The provisions of a Shareholders’ Agreement will always be subject to negotiation and the outcome of those negotiations is likely to be governed by the parties’ relative bargaining power. However, Shareholders’ Agreements will commonly include the following provisions.
Veto rights
It is common for a Shareholders’ Agreement to include a list of matters that require the consent of all (or a certain number or a majority) of the shareholders. Such provisions may also reserve particular matters concerning the day to day running of the business to the shareholders (i.e. matters that would usually be decided by the board of directors).
Examples of matters which commonly require the consent of all shareholders include:
- increases in authorised share capital (if relevant);
- change of the company’s name;
- changes to the Articles;
- variation of any rights attaching to the shares in the company;
- entering into any borrowing or entering into any borrowing over a certain threshold;
- acquiring shares in, or other property from, any other company – sometimes this has a de minimis amount set such as £20,000 (i.e. acquisitions costing more than £20,000 require the consent of all shareholders);
- change of registered office;
- change of auditors;
- change of accounting reference date;
- matters of policy (i.e. the commercial direction of the business); and
- appointments or changes of bankers.
Where some formal procedure for decision-making is set out in a Shareholders’ Agreement but the shareholders fail to follow that procedure, provided that all the shareholders agree, their decision will be binding, notwithstanding the failure to follow the stipulated procedure.
Provisions relating to directors
These provisions deal with the appointment and removal of directors and also procedural issues relating to the day to day management of the company by the directors.
Such provisions may include quorum, notice and voting provisions (these provisions may also be repeated in the Articles). For example, above a certain percentage of shareholding, each shareholder is likely to be entitled to appoint a representative or representatives to the board or it may be provided that no director shall be appointed to the board or removed from the board except with the consent of all of the shareholders.
If the company is deadlocked, each shareholder will normally be entitled to appoint the same number of directors or representatives. They will also have the right to appoint the chairman of the board without a casting vote but probably on a rotational basis for a fixed period.
Quorum requirements for shareholder meetings
Though the Model Articles do set out quorum requirements for company meetings, it is common in a Shareholders’ Agreement, especially in joint venture arrangements, to set overriding quorum requirements that provide that certain persons (or their representatives) from each party to the Shareholders’ Agreement must be present in order for a quorum to be reached.
A deadlocked company often provides that no decision of a meeting can be taken unless a representative of each shareholder is present throughout the meeting. If the company is not deadlocked, it may be the case that a representative of the minority shareholder will be required to be present for the meeting to be quorate or have the right to receive notice of the meeting and decide whether to attend or not. If the minority shareholder’s representative is required to be present before the meeting is quorate, this can effectively give it a right of veto over decisions. This position is naturally resisted by a majority shareholder.
Financing the Company
Provisions may be included which set out how the company is going to be financed. In an investment arrangement or a joint venture arrangement, the Shareholders’ Agreement is often made conditional upon receipt of the financing. The types of provisions will depend upon the reason for which the Shareholders’ Agreement is being entered into.
If the parties are entering into a joint venture arrangement, the parties often contribute different assets, equipment and property to the venture as well as capital in return for shares. The Shareholders’ Agreement will need to describe who is contributing which assets, equipment and property and what will happen to these items (if anything) when the joint venture terminates or any of the parties exit the joint venture.
If on the other hand the Shareholders’ Agreement is being entered into in connection with an investment or as a result of a private equity buy-out, the Shareholders’ Agreement will detail the precise share subscriptions of the parties and the rights attaching to the shares as well as any loan financing that is being provided by the parties.
These provisions should also include what is to happen if a shareholder leaves and, for example, a loan is still outstanding.
As mentioned above, Shareholders’ Agreements also have the advantage of confidentiality. Unlike a company’s Articles, they do not have to be filed at Companies House and are therefore not open to public inspection. Nor are Shareholders’ Agreements open to inspection by a company’s creditors or employees. Shareholders may feel that they do not want provisions dealing with funding to be public. The same issue is also likely to arise with other provisions such as those relating to directors’ remuneration which the parties will want to keep confidential (subject to any company law or accounting regulatory requirements).
Pre-emption rights on transfer
S.561 CA 2006 gives statutory pre-emption rights on the allotment and issue of new shares in a company, whereby statute gives existing shareholders a statutory right of first refusal to take up new shares that are being issued by a company. I will cover this in more depth in a later post.
One important clause for all shareholders in a Shareholders’ Agreement will be the clause relating to pre-emption rights on the transfer of existing shares in the company. This is because there is no statutory provision giving existing shareholders a right of pre-emption on a transfer of shares from an existing shareholder to a new or another existing shareholder. A Shareholders’ Agreement provides for contractual pre-emption rights. Contractual pre-emption rights in a Shareholders’ Agreement give existing shareholders a right of first refusal to accept a transfer of shares from a departing shareholder. In a joint venture or private equity buy-out scenario, the nature of the business depends on the expertise of the joint venture parties or (in the buy-out scenario) the management team (who will also be shareholders), so shareholders will very often not want shares in the company to fall into the hands of people other than the original shareholders to protect their investment.
A Shareholders’ Agreement will therefore often provide that the shares belonging to the exiting shareholder must be offered to the remaining shareholders pro rata and that the consent of all shareholders will be required in order for the transfer of existing shares to be registered by the directors. It is also common for these provisions to be repeated in the Articles of the company. On a major investment or private equity buy-out where the majority shareholders are an institutional investor or private equity house, the transfer provisions may provide that the departing shareholders’ shares must first be offered to the majority shareholders before they are offered to other shareholders.
If there is a majority shareholder there may be so-called drag-along provisions which require the minority shareholders to sell their shares in the event that the majority shareholder wants to sell to a third party. The majority shareholder can force the minorities to sell.
You may also find so called tag-along provisions which state that a majority shareholder wishing to sell to a third party cannot do so unless he procures an offer by the third party to purchase the minority shareholders’ shares on matching terms – the smaller shareholder can tag along with the sale.
Whatever is agreed, it is often the case that there will be exceptions for certain transfers, the most common being intra-group and intra-family transfers. For clarity, and to avoid conflict in the future, the permitted transferees are often specifically defined in the Shareholders’ Agreement.
Anti-dilution provisions/Rights on allotment of new shares
Shareholders may also not want their current shareholdings to be diluted by the issue of new shares. Although the CA 2006 provides for pre-emption rights on the allotment of certain types of shares (“equity securities” defined in s.560 CA 2006), this only protects shareholders from the dilution of their shareholding in respect of these types of shares, if they can all afford to and wish to take up those new shares. A Shareholders’ Agreement may therefore provide that the consent of all shareholders will be required in order for any new shares to be allotted at all.
Dividend policy
A Shareholders’ Agreement will almost always set out some kind of policy on whether to declare dividends or not and in what proportions those dividends will be paid. The Shareholders’ Agreement may for example state that a dividend is not to be declared for a certain period of time and/or that a dividend is not to be declared until such time as certain financial milestones have been reached by the company (e.g. the repayment of all loans).
Pre-completion obligations
It may be the case that certain arrangements need to be entered into before the parties agree to set up the company or subscribe for shares in the company. The idea behind this is that all parties’ initial obligations will be subject to each other so that the company will only be established once all initial obligations have been fulfilled. Such matters are often set out in a Shareholders’ Agreement. For instance, prior to completion each party would be obliged to subscribe for a certain number of shares in the company at a certain price or to transfer certain property into the name of the company.
Restrictive covenants
Restrictive covenants exist to protect legitimate business interests which include trade secrets, confidential information, etc. It is common to have restrictive covenants dealing with the period during which a party is a shareholder and also for a period following the shareholder’s departure to protect a company’s legitimate business interests.
Such covenants often prevent former shareholders from competing with the business of the company or from soliciting customers, suppliers and employees from the company. As such these covenants can be regarded as a critical issue to negotiate (from the outset) where, on departure of a shareholder, the company is intended to continue as an ongoing business.
Deadlock
Deadlock provisions will always be included in a Shareholders’ Agreement to provide for what is to happen in the event of the company becoming deadlocked either at board or shareholder level – although it is usually the case that if the company is deadlocked at board level it will be referred up to shareholder level.
Deadlock occurs when, for whatever reason, it is not possible for the board or a meeting of the shareholders to pass resolutions (e.g. because certain directors or shareholders refuse to attend meetings so that they cannot become quorate).
Deadlock may also occur if a party wants to sell its shares and leave the company and the other shareholders are not willing to buy its shares but it is not permitted to sell the shares to a third party as mentioned above.
In practice you may come across deadlock resolution procedures referred to as Russian Roulette or Mexican/Texas Shootouts, where the end result is that certain shareholders buy the shares of others.
A “Russian Roulette” mechanism typically provides that a shareholder (A) can serve notice on another shareholder (B) offering to buy all of B’s shares in the company at a price specified by A (or to sell its shares to B at the stated price). B must accept A’s offer and sell its shares to A at the stated price or must buy A’s shares at the same price per share.
A “Mexican/Texas shoot-out” is a variation of the Russian Roulette provision in that either party can serve notice on the other party to buy the other’s shares or to sell its own shares to the other party at a specified price. This type of mechanism generally occurs where both parties are interested in buying the company, and provides that in this case they both submit sealed bids to an ‘auctioneer’ and the party who makes the higher bid is entitled to buy the company at that price.
These procedures are not the only remedy in all deadlock situations. It may not be appropriate or workable in certain circumstances to follow these procedures. As such, a deadlock provision can also provide for the company to be wound up. Whilst liquidation may appear to be an obviously drastic result for a deadlock situation, the clear benefit is to focus the shareholders’ minds as to whether the deadlock is irretrievable or whether they wish to continue with the company.
Deadlock provisions may also provide for a period of arbitration, mediation or other form of alternative dispute resolution in order to settle the dispute before any of the more serious steps, as identified above, are taken. In any event, when drafting deadlock procedures it is important to ensure that they clearly provide for what circumstances will constitute a deadlock and for the procedure to be followed once the deadlock situation has arisen.
Termination other than by Deadlock
As well as providing for termination in the event of deadlock, it is usual for Shareholders’ Agreements to be terminable on the happening of any of the following events:
1. a shareholder committing a material breach of the agreement which it has failed to remedy within a specified time;
2. the company or a shareholder becoming insolvent;
3. change of control of a shareholder (if it is itself a company);
4. the expiry of a definite term or completion of or failure of a particular project undertaken by the company; or
5. service of notice by a shareholder or shareholders.
The above ‘termination situations’ can be categorised into two categories: termination by default (points 1-3) and termination by consent of the parties (points 4 and 5).
Where termination by default occurs, the Shareholders’ Agreement will usually specify a mechanism by which (1) the other party is put on notice that such a breach has occurred; (2) the breach is verified by a third party; (3) the infringing party has had an opportunity to remedy the breach; and (4) the infringing party’s shares are purchased by the other innocent party. Termination by consent is, of course, the more straightforward scenario.
Provisions dealing with termination (including termination by deadlock) must provide for how the company assets are to be allocated. Such assets will include any intellectual property rights generated by the company.
Where there is termination other than as a result of deadlock, termination provisions can be drafted to provide that the shareholder who has not defaulted is then able to force the sale to itself of the defaulting shareholder’s shares in the company. These are known as compulsory transfer provisions. Similarly, options can be put in place for a non-defaulting party to exercise (put or call options). These allow the non-defaulting party to buy the defaulting party’s shares, or to sell its shares to the defaulting party. The price at which the shares will be purchased will either be expressed as being a fair value or will be ascertained by reference to a pre-agreed formula.
New shareholders
It must be remembered that the only parties to a Shareholders’ Agreement are those shareholders who have signed up to its provisions (and perhaps also the company itself). Unlike the Articles where every person is automatically bound upon becoming a shareholder, with a Shareholders’ Agreement shareholders must actively enter into the Shareholders’ Agreement in order to be bound. New shareholders are often signed up to the provisions of Shareholders’ Agreements by entering into a Deed of Adherence. A proforma Deed of Adherence is usually appended to the Shareholders’ Agreement.
Note that the provisions of a Shareholders’ Agreement dealing with pre-emption rights on allotment and/or transfer may make new or additional shareholders an unlikely proposition. In any event no person is likely to be permitted to become a shareholder unless they enter into a Deed of Adherence.
Departing shareholders
As stated earlier, it is often the case that restrictive covenants are entered into between the parties to a Shareholders’ Agreement. Restrictive covenants require careful drafting as they must be drafted no more widely than is reasonably necessary to protect the legitimate business interest of the company concerned. A restrictive covenant which is unreasonable in its scope will be held to be void and unenforceable.
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