How to Draft Shareholders Agreement?
Watch this to Learn How!
What does a Shareholders’ Agreement cover?
Shareholders’ Agreements only apply to companies with more than one shareholder. If you have a company with two or more shareholders, you should look at putting in place a Shareholders Agreement.
Generally, a Shareholders’ Agreement can cover things like how many shares does each shareholder owns.
It could set out whether there are different classes of shares. If so the rights and responsibilities that are applicable to each different share class.
Often though the Company Constitution can also set out the share class information, it’s not necessarily in a Shareholders’ Agreement, but can be in there.
A Shareholders’ Agreement can set out whether or not the company is able to issue additional shares in the future. And if so, whether current or existing shareholders could have their shares diluted, or whether they could buy more shares to keep their current share percentage.
A Shareholders Agreement could also set out:
- how new shareholders may join the company,
- how existing shareholders can leave the company,
- whether a shareholder could ever be forced out of a company and
- what happens if a shareholder was to die, unfortunate as it may be, also
- some Shareholders Agreements even have things like drag along and tag-along rights, which are rights that are applicable to sale.
What are the advantages of a Shareholders’ Agreement?
The main advantage is that it sets out the rights and responsibilities of shareholders.
It is a contract between the shareholders. Because it’s a contract and binding, it compels those shareholders to do or not to do certain things in accordance with the terms of the Shareholders’ Agreement.
So because of that, Shareholders’ Agreements can be instrumental in preventing disputes. They also can be helpful because they can clearly set out the roles and responsibilities of each shareholder under the company.
They can also set out things like
- how to sell shares,
- how to join the company,
- whether your current shares can be diluted
- whether when you sell your share you are bound by a restraint,
- And whether you can enter into or buy shares in a company that competes with the company that the shareholder is currently a shareholder of.
Is a Shareholders’ Agreement necessary?
Does the law require it? No.
Should you have one? Definitely.
You should definitely put in place a Shareholders’ Agreement where shareholders could have competing interests. That’s when you definitely want one. When you think about it, even if you have a company with family members, whilst your interests may align today, that does not guarantee or necessarily mean that your interests will align in the future.
Also, it’s worth mentioning that it’s much easier when things are going well at the start to put in place a Shareholders’ Agreement. This will then govern the relationship between the shareholders.
So that if, and when things do go sour in the future, at least you’ve already pre-agreed the terms. You have terms as to what’s going to happen in the event of a dispute, or if one party wants to leave or sell their shares.
What are the risks of not having a Shareholders Agreement?
There is generally going to be some sort of disagreement between the shareholders. If you have a Shareholders’ Agreement, you can substantially reduce the risk of things going south. [This is] because the Shareholders’ Agreement should deal with the scenario that is the subject of the dispute.
As an example, you may have someone who has been promised that if they work in the company for a certain period of time, that they’re going to get shares.
If that’s the case, you can have all that dealt with in the Shareholders’ Agreement. You can have what is a share vesting regime.
On the completion of a certain number of months or years of work, then the number of shares agreed on will vest (or become owned by) the employee.
You could clearly specify in the Shareholders Agreement if and when they are to be granted shares in the company. I.e. do they have to meet milestones? Do the milestones depend on deliverables, or do they depend on just the passage of time?
In addition, you might be the majority shareholder of the company, and you may want to sell your shares, but you might discover that you can’t actually sell your shares because the minority shareholders are able to vote against you and hold you to ransom.
Basically you can set out whatever you need in the Shareholders’ Agreement that it’s going to be relevant for the circumstances of your company, and what your shareholders are doing.
What is a Partnership Agreement?
A Partnership Agreement is a document that creates a partnership and sets out the rules between partners.
What is the difference between a Shareholders’ Agreement and Partnership Agreement?
A Partnership Agreement is an agreement between partners of a partnership. On the other hand, a Shareholders’ Agreement is an agreement between shareholders of a company.
Some people misinterpret the two agreements. They look to put in place a partnership agreement when in fact they need a shareholders agreement.
This is the most common mistake we see.
When you form a company, a company is a separate and distinct legal entity while a partnership is not. A partnership is the coming together of multiple separate legal entities to operate or run a business (usually).
What does that mean? A Partnership Agreement creates a partnership where all individual partners themselves are separate entities (for legal purposes). All those individual people collectively form the partnership.
If you ever need to know what sort of entity you are, you can go to the ABN lookup. It will tell you what type of structure your business is.
What are the Shareholders’ Agreement, Articles of Association, Corporate ByLaws, Company Constitution, and Replaceable Rules?
These are all terms that one will encounter when it comes to companies.
The Shareholders’ Agreement is the contract between people who own shares in the company. It sets out the rights and responsibilities of those people.
Articles of Association
Prior to 1998, companies used the Articles of Association. It includes mainly the internal governance of the company and regulates the company’s operational activities. Such internal governance as:
- Rights and Obligations, and so forth.
Corporate Bylaws, on the other hand, are articles that the members of the company have set to govern and organize its internal management. This includes:
- Board of Directors
- Conflict of Interest, and so forth
When you form a company in Australia if you use one of the online company formation websites, which is always a good thing to do, because they provide a good service and they’re pretty cheap, and there’s plenty of them around if you just search on Google, you will always be issued with a Company Constitution as part of forming the company.
The Company Constitution sets out the overriding governance of the company. It generally specifies what classes of shares there are, what preference shares there are, what preference or voting rights come with various share classes and other more general items.
For example, in your company, you may have
- A class shares,
- B class shares,
- C class shares.
The people who own A class shares may have 10 votes for each share, whereas a B class shareholder may only have 1 vote per share and C class may have no voting rights.
If you don’t have a Company Constitution, if you don’t get one when you purchase your company, or you just set it up yourself by registering it with ASIC, then you’ll be covered by the Replaceable Rules.
Replaceable Rules are a basic set of rules for managing your company. These are set out in the Corporations Act. They automatically apply if you don’t have a Company Constitution.
Can you have a Verbal Shareholders Agreement?
All contracts in Australia can be verbal. Can Shareholders Agreement be verbal? In a practical sense, it can be.
Do you want a contract to be verbal? No, you do not. In fact, let me say that another way…. ‘Hell NO!
In the event of a dispute between the parties, you will definitely have a hard time, in a legal sense, trying to prove what were the terms of in the verbal contract and how you’re going to prove your position or your belief as to what was agreed is the correct one. And in fact, you may not be able to prove what you believe was agreed upon.
That is the main reason you don’t want a verbal Shareholders’ Agreement – as you will have a very hard time proving what was actually agreed.
Can you vary or amend a Shareholders’ Agreement?
Will you be stuck forever and a day when you sign a Shareholders’ Agreement? The answer obviously is no.
Any contract can be altered, varied, changed, or amended, it just requires the consent of the parties.
Most contracts have a variation process written into the contract that basically says that to change the contract all parties to the contract need to consent and their consent needs to be provided in writing.
Assuming that is the case (and it is for 95% of contracts, and even if it’s not spelt out it is best practice to always do variations in writing) then this is where the Deed of Variation comes in.
What is a Deed of Variation?
This is a document that sets out the relevant changes to a contract, in this case, the changes to the Shareholders’ Agreement.
You don’t always have to do a Deed of Variation. You can in fact put in place a whole new contract.
To do that, you can make your new changes in version two of a Shareholders’ Agreement and reflect the fact that the parties have agreed to terminate the first Shareholders’ Agreement and then proceed to sign Shareholders’ Agreement version two.
This has the effect of rendering Shareholders’ Agreement v1 null and void and putting in place Shareholders Agreement v2.
What clauses should be included in a Shareholders Agreement?
There’s a whole lot of stuff you can put in a Shareholders’ Agreement. For instance, you should start off with what are the objectives of the company, what is the company looking to achieve, and what are the business activities.
Share Classes and Voting Rights
Sometimes the share classes and voting rights are set out in the Company Constitution. Just understand that the constitution may say things like there are five classes of shares, A, B, C, D, E:
- A Class Share has 10 votes per share,
- B Class Share has five votes per share
- C Class Share has three votes per share,
- D Class Share two votes per share and
- E Class Share, one vote per share.
That’s usually as far as the constitution would go. It would just set out that there are different shares and each share class has a different set of voting rights that attach to them.
The constitution just sets out the general overriding principles as to what sort of classes and types of shares there are, but it’ll actually be in the Shareholders Agreement where it will specify who owns which, or how many of which type of share class.
Other Clauses in a Shareholders’ Agreement
- You can have other things like Shareholders Loans. You can include this on the Shareholders’ Agreement and set out how and how much the payable interest will be shouldered by the members who avail loans.
- Have things like a Dividend Distribution Policy. This sets out the ascertain amounts that can be distributed to shareholders such as the dividends or profits made by the company.
- Board Meetings. You can also include how often you can conduct for a board meeting and the required quorum in decision-making during board meetings.
- New Shares and Capital Calls. You can specify these on Shareholders’ Agreement the issuing of new shares and capital calls.
New Shares are shares as a means of raising additional capital to fund business activities and operations or taking up new investments.
Capital Calls are very essential to be included in the Shareholders’ Agreement as it secures the fund for ongoing or new investments.
Selling or Transferring of Shares. When a party wants to sell or transfer their shares, they can offer it first to other existing shareholders before they sell or they can sell directly to a third party.
If they sell directly to a third party, the other shareholders will have to decide as to whether they’ll accept the new third party coming into the company.
You can have other things like Drag-Along Rights. Drag along rights are rights that make the majority shareholder force or compel minority shareholders to join in the sale of the company.
If you’ve got a majority shareholder who is willing to sell their shares to a third party, the smaller or minority shareholders can be dragged along and be compelled to sell their shares. In that way, the majority shareholder is able to force a sale of the company to another entity.
You can include things to happens such as if a party or a Shareholder becomes a Divorcee, Incapacitated, or Died. You can clearly set this on the Shareholders’ Agreement as to what will be the next step if a shareholder gets into unavoidable happening. Clearly specify this so you won’t put the other shareholders into chaos if something might happen.
You can put what is the price that you can sell your shares for in case you want to sell them.
Another one is Business Valuation. Business Valuation is a provision made for share valuations in the event that a shareholder wishes to exit the company.
Confidentiality and Non-Compete Clauses
You’ll definitely want Confidentiality Provisions to be included in a Shareholders Agreement. This sets out where the shareholders or members of the company are guaranteed to deal with data and information about the company as a secret and not to disclose such data and information to others without authorization.
You could have Non-Compete Clauses. This basically means if you are a shareholder and if you sell your shares, will you be forbidden or stopped from owning shares in a competing company, I.e. a company that competes with your old company.
- What are the events of default?
- What happens if there’s a dispute?
- How is that resolved?
- Does the dispute go to arbitration where an arbiter or a mediator makes a determination?
- And then how does the agreement terminate and what is the governing law of the agreement?
How do different share classes work (ordinary, non-voting, preference)?
The constitution will set out different classes of shares, but the Shareholders’ Agreement can set out more or additional information into share classes and voting rights.
Also, shareholders can agree on the names for the share classes. For example,
- A class,
- B class, and
- C class
But shareholders could agree to call the share classes things like
- ordinary shares,
- non-voting shares, and
- preference shares.
Or they could say
- first-class shares,
- second class shares,
- or third class shares.
You can have preference shares. They could have a preference for dividends. So only people who own preference shares or class A shares have the right to receive a dividend.
Which basically leads to the point, which is you can set up in Shareholders’ Agreements, to take full advantage of your position (if you’re the majority shareholder), because you could be the only party that has class A shares.
And those class A shares have 10 votes per share or a 100 votes per share. And class A shareholders are the only shareholders designed to receive any sort of dividend.
So it’s when you understand these sorts of things and how Shareholders’ Agreements can really protect one party and potentially take advantage of others.
Let’s say you want to be compensated by being ‘given’ 10% of the company. But if the 10% you own is in share classes where you actually don’t have a right to receive dividends, or you don’t have the right to vote, then really you’ve got nothing.
This is very important if you’re looking to buy into a business, you actually really need to understand what you’re buying, as in what type of shares and what are the rights that attach to those shares.
And then there’ll be other clauses in the Shareholders’ Agreement like, what happens if the company wants to agree to pay third parties or enter into loans. Can that be done by just the majority shareholder or does the consent of all shareholders need to be required or compelled?
You really need to understand all of that and how it works so that you can understand that if you were buying into a business, how can you be taken for a ride.
How can sweat equity be accounted for in a Shareholders Agreement?
Sweat equity is a form of an investment where the person’s contribution is in the form of labor, time, or effort as opposed to financial equity. Once the person has worked for a certain amount of time they are granted shares in the company.
This can be done by having a share vesting arrangement in the Shareholders’ Agreement whereby shares vest or are given to an employee at certain times (e.g. 25% each year until after 4 years the full 100% of shares offered to that employee have been allocated).
What if a shareholder is also an employee of the company or startup?
You can have shareholders who are also employees, there’s no issue with that.
The question then becomes, how are they getting paid? Are they getting paid through the vesting or granting of shares? Or are they actually being paid as an employee or are they getting both?
How can a new investor be added to an existing Shareholders’ Agreement?
The Shareholders’ Agreement should set out the process for adding or removing shareholders.
The Shareholders Agreement usually sets out what happens where a shareholder wants to sell and what will be the process where a new person or investor wants to own shares in the company.
You always want the incoming person, whether they’re an investor or just a new ‘standard’ shareholder, to be bound by the existing Shareholders’ Agreement. You can easily do this by having them sign a Deed of Accession.
95% of Shareholders’ Agreements have in a schedule or an annexure at the end a “Deed of Accession.”
It is the document that an incoming party signs. By signing the Deed of Accession that is their way of saying that they agree to binding to the terms and conditions of the Shareholders’ Agreement.
If you ever see a Deed of Accession on a Shareholders’ Agreement, that is what that is for, and you should always use them.
If you don’t get a new incoming person to sign a Deed of Accession then that new incoming person will not be bound by the Shareholders’ Agreement. Yet all the other pre-existing shareholders will be. That is a position you do not want to be in, where some shareholders (but not all) are bound by the Shareholders’ Agreement.
How can I avoid being diluted when a new investor joins?
Let’s say a new investor comes in, and they invest some money into the business. Will that dilute your shares?
It might dilute your shareholder, but this will depend on what it said in the Shareholders’ Agreement. [because] You might have the right to match the investors’ investment (if the Shareholders’ Agreement says as much).
What share transfer restrictions should a Shareholders’ Agreement include?
Should you have share transfer restrictions? Yes, you should.
In other words, most Shareholders’ Agreements obligate a selling shareholder to offer their shares to the remaining shareholders before they try and sell them to someone or a third party.
The other thing too, is that often a person will not be able to sell their shares to a third party unless they receive the consent of the remaining directors to that sale.
Usually if a party wants to sell their shares, they are able to do so. They generally don’t need the consent of the directors. But once again this will be set out in the Shareholders’ Agreement.
Generally, when a shareholder wants to sell their shares, the Shareholders’ Agreement will stipulate that they have to offer the shares for sale to the other existing shareholders.
Most Shareholders’ Agreements will say that the selling shareholder must offer their shares to all remaining shareholders. If any of the remaining shareholders do not want to buy the shares that have been offered to them, then the other remaining shareholders who do want to buy the shares actually have the ability to purchase the additional shares.
An Example of a Share Transfer Situation
So if you’ve got a person selling 20% of the company to five people, so there’s six people in the company, but this one shareholder has 20%. The process would be that they offer their 20% to the 5 remaining shareholders who are not selling. This means each party would get the chance to buy 4 shares (if there were a 100 shares total in the company).
So if one of those shareholders who received an offer on the 4 shares decides not to buy the shares, then the 4 shares offered to them would be offered to the other shareholders who do want to buy shares.
The other purchasing shareholders would be offered shares in equal proportions. So assuming the other 4 shareholders want to buy shares they would all be offered the chance to buy 1 extra share each.
What are buy-sell provisions?
Buy-sell provisions set out how shares may be bought or sold, don’t confuse this for a buy-sell agreement.
A buy-sell agreement is a different document, and it is usually triggered when certain events happen between partners.
However buy-sell provisions in the Shareholders Agreement are just the clauses that deal with the actual purchase or sale of shares.
What happens if a shareholder dies?
The Shareholders’ Agreement should set out what happens if a shareholder dies or becomes insolvent, disable, or retires. Do any of those events trigger the disposal of the shares? The shareholders’ agreement should tell you.
So, if someone dies what happens?
This can actually be quite complex because if it’s not in the Shareholders’ Agreement, then the shares will then form an asset of that deceased person’s estate.
The shares will then pass in accordance with the dead person’s will. Practically what this means is that the remaining shareholders in the company are actually then going to be in the business with the person who acquired the shares under the will. An interesting place to be!
So one of the shareholders dies, leaves all the shares to their daughter. The daughter would now be a shareholder in the company. And as mentioned above, they may not necessarily be obligated to the Shareholders’ Agreement. You’d have to check that because they really should sign a Deed of Accession.
Is a Shareholders’ Agreement legally binding?
Yes, it is a legally binding contract.
So as long as you satisfy the standard and basic requirements of contract law, offer acceptance, consideration, all those sorts of things and the document is appropriately signed, then yes, it will be binding. It will be binding on all shareholders who sign the Shareholders’ Agreement.
Don’t forget that initially, all shareholders who you want to bind to the agreement must sign.
For new incoming people, the Shareholders’ Agreement binds them by signing the Deed of Accession.
What happens if a shareholder breaches the agreement?
If one of the shareholders breaches the agreement, for instance, they don’t pay money when they should, then the Shareholders’ Agreement should set out as to what will be the consequences.
Generally, you can do things like withholding their ability to vote, as in nullifying their voting rights. This is until such time that the said shareholder rectifies the breach.
However, bear in mind that a Shareholders’ Agreement is a contract. A party can always sue on the contract where a shareholder breaches the agreement.
What if the Shareholders have a disagreement or dispute?
If there’s a dispute or disagreement, then the Shareholders Agreement should specify how to deal with such.
There should be clear clauses that deal with how disputes will be resolved.
Can a shareholder be forced out?
It is possible.
For example, there are new shares that dilute the interest of an existing shareholder. Then that shareholder may find that they actually no longer have the voting power they once had.
And then on that basis, the shareholder who now has the increased voting rights could pass a resolution to force that shareholder out of the company and compel the sale of their shares.
But that is a drastic or random type example, and a well-drafted Shareholders’ Agreement can protect against that.
Can shareholders call a secret meeting, excluding some shareholders?
Yes, they can.
There are certain requirements where you have to notify all directors about the director’s meetings. But shareholders can hold meetings in secret.
What you need to understand is that while they can meet in secret, for a meeting of shareholders to be valid under the Corporations Act, notice of that meeting must go out to all shareholders.
And if not all shareholders receive notice, then the meeting is not a valid meeting for the purposes of transacting certain matters under the Act or under the Shareholders’ Agreement.
So what you basically have then is a secret invalid meeting… not much point in that right?!
How can a Shareholders’ Agreement be terminated?
As with any contract, if you have the agreement of the other shareholders. then it can be terminated.
Shareholders’ Agreements generally automatically terminate if the company winds up. This is because now there is no company to be a shareholder of.
Generally, the Shareholders’ Agreement will say that the agreement itself terminates if in case of the transfer of all shares to a single shareholder. This makes sense theoretically because Shareholders’ Agreements are only relevant for two or more parties.
If there was only one person owning all the shares, then there is no reason for a Shareholders’ Agreement.
Also, the Shareholders’ Agreement could terminate in other circumstances.
For instance, the Shareholders’ Agreement will say if you have an Initial Public Offer (ie the company goes public). That will terminate the Shareholders Agreement.
I hope you find this article helpful in drafting your Shareholders Agreement. Any questions please get in touch! Thank you.
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