You are about to launch a new business with your close friend, and have dealt with some of the main issues of setting up a business, such as:
- incorporating your company;
- using trademark protection for your business name; and
- entering a lease on your new premises.
Your investor then asks to see your proposed shareholders’ agreement. Quite often the response will be “Why do we need this?”, “We’re all friends and aren’t going to fall out” or “Haven’t we spent enough time/money with professional advisers already?”.
It is easy to overlook the importance of entering into a shareholders’ agreement, however they provide, amongst other things, an excellent dispute resolution mechanism if the parties involved fall out further down the line.
This article looks at why shareholders’ agreements should be considered as a necessity, rather than a luxury, and suggests top ten tips for entrepreneurs looking to regulate shareholder arrangements.
1. Ensure you protect your concerns in the business relationship
A shareholders’ agreement regulates the relationship between the company and its shareholders. Yet it should also regulate the relationship between:
- the majority and minority shareholder; and
- the board and other shareholders.
Starting a business with close friends may, in your eyes, negate the need for formal arrangements. However, these friendships may not have been tested by the daily strain of running a business together.
A shareholders’ agreement can flesh out key issues relating to share transfers, the business of the company, further share allotments and the parties’ obligations. This codifies your business relationship and should prevent the exploitation and manipulation of personal friendships if relations unfortunately start to deteriorate.
2. Consider a combined shareholder and subscription agreement
A combined agreement will deal with:
- subscription provisions (dealing with how the investor is investing); and
- shareholder provisions (regulating the running of the company going forward).
Using such a combined agreement can help to save time and additional expense by dealing with both sets of issues at the same time.
An investor will typically receive comfort (known as warranties) that he’s getting good title to his shares and that the material assets or liabilities of the company have all been disclosed to him. In a well-drafted agreement, the warranties should also reassure an investor that the company is solvent, accounts are accurate and that all legal and other requirements relating to the business of the company have been complied with.
Executive directors of companies will often be willing to grant warranties to investors up to specified total amounts. These figures can be negotiated and then set out in the agreement.
3. “Are you negotiating the right agreement” – a taxing question?
Important consideration should be given to the business medium which will best serve your commercial and tax objectives.
Investors often favour a limited company as they receive a share certificate and may, in certain circumstances, be entitled to the recently introduced SEIS or EIS reliefs on income tax and/or future capital gains.
However advice should be taken to ascertain if, for example, a limited liability partnership (LLP) should be set up. An LLP is a hybrid between a traditional partnership model and a company. It has the advantages of members being taxed personally whilst remaining a separate legal personality with limited liability and the ability to grant charges (including fixed/floating charges) over its assets. In addition, an LLP can also maintain a flexible organisational structure of a traditional partnership.
If an LLP is considered to be more suitable, the parties will be negotiating a members agreement rather than a shareholders’ agreement, although many of the issues and clauses involved will be similar.
4. Keep it private
Many companies do not have shareholders’ agreement and include operational details in their articles of association. Common examples include:
- the issue and transfer of company shares;
- the number of directors;
- directors’ duties and interests; and
- company procedures, such as the number of directors/members who need to be present at meetings (known as the quorum).
The articles of association need to be filed at Companies House and accordingly you need to consider what information you are happy for your competitors or members of the public to have access to.
However certain information should definitely be kept out of the public domain, such as:
- dividends policy;
- exit strategy; and
- how to keep managers incentivised.
One of the main benefits of a shareholders’ agreement is that it does not need to be filed at Companies House and this potentially sensitive information can be kept private.
5. Ask, and address, those difficult questions
The company may be launched in a blaze of optimism but what if:
(a) the bank stops lending (not unheard of in the current climate). Which of the shareholders is on standby to provide any additional funding?
(b) the parties fall out? How will the deadlock be broken?
(c) one of the employee shareholders falls ill and has to leave the company. Can he retain the shares?
The above questions, and many more, should be posed to the participants. The negotiation of the shareholders’ agreement provides an excellent opportunity to make sure everybody is on the same page before going into business together.
6. Use restrictive covenants effectively
UK Courts have long upheld the right of the working person to earn a living and any restrictions on this right must be reasonable. The recent dispute between the financial advisers Raymond James and Edward Jones indicates the inherent difficulties of enforcing restrictive covenants (particularly in service agreements).
However, as a general rule, restrictive covenants contained in a shareholders’ agreement or business sale agreement are generally easier to enforce. The Courts’ perceive them as being part of commercial arrangements which are negotiated between business people on equal footings and it is therefore accepted that the restrictive covenants in shareholders’ agreements will be longer in duration than those contained in an employment agreement. There is usually clear consideration being provided in the form of share capital or proceeds of sale and the Courts therefore perceive it as legitimate for a buyer to expect longer periods of restraint.
7. Vesting your shares
Time and time again on the negotiation of shareholders’ agreements, the biggest “battleground” area which emerges is the whole question of an employee shareholder retaining/selling their shares when they leave the business as an employee.
When the business is launched, there is normally an assumption that the managers have received shares because they are going to help drive the business forward on a daily basis. A well drafted shareholders’ agreement will make it clear:
- when departing employees can retain their share; or
- when they are deemed to have offered them for sale to the company/other shareholders. There is normally a right to buy these shares, rather than an obligation.
An equally contentious issue will be the price that the shares are sold for, with employee shareholders falling into two categories:
- Good Leavers: typically means employees who have retired through ill-health or, after an agreed number of years. They will usually receive the market value price for their shares.
- Bad Leavers: typically means employees who have either been dismissed due to misconduct or breaches of the shareholders’ agreement. Bad leavers will receive a lower price, which is usually the nominal value of their shares.
Also worth considering key man insurance-if one of the main revenue generators dies, how will the company replace the shortfall in turnover/profit whilst they are finding a replacement?.
If a shareholder is leaving and is forced to sell his shares, how is the valuation impacted if he is a material revenue generator. Has the company/other shareholders taken out insurance to provide funds to pay for the share purchase if exit is down to death/ill health.
8. Prepare for exit
It may seem strange, when the company has just been launched, to include an exit clause. However by including plans for the future, it forces shareholders discuss their visions (hopefully mutual) for the future. Any disagreements you may have can also be resolved, thereby limiting the scope for conflict further down the line.
Including a clause which manages the duties of non-manager shareholders is also advisable. Such clauses ensure that these shareholders have no obligation to give any warranties in a future sale (other than good title to the shares).
9. Strike the right balance
A shareholders’ agreement can be drawn up to protect a minority shareholder. This is to compensate for the fact that a majority shareholder will usually control the board and may have the power to change the articles of association. For example, provisions can be included which require a selling majority shareholder to procure a third party purchaser to buy the minority shareholders’ shares on the same terms (known as ‘tag along’ rights).
However, it can also be drawn up to protect a majority shareholder who is not involved in the day-to-day management of the company. In addition, it needs to strikes a balance between the board and the other shareholders about how much shareholder approval is required for key decisions. Similarly, in contrast to the above example in relation to ‘tag along’ rights, in the event of a company sale the shareholders’ agreement may include ‘drag along’ rights, which can force minority shareholders to accept the terms of the offer.
These issues will usually be addressed in the consent matters clause. This will contain a list of key issues (merger, litigation, borrowing, granting of security etc) which need to be approved in advance by the board and/or certain shareholders.
10. Be consistent
If you are utilising a shareholders’ agreement care should be taken to ensure it sits alongside your articles of association. It is not advisable for these key documents governing the relationships between stakeholders to contain contradictory provisions.
For example, if the articles and the shareholders’ agreement specify a different number of directors who need to be present at a board meeting. If such a conflict does arise, either document can take priority subject to the stated intention of the parties. Usually a shareholders’ agreement will take precedent over the articles of association.
By utilising a shareholders’ agreement, the final negotiated agreement provides clarity as to the future direction of the company.
However just as importantly, the negotiations leading up to signature will force the shareholders to sit down and address difficult issues. Hopefully this will ensure they have the same aspirations/plans before taking the big step of going into business together.