Shareholder Agreements

A shareholder agreement is one of the most important documents the owners of a company will need to create to protect their interests in the company. A single shareholder does not need a shareholder agreement, but two or more shareholders should certainly have one in place.

Initially, when friends or business colleagues set up a new company, they may all be excited to simply focus on getting the business to market and all have the same goals to make the business grow. However, all too often, the initial enthusiasm wears away, and arguments and disputes can and often do arise.

Without a shareholder agreement in place, the company can become ‘deadlocked’ – unable to make any decisions, or a shareholder can simply walk away holding a substantial percentage of the company’s shares. The only option left to the remaining shareholders is to then go to court to try to resolve the dispute (which is costly and lengthy), to reach terms to buy out a disgruntled shareholder or to simply wind the company up and start again.

Much better to have an agreement in place which avoids all of that.

The shareholders have a right to decide who the directors of the company will be, and how they will vote on Board decisions. For example, will a majority or a unanimous vote of all directors be required. Will a chairman of the Board have a casting vote in a tied decision? Will some decisions require the consent of shareholders too, not just the directors?

Will all the shareholders receive their shares up front, or will some shareholders receive their shares over a period of time, known as share ‘vesting’? Will the company have a right to buy back shares from an employee shareholder who leaves the business? How do you calculate the amount you pay for the shares when buying them back? Does it depend on whether the shareholder was a ‘good leaver’ or a ‘bad leaver’?

Do the existing shareholders have the first right of refusal over the issue of any new shares, before they are offered to any third party (also called ‘pre-emption rights’)?

These are just some of the main terms which will often be included in a shareholder agreement. In addition there are usually what is called ‘drag along’ and ‘tag along’ rights. These allow the majority to ‘drag’ the minority into a sale of the company, and allow the minority to ‘tag along’ on any substantial sale.

There are two commonly-used mechanisms in a shareholders agreement for resolving a deadlock, which goes by the somewhat exotic names of ‘Mexican Shootout’ and ‘Russian Roulette’.

The ‘Mexican Shootout’ is easier to describe: if a deadlock occurs and cannot be resolved than either party can initiate the process to buy the other one out. If the business is owned 50/50, neither party should be given preferential treatment and the person who is prepared to pay the most for the other person’s share of the business wins.

This type of resolution doesn’t require the business to be valued, or for a minimum amount to be paid. Simply, the two owners bid against each other until there is no higher offer on the table.

The other option is called ‘Russian Roulette’. As the name suggests is that this is a one-shot deal. In the event of a deadlock, either party triggers the process by sending a notice to the other side stating a price. The recipient can then decide whether they want to either buy out or sell out their shares of the business at this price.

This idea works in practice because the person initiating the process doesn’t know if he’s going to be bought out, or if he’ll be the one buying out the other, so he should choose a reasonable, fair price.

Both of these methods provide an alternative to the company to become paralyzed or ‘frozen’ due to a disagreement. Of course, the business owners are always free to negotiate any other solution to the deadlock, but having these clauses in place means there is always a binding fallback solution which can be relied upon, if no other resolution can be found.