The importance of a shareholders agreement

July 28, 2021

It is always exciting starting a new business. It is usually commenced with the best intentions with the parties trying to keep the start-up costs to a minimum. However, a pinch of prevention is worth a pound of cure and business partners should be encouraged to enter into a Shareholders' agreement.

A Shareholders' agreement is a document which governs the relationship between the Shareholders (and Directors) and the way the business is to be conducted. Normally, a Shareholders' agreement is put in the bottom drawer and is only retrieved in the event of a dispute or departure from the business.Shareholders' agreements can regulate and govern many scenarios and can be tailored to the needs of the parties and the specific business.

The following potential clauses in a Shareholders' agreement may assist you:

Restraint of trade

A Shareholders' agreement can include a restraint of trade clause for Directors, Shareholders and the Shareholders' representatives to ensure that the parties spend their time and resources in developing and running the business.

A breach of a restraint of trade can also be worded to trigger an event of default, which means that the defaulting party is required to sell his or her shares back to the company or the remaining shareholders at market value (or market value less a penalty). Directors are normally required to enter into employment contracts and, as such, restraint of trade provisions can be mirrored in the employment contracts. Restraints of trade are powerful clauses to ensure that the parties act in the best interest of the company and the business.

Management, dividends and capital injections

A Shareholders' agreement (as read with the company's constitution) can set out how the company and business should be managed and the parties who are responsible for the day-to-day operations. It can govern the composition of the Board of Directors and set out the frequency of board meetings, as well as the quorum and voting rights to be exercised at board meetings. The agreement can also dictate which decisions of the Board / Shareholders require consent by special or unanimous resolutions.

Our firm recently dealt with a matter where an insolvent company required unanimous consent to put the company into voluntary administration. This caused a problem due to the fact that it required unanimous consent of the Shareholders and we faced a situation where the company had a dissenting and uncooperative shareholder.

Shareholders' agreements can also make provision for how and when initial and additional working capital is to be sourced from the shareholders directly or from third party investors. Again, a failure by a shareholder to inject capital into the company could result in an event of default whereby the relevant party will be required to sell its shares. The agreement can also make provision for the timing, amount and frequency of distributions to shareholders.

Events of default

Shareholders' agreements normally include events of default by a Director / Shareholder or a Shareholders representative where the relevant party is required to sell his shares back to the company or the remaining shareholders. These events might include death, physical or mental incapacity, insolvency, resignation, conviction of an indictable offence, divorce or breaches of restraint of trade. The defaulting or exiting shareholder will, in the event of a default, be required to sell his shares back to the company or the remaining shareholders at a price determined in the agreement or at market value.

In some scenarios, the agreement might also make provision for a penalty to apply.

For example where a shareholder is only entitled to 90% of the market value of its shares where the shareholder breached a restraint of trade clause.

Pre-emptive rights

It is important for a Shareholders' agreement to include a pre-emptive rights clause. This will ensure that an exiting shareholder who leaves the business, must offer his or her shares, in the first instance, to the remaining shareholders. This will have the effect of the remaining shareholders being able to prevent new shareholders acquiring an interest in the business. Shareholders' agreements normally also contain unanimous approval for the issuing or transfer of shares to incoming shareholders.

Tag along and drag along rights

Tag along provisions apply where a major shareholder wishes to sell its shares to a third-party purchaser. In this instance, another shareholder may give notice to the major shareholder that the third party is required to also purchase his or her shares.

In effect the shareholder "tags along" with the major shareholder and the major shareholder will be unable to sell his or her shares unless the other shareholders shares are also purchased by the third-party purchaser.Drag along provisions apply where a third-party purchaser wishes to purchase all the shares in the company. Without a shareholders' agreement, a minor shareholder will be able to stop the sale of the shares, which could result in the minor shareholder demanding an exorbitant price for his or her shares in order for the sale to go through.

By having drag along provisions, the major shareholders can "drag along" the minor shareholder to ensure that all the shares in the company are sold without being held ransom by the minor shareholder.

Share valuations

When a shareholder wishes or is required to sell his or her shares to the company or the other shareholders, it is important to have a purchase price that can be determined in accordance with the Shareholders' agreement. The method of determination of the purchase price could be calculated in a manner of ways.

The parties can agree that in the event of a sale of shares, an accountant or valuer be instructed to provide the company with a market value for the shares. The relevant professional will look at assets, liabilities, income, expenditure, past performance of the company, as well as future prospects. This is a fair method to determine the value of the shares, however it could be a costly exercise to undertake every time a shareholder wishes to sell his or her shares.

The parties can agree that the value of the shares will be determined by considering the performance of the company, for example, over the past three years can be seen as an incentive to some shareholders to sell their shares when the company has made good profits over the last three years, but future prospects may seem bleak (think COVID-19 or the GFC).Another option is for the parties to agree on a fixed amount.

For example, the purchase price for a share in the company is $100 and upon departure of a shareholder, that shareholder will receive $100 for each of his or her shares held.

Dispute resolution

Shareholders' agreements normally contain provisions dealing with resolving disputes between the shareholders. These clauses may contain the requirement(s) to first apply for the dispute to be determined by mediation and / or arbitration.

This has the effect that the parties will first have to adhere to the prescribed requirements for dispute resolution before institution proceedings in court.As can be seen, it is of absolute importance to enter into a Shareholders' agreement when you are starting a new company. It might come at a slight cost, but it will be a real money saver (including reputational damage) down the line in the event of a dispute and / or litigation between the parties.

The same principles apply for parties intending to establish a unit trust and, as such, we strongly recommend entering into a unitholders' agreement.

If you require assistance in relation to any of the information provided above or to book a consultation, please feel free to contact Henry van der Westhuizen at Pragma Lawyers.

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