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Shareholder Essentials for Private Companies: The Importance of a Robust Shareholder Agreement

If you’re setting up a business, or you have set up a business, you most likely will or have, set up a proprietary limited (Pty Ltd) company or private company.  Pty Ltd companies are the most common type of company.

Shareholders: The Basics

Private companies are incorporated with a share capital and accordingly, shareholders (also known as members) own shares or equity in the company.  A shareholder can be an individual, another company or an executor or trustee of an estate or trust.

Typically, shareholders have the right to vote on company resolutions and to receive dividends, where they are paid by the company, in accordance with their share ownership.

A private company must have a minimum of one shareholder and a maximum of 50 shareholders that aren’t employees or shareholders connected with crowd sourced funding offers.

What is a Shareholders’ Agreement?

It is prudent that any company with more than one shareholder has a shareholders’ agreement.  A shareholders’ agreement is a binding contract between shareholders.  Its purpose is to govern the relationship between shareholders.  A robust shareholders agreement should specify:

  1. The structure, management and direction of the business;
  2. How responsibilities will be divided between directors and shareholders;
  3. How shareholders may acquire or dispose of shares;
  4. How the company will be funded;
  5. Shareholder rights and how they are protected;
  6. How decisions are to be made;
  7. How disputes will be resolved; and
  8. What occurs should a breach of the shareholders’ agreement occur.

Without a robust shareholders’ agreement, uncertainty and disagreements can arise quickly causing disruption and can be costly to resolve.

Shareholder or Director

While shareholders are the owners of a company, directors are responsible for the oversight of company.  Shareholders do not need to be directors and directors do not need to be shareholders.  However, a person may be both a shareholder and a director.  This is particularly common in start-ups where co-founders are both directors and shareholders.

The shareholders agreement should set out what matters are reserved for the board and those which require shareholder approval.  Typically, decisions made by the board relate to the day-to-day management of the company and those that require shareholder approval relate to fundamental matters of the company.  These include, for example, director remuneration, share issuances, debt, litigation and major acquisitions and disposals.

Where a shareholder is also a director, personal benefits as a shareholder may not align with the best interests of the company.  One example is where a shareholder desires a declaration of dividends, but a company may not be able to afford this, or it is in the best interest of the company to reinvest the funds.  Directors have a duty to act in the best interests of the company and must not put their own interests over that of the company.  Director shareholders should ensure that conflicts are recorded in a conflicts of interest register and controls are in place to manage such conflicts.  A well-drawn shareholders agreement will facilitate this.

Shareholders Decision Making

The shareholders agreement should set out the level of shareholder majority required to pass shareholder resolutions.  Most matters can be passed by an ordinary resolution (requiring more than 50% support) however, others may require a special resolution (typically requiring more than 75% support) or a unanimous resolution.  Due to the importance of shareholder resolutions, it is essential that the shareholder’s agreement to provide a mechanism to resolve a deadlock, for example, the Chairman could have a casting vote.

If the company is an Australian Financial Services (AFS) Licensee, the Responsible Manager may also be a shareholder.  There should be particular caution where the Responsible Manager is also a key person on an AFS licence.  As a key person typically has greater powers than other directors, due to the reliance of the company on their expertise, the key person may be tempted to exert undue power to influence other shareholders in making a particular decision which bears on the company but not the AFS licence.  It is also prudent for AFS licensees to have a comprehensive Responsible Manager agreement in place to govern the powers of those directors who are both shareholders and Responsible Managers.

Issuing shares

Should existing shareholders agree, new shares may, in specific circumstances, be issued.  It may be that these are issued to new employees to promote loyalty.  To protect the rights of existing shareholders, shareholders agreements should include anti-dilution and pre-emptive rights provisions.  These provisions enable shareholders to maintain their percentage ownership of the company, for example, by giving shareholders the right to buy additional shares when new shares are issued.  Without such provisions, existing shareholders ownership might be diluted.

All new shareholders should be required to adopt and be bound by the shareholders agreement before they are listed on the company’s shareholder register.  To be bound by the shareholders agreement, the new shareholder and existing shareholders will need to enter into a deed of accession.  Alternatively, in some circumstances, the shareholders agreement may be renegotiated and revised at this time.  This may occur where a new shareholder is receiving a substantial equity issuance.

Sale of Shares

The shareholders agreement should outline when and under what circumstances a shareholder may transfer, sell or assign its shares to a third party.  It could, for example, require a shareholder to obtain unanimous written consent from all remaining shareholders.  As with share issuances, pre-emptive rights may also be in place to ensure that existing shareholders have the option of purchasing the shares prior to the shares being sold to a third party.

Drag along and tag along provisions are common in shareholder agreements in relation to the sale of shares.  If a majority shareholder wants to sell its shares to a third party, a drag along provision enables the majority shareholder to force minority shareholders to sell their shares at the same price and on the same terms that the majority shareholder has negotiated with the proposed purchaser.  Alternatively, a tag along provision gives shareholders a right to join or tag along with a deal to sell their shares on the same terms and negotiated conditions as a shareholder looking to sell their shares.

Employee Shareholders Leaving the Company

Where an employee shareholder leaves the company, the shareholder agreement will typically specify how the shares must be dealt with.  Typically, the shares will be sold back to the company or on-sold to the replacement employee.  The shareholders agreement may specify a formula for determining the sale price.

Disputes between Shareholders

Like any arrangement between multiple parties, disagreements and disputes may occur.  The shareholders agreement should contain unambiguous provisions for the resolution of disputes.  The preferred option is for the shareholders to negotiate and come to an agreement amongst themselves, however, this may not always be achievable.  Mediation should be required prior to any Court or arbitration proceedings being commenced.

How we can assist

If you require a new shareholders agreement, a deed of accession, or are negotiating an existing shareholders agreement or a dispute, Holley Nethercote Lawyers has expertise in all aspects of the relationships between shareholders and can assist you.

Contact our commercial team, or the authors of the article directly, to see how we can assist.

Authors: Alexa Bowditch (Lawyer) and Tim Dixon (Special Counsel)