Why you need a shareholders agreement when starting a company

Writing a shareholders' agreement may save you time, money and stress in the long term, says Catherine Feechan, a partner in the corporate department at law firm Brodies.

A client arrived in my office about six months ago. He explained that he had been made redundant, received a significant pay off, and was going to invest approximately £250,000 in a business that had recently been started by a friend of his. He was full of enthusiasm for the new project and keen to get things moving.

I suggested that a shareholders’ agreement and a proper constitution for the company would be worthwhile given the size of his investment. However, I was met by the response that my client’s new business partner was a ‘top bloke, he had known him for years’ and there was ‘no need to waste money on needless legal documentation’. Fast forward six months and the same client is back in my office, the £250,000 he invested in the business is gone and his first words as he walks through the door are: ‘You don’t even need to say it – I will do it for you. I told you so.’

Shareholders’ agreements are one of the most important documents in any privately owned company – and should definitely be scheduled for when you are starting a business with partners or investors. They provide the answer to all the “what if” questions and putting one in place at the outset of a business relationship is simple and relatively inexpensive. Sorting out the disputes that arise later is considerably more costly, time consuming and generally stressful.

The shareholders’ agreement should address all the “what if” issues. For example:

  • What if one of the shareholders dies, becomes too ill to work in the business or becomes bankrupt? The solution here is to provide that in those circumstances his shares will be offered to the other shareholders at a fair market value.
  • What if one the shareholders wishes to sell his shares to a third party or to leave the business? In either of these cases again the shareholder should be required to offer his shares first to the other shareholders of the company at a fair value.
  • What if one of the shareholders working in the business has failed to perform? If performance is going to be an issue then the agreement should provide that in specific circumstances he can be forced to sell the shares to the other shareholders at a price lower than the fair market value.
  • What if an ex-shareholder wishes to set up in competition? The shareholders’ agreement should contain a restrictive covenant preventing shareholders who sell their shares from setting up in competition to the business and specifically from poaching staff and customers.
  • What if the directors do not agree on key business issues? The shareholders’ agreement should contain a list of matters on which majority consent is required. Depending on the number of shareholders, a majority could be set at 50 per cent or any higher figure. Indeed there may be some issues on which the shareholders require to be unanimous before such an action can be taken. If agreement cannot be reached and there is a deadlock, the shareholders’ agreement should set out what happens next – can one party buy out the others or should the company be wound up?
  • What if one shareholder refuses to participate in meetings? The shareholders’ agreement should set out all administrative provisions relating to the operation of the business such as how often board meetings will be held, how notice will be given and what happens if one party refuses to show up. In addition it should deal with other administrative matters such as who the company’s bankers and advisers will be and who has authority to access company funds and sign contracts. It is important to make clear what level of input is required from each of the shareholders at the outset to be certain that everyone has the same expectations.
  • What if the company makes money? Shareholders should agree whether it is intended that the company should retain profits for a period or whether they intend that any profits should be distributed and work out a timescale for any distributions.

Without an appropriate drafted shareholders’ agreement and articles in place, any shareholder can:

  • sell his shares to any third party – even to a competitor;
  • on death pass his shares to a spouse or to family members, who know nothing about the company and could well cause problems in its day to day operation; and
  • (if the shareholder is also a director) enter into contracts or commitments on behalf of the company without any recourse to the board which could spell financial ruin for the company and the other shareholders.

A proper shareholders’ agreement regulates all these issues. So don’t leave things to chance, protect yourself, and ask “what if”.

Update: Catherine Feechan now works for business lawyers Kergan Stewart

See also: What is a drag along covenant? – This increasingly common clause in shareholder agreements can have a huge effect on majority and minority shareholders’ fortunes.

Praseeda Nair

Praseeda Nair

Praseeda was Editor for GrowthBusiness.co.uk from 2016 to 2018.

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