What is a Shareholders’ Agreement, and why your limited company should have one

When you start a business with someone else, it’s always a good idea to lay down some rules on important issues, such as; how you will run the company, your respective responsibilities and what happens if someone wants to leave the business. Agreeing on how you will handle these, and other important matters, will save a lot of anguish down the line.

If you are going into business with other individuals working under a partnership structure, you should do this with a Partnership Agreement. If you are setting up a limited company, you will a need to record these in a Shareholders’ Agreement.

This guide explains what a Shareholders’ Agreement does, who should get one and what should be included in the document.

Who should have a Shareholders’ Agreement?

A Shareholders’ Agreement is a good idea for a limited company that has two or more shareholders, particularly a smaller private company.

A Shareholders’ Agreement differs in some ways to the company’s Articles of Association – a shareholder’s agreement can be more easily amended, and, unlike the Articles of Association, it isn’t on the public record and can be kept private.

The Articles of Association can be used to implement restrictions on shareholders, but you may need to adjust these restrictions as the company grows and more shareholders come on board. Using a Shareholders’ Agreement simplifies making these changes.

Also, this type of Agreement is governed by contract law, rather than company law.

What could be included in the paperwork?

The shareholders’ agreement should clarify the rights and responsibilities of the shareholders, heading off any future disputes and making sure the business will not be jeopardised by the actions of a rogue shareholder.

Here are a few things you might want to consider including in your document:

1. Voting on significant decisions

A Shareholders’ Agreement can be used to dictate the responsibilities and contributions of the shareholders.

It can also be used to establish how significant decisions will be made and approved in the business. These would usually be made after a vote – the agreement can set out what percentage of shareholders will be needed to approval a proposal (70%, for example).

This way, if a shareholder or director makes a proposal to change the company name, go into new business activities or enter into a major business partnership, it cannot go ahead without the approval of the shareholders.

The circumstances in which a vote is needed can be specified too – for example, the agreement can stipulate that if the shareholders must vote before entering into a contract worth more than £100,000.

2. Financing and profit

The agreement can be used to specify how the company will be financed in future – whether this will be done through loans, contributions from the shareholders, or from another party.

If shareholders are to contribute financially to the business, you should also come to an agreement on a fair way for this to be done – for example, having shareholders contribute based on their share of the business. This can be included in the Shareholder’s Agreement.

You can also establish how and when dividends and other payments will be granted to shareholders.

Dividends could be scheduled to be paid out at a certain time every year. The agreement could also include caveats for this – for example, preventing dividends from being paid out when profits are lower than expected. It could also specify how the amount paid out will be calculated.

3. Transfer of shares

Giving shareholders free rein to sell their shares as they please seems fair enough. However, it can cause problems down the road, particularly if a shareholder has a significant number of shares.

A shareholder might sell their shares to a rival company, or threaten to sell them to gain the upper hand in a dispute. Fortunately, there are a number of different ways to control how shareholders can sell their shares.

For example, an agreement can specify that all shareholders must consent to any transfer of shares. If a shareholder attempts to sell their shares in a way which might damage the company (such as selling a large number of shares to a rival company), the other shareholders can stop it.

This is a simple and often effective solution, but it wouldn’t be ideal for a company with a larger number of shareholders – this would mean that a sale that most shareholders approve of could be vetoed by a single minority shareholder.

Alternatively, the agreement can give other shareholders the right of first refusal – this would give other shareholders an opportunity to match the offer of another buyer and prevent another entity from gaining partial control of the company.

Another potential solution is a drag along clause. A drag along clause comes into play if the majority of shareholders want to sell their shares to a buyer who wants to own the company outright.

If the majority shareholders want to sell the company to the buyer, a minority shareholder would be able to prevent the sale by refusing to sell their shares. In this situation, a drag along clause would force the minority shareholders to sell their shares at the same value as the other shares.

A Shareholders’ Agreement can also specify what happens to a shareholder’s shares when they die. Without any specific provision for this, the shares would probably be left to a family member or friend of the now-deceased shareholder, potentially giving a controlling share in the company to someone who doesn’t understand the business or have any business acumen.

You can avoid this by putting provisions into the agreement which allow the other shareholders to buy out any shares that belong to a shareholder after they die.

4. Specify what shareholders can’t do

As well as limiting how shareholders can transfer their shares, you can limit other things that shareholders do.

A Shareholders’ Agreement will often include a non-competition agreement, which prevents any shareholder from working with or holding any stake in a rival company.

This will usually extend for a period of time after a shareholder sells their shares, preventing them from leaving the company and immediately starting up, or working for a competitor.

A non-compete agreement can also restrict other activities, such as sharing confidential information and poaching staff.

This guide has been written for ByteStart by James Watkins who is part of the team at Law on the Web.