A company constitution is usually drafted in a standard format and may not provide adequate protection for shareholders in the event of a dispute between them or where issues arise not sufficiently covered in the constitution.
A shareholder agreement, properly outlining the steps to be taken in the event of disputes between shareholders and other various issues affecting them that may arise, can be an effective tool for avoiding the costs of litigation and ensuring the ongoing smooth operation of the company.
A shareholder agreement sets out from the outset how disputes and deadlocks are to be resolved and facilitates shareholders more easily resolving issues which arise – quickly and with finality. In essence it can be “the rule book” to turn to when required.
What is a shareholder agreement?
A shareholder agreement is a private contract made between all the shareholders of a company, setting out the rights, obligations and liabilities of each of them to each other. Such agreements do not have to comply with any set form or procedure. However they must be drafted so as to ensure that the agreement is clear, valid and enforceable.
A shareholder agreement requires the consent of all shareholders and, unless otherwise specified, all the existing shareholders must consent to any changes or alterations. New shareholders from time to time will also usually sign the agreement when or before shares are transferred or issued to them.
Do I need a shareholder agreement?
Most proprietary companies adopt a constitution upon incorporation. Some companies do not and rely upon the replaceable rules in the Corporations Act. It might be assumed that a company constitution is sufficient to address the rights and obligations of shareholders however, a company constitution is usually more limited in its scope and is focused on setting out the company’s objectives, activities and internal administrative matters rather than shareholder rights and disputes. A standard company constitution may not adequately protect a shareholder’s interests in the event of a dispute between the shareholders or where issues arise not covered by the constitution.
In contrast, a shareholder agreement can be an extremely useful legal document for managing any issues affecting shareholders, not covered by the constitution, which might arise in the future. It can be quite detailed, and carefully tailored to meet the specific needs of a company and its shareholders.
It is not compulsory to have a shareholder’s agreement but it is highly recommended for all companies, particularly smaller, privately held companies where there may be a closer relationship between the owners (shareholders) and management.
When a company is created and there is goodwill between the shareholders, a shareholder agreement might not seem necessary. However, it is easier to negotiate the terms of a shareholder agreement from the outset at the start of a business venture when issues can be discussed amicably, rather than when parties are frustrated by disagreements down the track.
What to include in a shareholder agreement?
For a shareholder agreement to be useful it needs to be customised to meet the specific requirements of the company and its shareholders.
Listed below are some common provisions which most shareholder agreements might contain.
Primacy of shareholder agreement over the constitution: in the event of any inconsistency between the shareholder agreement and the constitution, shareholders would typically desire that the customised shareholder agreement would prevail.
Alternative dispute resolution: to avoid the cost and uncertainty of litigation, it is advisable that shareholder parties be required to attempt to resolve their disputes through alternative dispute resolution means, before any formal litigation can be commenced.
Deadlock breaker: these provisions deal with circumstances where shareholders cannot agree on the management of the company. They can include:
- A shotgun clause, which works by way of an arrangement allowing a shareholder to break a specific deadlock by purchasing the shares of the other shareholder at a nominated price.
- A chairman clause, which allows one shareholder to become the chairman and hold the casting vote; or
- A liquidation clause, which provides that the company is to be voluntarily wound up if the deadlock continues for a set period of time.
Pre-emptive rights: which impose restrictions on the transfer of shares. Such a provision can require exiting shareholders to offer their shareholdings to other existing shareholders firstly, before the shares can be offered to outside parties.
Drag-along, tag-along rights: are provisions which are aimed at balancing the rights of a majority shareholder and a minority shareholder. Under a drag along option, majority shareholders can require a minority shareholder to join in the sale of shares in the company. Under the tag along option, where a majority shareholder is selling shares in the company, the minority shareholder has the right to join the transaction and sell their minority stake Upon the same terms, including the sale price as the majority shareholder.
Mandatory sale events: a provision which sets out triggers for the mandatory sale of shares in certain circumstances (for example, a director of a shareholder passes away, resigns or files for personal bankruptcy).
Share valuation methods: it is prudent to set out the method by which shares are to be valued in the future relation to any pre-emptive rights and mandatory sale events. For example, shareholder agreements often provide for the appointment of an external valuer with set criteria for the valuation. A set valuation formula can often reduce the scope for disputes as to market value of a company.
A shareholder’s agreement is preferably prepared when a company is first incorporated, at a time when there is goodwill between the parties and there have usually not yet been any disputes or disagreements about the management of the company business.
It can be a useful document, setting out the rights, obligations and liabilities of the shareholders and detailing the process as to how risks and disputes are to be managed in the future.
A shareholder agreement should be professionally prepared as it needs to be tailored to the particular needs of the shareholders and company but should usually contain some or all of the key provisions set out above.
If you or someone you know wants more information or needs help or advice, please contact us on (08) 8344 6422 or email [email protected].