A company constitution is usually drafted in a standard format. However, it does not provide protection for shareholders in the event of a dispute between them or where issues arise not covered by the constitution.
By contrast, a shareholder agreement outlines the steps to be taken in the event of disputes and certain circumstances arising. As a result, it can be an effective tool for avoiding the cost of litigation.
In addition, a shareholder agreement sets out up front how disputes and deadlocks are to be resolved. This allows shareholders to resolve issues quickly and with finality.
What is a shareholder agreement?
A shareholder agreement is a private contract made between all the shareholders of a company. It sets out the rights, obligations and liabilities of each shareholder. Such agreements do not have to comply with any set form or procedure. However, parties must draft them to ensure the agreement is valid and enforceable.
Furthermore, a shareholder agreement requires the consent of all shareholders. Unless otherwise specified, all existing shareholders must also consent to any changes or alterations.
Do I need a shareholder agreement?
All proprietary companies must provide a constitution upon incorporation. At first glance, it might be assumed that a company constitution is sufficient to address the rights and obligations of shareholders.
However, a company constitution is usually limited in scope. In particular, it focuses on setting out the company’s objectives, activities and internal administrative matters.
Importantly, a standard company constitution will not protect a shareholder’s interests in the event of a dispute between the parties or where issues arise that are not covered by the constitution.
In contrast, a shareholder agreement can be an extremely useful legal document for managing shareholder issues. Specifically, it deals with matters not covered by the constitution that may arise in the future.
Although it is not compulsory to have a shareholder agreement, it is highly recommended for all companies. This is especially the case for smaller privately held companies where there is a close relationship between owners (shareholders) and management.
At incorporation, shareholders usually share goodwill. For this reason, a shareholder agreement may not seem necessary at the start of a business venture.
Nevertheless, it is easier to negotiate a shareholder agreement at the beginning. At that stage, issues can be discussed amicably, rather than later when disagreements arise.
What to include in a shareholder agreement
To be effective, a shareholder agreement must be customised to meet the specific requirements of the company and its shareholders.
Accordingly, the following are common provisions which most shareholder agreements should contain.
Primacy of shareholder agreement over the constitution
Where there is any inconsistency between the shareholder agreement and the constitution, the shareholder agreement would normally prevail. This ensures the customised agreement governs shareholder relationships.
Alternative dispute resolution
To reduce litigation costs and uncertainty, parties should first attempt to resolve disputes through alternative dispute resolution. Only after this step should formal litigation commence.
Deadlock breaker
These provisions deal with situations where shareholders cannot agree on the management of the company. They may include:
- A shotgun clause, which allows a shareholder to break a deadlock by purchasing the shares of the other shareholder at a nominated price.
- A chairman clause, which allows one shareholder to act as chairman and hold a casting vote.
- A liquidation clause, which provides that the company will be voluntarily wound up if the deadlock continues for a set period of time.
Pre-emptive rights
These provisions impose restrictions on the transfer of shares. Typically, exiting shareholders must first offer their shares to existing shareholders before offering them to external parties.
Drag-along, tag-along rights
These provisions balance the rights of majority and minority shareholders.
Under a drag-along option, majority shareholders can require minority shareholders to join in the sale of shares in the company.
Conversely, under a tag-along option, minority shareholders may join the transaction and sell their minority stake if the majority shareholder sells.
Mandatory sale events
This provision sets triggers for the mandatory sale of shares in certain circumstances. For example, this may occur where a director passes away, resigns or becomes bankrupt.
Share valuation methods
It is prudent to define the method used to value shares in relation to pre-emptive rights and mandatory sale events.
For example, shareholder agreements often appoint an external valuer and set clear valuation criteria to reduce disputes.
Conclusion
A shareholder agreement is best prepared when a company is first incorporated. At that time, goodwill usually exists between the parties. Importantly, disputes or disagreements about the management of the business have not yet arisen.
Therefore, the agreement becomes a useful document that clearly sets out the rights, obligations and liabilities of shareholders. It also explains how risks and disputes will be managed in the future.
Because each company is different, a shareholder agreement should always be professionally prepared. It must be tailored to the specific needs of the shareholders and the company. It should also include the key provisions set out above.
If you or someone you know wants more information or needs help or advice, please contact us on 07 5576 9999 or email [email protected].
