse of a specific number of years from the date of the agreement.
Fundamentals To Remember While Drafting Shareholders’ Agreement
- One needs to understand the need for a shareholders’ agreement including why is it necessary to create a balance between shareholders’ interests and company interests.
- Do not make the terms ambiguous but keep them precise which limits the terms’ interpretation. Wide interpretations cause problems in the long run. The terms of the agreement need to be clearly defined so as to avoid any further confusion
- Clearly, list out the rights and obligations of both parties – i.e. shareholders and the company. It must be specified in a concise manner.
- The agreement must be airtight bearing in mind the mutual benefit of both the company and the shareholders.
- All matters set out in the agreement must be provided for in accordance with the relevant laws in place.
- The policies, procedures, and guidelines set out in the agreement must be brief and coherent.
- Keep in mind that there is a high possibility that a shareholder might want to leave – clauses regarding such a process should be clearly laid out.
- Dispute resolution clauses should be clearly defined especially on the following points – mode of dispute resolution, place of such dispute resolution, powers, and duties, etc.
- Restrictions on the transfer of shares should be clearly defined and the process for the same should be laid out.
Legal Jargons Explained
There’s a lot of terminologies that are unique to a Shareholders’ Agreement. We explained the most common terms below:
- Drag Along Right requires minority shareholders to sell their shares once the majority shareholders have agreed to sell the company.
- Piggyback Right the opposite of a drag-along right, it’s intended to protect minority shareholders by requiring any offer to purchase shares from the majority shareholders to also make the same offer to all minority shareholders. The minority shareholder would then have the option to sell their shares to the buyer. This is also referred to as a tag-along right.
- Put Clause gives the shareholders the right to require the company to purchase their shares back from them at any time. It’s also referred to as a ‘Buy-Back’ clause.
- Non-Competition Clause prevents a shareholder from becoming involved with one of the business’s direct competitors for a specified time period and location.
- Non-Solicitation Clause prevents a shareholder from trying to solicit the business’s clients or employees for another company.
- Right of First Refusal provides that if one shareholder has received an offer to sell their shares, all other existing shareholders have the first opportunity to match that offer to purchase the shares.
- Right of First Offer slightly different than a Right of First Refusal clause, a Right of First Offer clause sets out that a shareholder who wishes to sell their shares must first offer those shares to existing shareholders at a specific price. It’s only after no other existing shareholders choose to purchase the shares that the shareholder is free to sell to anyone, so long as the price of the shares is equal to or higher than the original offer.
- Shotgun Clause outlines a process for one shareholder to sell their shares and leave the company or require the remaining shareholders to purchase their shares. One shareholder can set a price for the company’s shares and the other shareholder(s) must then either sell their shares at that price or purchase the shares belonging to the shareholder who set the price.
Do’s and Don’ts of Share Holders Agreements
- Don’t confuse shareholder issues with management issues;
- Don’t confuse return on capital with return on labour (i.e. cash investment vs. founders’ time commitment);
- Don’t assume that everyone will always be agreeable (greedy? who-me?);
- Don’t get bogged down in legalese – decide what you want, then have your lawyer put it in proper form;
- Do make sure everyone’s objectives and visions are compatible (this can be a major problem area);
- Do separate the roles of shareholders, directors, and managers (these roles often get confused in these agreements);
- Do talk to others who have gone through this process;
- Do ask yourself what the downside is, i.e. what’s the worst that can happen to you under the agreement?
- Do get some tax advice. It is very important that some tax planning be done early to avoid a headache later when you’ve made millions. e.g., you want to make sure that you are not compensated by being given shares, you want to make sure you own shares early so that you can use the small business lifetime capital gains exemption, maybe a family trust or holding company should own your shares.
The shareholders’ agreement fundamentally constitutes the regulation for the overall conduct of the company and the right of shareholders in such conduct of the company.
It was introduced with a view to enhance the operations related to the functioning of the company, and provide clarity and structure with regard to the relationship between the company and its shareholders at any given point in time.
Every shareholder agreement has to have the key provisions stated above to create a balance between shareholder interests and the company’s interests.
It saves the company from losses and protects its interest. It helps in quicker resolution of disputes and leads to the undeterred and smooth functioning of the company and its operations.
It minimize the chance of disagreements among the shareholders by specifically explaining their roles and rights in the company.