How to Draft a Shareholders Agreement That Actually Protects Your Business

A shareholder’s agreement is not legally required for your business but running your business without one can get pricey with disputes that you could easily prevent.

Private equity firms and institutional investors almost always need a shareholder agreement before they invest. The benefits go way beyond the reach and influence of just keeping investors happy. Your business stays vulnerable without a proper shareholders agreement. For example, you might not be able to stop a co-founder from selling shares to an outside buyer or you could even lose your board position with no way to fight back.

These agreements also protect minority shareholders. Without such agreements shareholders with minority holdings have very limited rights, but these can be enhanced by for example ensuring certain decisions need everyone’s approval in the terms of the agreement. .

This article will run through how to create a shareholder’s agreement that shields your business from potential risks before they surface.

Common Risks Without a Shareholders Agreement

Running a business without a shareholders agreement puts your company at risk and threatens its stability and future.

Small businesses often start with two directors who split ownership 50:50. This arrangement looks fair on paper but can create deadlocks when disagreements occur. Your business can grind to a halt without a proper mechanism to resolve these standoffs.

Unexpected ownership changes can leave your company exposed. Any shareholder could sell their shares to strangers without asking other shareholders. Someone you have never met could suddenly own a large share of your business.

The lack of drag-along rights in a shareholder’s agreement can stop majority shareholders from selling the business. Minority shareholders might block profitable company sales when these provisions do not exist.

Problems arise when employees or directors who received shares as incentives decide to leave. The company cannot force departing employees to return their shares without specific provisions in a shareholder’s agreement. They will keep getting dividends even though they no longer help the business grow.

Former shareholders can also take your business knowledge and customers away. They might start competing businesses if a shareholder’s agreement does not include restrictive covenants.

Your investment options become limited too. Standard articles usually include just one share class with equal rights to income, voting and capital. Different dividends cannot go to shareholders who contribute differently without a shareholder’s agreement (and the articles) that establishes various share classes.

Shareholder disputes without an agreement often lead to the company’s closure and goodwill loss. This worst-case scenario destroys everything you worked hard to build.

How a Shareholders Agreement Solves These Problems

A well-laid-out shareholders agreement protects your business by setting clear rules that prevent problems before they start.

Ownership control remains one of the biggest advantages these agreements offer. Your business stability stays intact through transfer restrictions like pre-emptive rights or tag-along rights. These measures let you keep control over who becomes a shareholder.

These agreements give vital safeguards to minority shareholders beyond standard company law. For example the agreements can allow shareholders to exercise contractual veto rights over specific matters, even if they lack shares to block special resolutions. This is always attractive to investors.

Your business needs predetermined resolution mechanisms if deadlock situations threaten to stop operations. Some options include:

• Mediation or arbitration procedures
• Texas Shootout provisions (highest bidder wins)
• Russian Roulette mechanisms (counter-offer process)
• Chairperson casting votes
• Independent third-party determination

The agreements help with succession planning by defining share transfer procedures to heirs, valuation methods, and purchase prices. Your business continues smoothly even after a shareholder leaves, becomes incapacitated, or dies.

“Drag-along” rights help majority shareholders compel minorities to join in selling shares when good offers come in. Small stakeholders cannot block beneficial deals this way. “Tag-along” provisions balance this by letting minority shareholders sell their shares under the same terms as the majority.

These agreements can connect shareholding with employment. For example they can promote loyalty by determining how long employees need to hold the shares before dividends or market value is available to them on sale. They also protect the company by ensuring employees must sell their shares when they leave, which stops former team members from reaping benefits without contributing to company success.

The agreement sets up structured dispute resolution methods instead of expensive litigation. This saves money and time while keeping business relationships intact. Clear decision-making processes for strategic matters minimize conflicts before they begin.

When and How to Draft Your Shareholders Agreement

Ideally, companies should create their shareholders agreement right at formation to provide vital protection from day one. This strategy will give a solid foundation where all parties can agree on fundamental decisions while relationships stay positive and before any conflicts surface.

The law does not require shareholders to implement a shareholder agreement, it is optional, and many companies say they will “do the agreement later,” or they either never get around to it or cannot agree on terms when they try and come to regret that decision.

Shareholder agreements are also not set in stone. You will need to review and update them at key points such as investors coming in, key shareholders’ approaching retirement, or shifts in your business model.

The original cost of setting up a proper shareholders’ agreement is small compared to the expense of settling disputes that could arise without one.

Conclusion

As can often be the case, shareholder agreements are one of those items put on the to-do list, but that never make it to the top. Unfortunately, the value of such agreements are not usually appreciated until it is too late.

We would urge you to take action and make this a priority to ensure you are protected against future challenges or disputes. It will be worth it.

If you would like to know more or want help reviewing your existing agreement or getting your agreement in place, please get in touch. We would love to hear from you.