Shareholder agreements – why should we have one?

Peter Stewart

If you and your fellow shareholders are never going to argue, if you’ll always agree on how your shares should be valued, if you have a common view about how to fund your business and a shared view about how a shareholder should act in relation to the business when they cease to be a shareholder, then you most probably don’t need a shareholder agreement.

For those of us who are mortal, however, putting a shareholder agreement in place in the good times, when each shareholder is in agreement, is a prudent approach to managing the shareholder relationship.

All too often I am approached by a shareholder who is in dispute with fellow shareholders (often family members) and who seeks to rely on a verbal agreement or even on the company’s constitution. It is true that the constitution of a company has the effect of a contract between a shareholder and each other shareholder (s140 Corporations Act) but most company constitutions are inadequate in providing a mechanism for dispute resolution, shareholder exit and valuation.

So when two family members approach me having fallen out after being in business together, without a shareholder agreement to use as a framework for resolving their dispute and possibly the exit of one shareholder, they are generally left with little option but to approach the court for appointment of an administrator to sell the business of the company at a value often far less than the value of the business as a going concern.

A good shareholder agreement will, at minimum, address the following matters:

How decision making is to be structured – including what decisions are reserved for shareholders rather than the board of directors (for example, changes to premises, the nature of the business, acquisitions etc), and the percentage of shareholder votes that are required to approve such decisions.

The consequences of a deadlock in decision making – including a dispute resolution mechanism that might involve an external adviser or formal mediation or even arbitration, and, in family companies where there are only two equal shareholders, the opportunity for one to acquire the shares of the other where the dispute is so great that the business cannot continue to operate.

Funding of the business – will shareholders fund the business by way of equity or loan? Will interest be paid on shareholder loans? What if one shareholder doesn’t have sufficient resources to provide funding when required?  To whom (and on what terms) can new shares be offered if the company requires a capital injection?

Pre-emptive rights – these grant first rights to existing shareholders to acquire the shares of a shareholder who wishes to exit the company or to take up any new shares being issued, in proportion to their current shareholding.

Funding exit – often shareholders make sure that the company takes out insurance on the life of each shareholder so that in the event of a death, there are funds available to allow the purchase or buy-back of the shares of the deceased shareholder.

Dividend policy – whilst the Corporations Act sets out the circumstances that must exist for a company to pay a dividend (at section 254T), a dividend policy is a useful tool to manage the expectation of shareholders and also to address the timely repayment of any shareholder loans – particularly where those loans need to be repaid prior to any dividend being declared.

Third party offers to acquire shares – where shareholding in a company is not equal, the inclusion of a ‘drag along’ clause (allowing a majority shareholder to force a minority shareholder to sell its shares along with the majority to a third party offeror) and a ‘tag along’ clause (allowing a minority shareholder to require a third party offeror to buy the minority shares as well as the majority shares), helps to ensure that minority interests have a reasonable exit strategy.

Restraints – whilst restraints are generally against public policy, courts do uphold restraints where the terms are reasonable in the circumstances. Shareholders should be restrained whilst they are shareholders and for a reasonable time after ceasing to be a shareholder from using information that comes to them through their involvement with the company for their own gain, or from soliciting employees or suppliers or customers away from the company after they cease to be shareholders or from competing (directly or indirectly) with the business of the company. Not all shareholders will be employees of the company and restraints in employment agreements are often not broad enough to address the risk of competition from an exiting shareholder.

The very process of working with your lawyer to develop and agree on the terms of a shareholder agreement can be an instructive and productive one, because it encourages shareholders to work together to address issues that might not otherwise be considered until a dispute occurs – by which time any form of rational discussion is often impossible. 

Hopefully, once you have entered into a shareholder agreement, it can be kept in the bottom drawer of your office, to be used only when a particular circumstance addressed in the agreement, arises. 

If you would like information about shareholder agreements please read our Plain English Guide to Shareholders and Partnership Agreements.  

If you have any questions about shareholder agreements please contact:

Peter Stewart, Principal
Phone: +61 2 9895 9258