Why You Need a Shareholders’ Agreement

April 24, 2008

The start of a new business will always bring challenges regardless of whether the business takes the form of a sole trader, partnership or a limited liability company. A sole trader trades in his own name and takes the risk of liability in the event of the business failing and will have to finance any liabilities that the business cannot meet. With partnerships, the risk is amplified as each partner is jointly and severally liable for the losses of the partnership. So, it is important that partners set out in partnership agreement, what their expectations are.

 When a company is incorporated, it carries the safety net of limited liability and the apparent prestige of “limited” is appended to the business name. In the world of commerce – it sends a message of professionalism. Incorporation is the creation of a legal person with designated roles for individuals such as the directors, the company secretary, the shareholders, and employees to name just a few. Each role carries its own rights and obligations.

The Company Director

Even though these roles are legally distinct from one another there is an inevitable blurring for small business start up companies. However, it is important to realise that the role of company director is one which should always be taken with care and consideration – the director is expected to be the custodian of the company. Directors responsibilities are an extensive area of law in their own right. With recent changes implemented by the new Companies Act 2006, directors responsibilities have more recently attracted a justified level of media and business attention. However, a lengthy discussion of director’s duties is beyond the scope of this article.

The Shareholders

When one or more individuals incorporate a business, decisions based on the shareholders and their shareholdings are limited to how much each member contributes and receives as a shareholding percentage to reflect their contribution. However, this early decision often taken in a simple form and at the very outset can have significant ramifications at a later date. For instance, if Bob and Mary incorporate X Co Limited, with Joe taking 75% of the shares as he invests £7,500 and Mary invests £2,500 then Mary is faced with the fact that Joe has effective control of the company by virtue of his shareholding and ability to pass special resolutions as he holds 75% of the shares. This may not be what is intended by Joe or Mary from the outset, but because of the relevant legislation governing the company’s affairs, the shareholding percentages themselves carry significant implications from the first day of incorporation.

This could potentially be remedied by the constitution of the company, the Memorandum and Articles of Association, but this is not necessarily the right course of action to take. After all, the Memorandum and Articles of Association is a public document for the world at large to scrutinise. The most effective way for the shareholders to set out their expectations and obligations is through a shareholders agreement.

A shareholders agreement is a private arrangement between the shareholders themselves, and can in effect govern the relationship from the outset and secure the long term future of the company itself. A shareholders agreement is probably too complicated a document for the shareholders themselves to draft. You need an understanding of the statutory provisions, the common law provisions and the company’s Articles, and a clear understanding of the common issues that could arise within a company, and the range of possible solutions the shareholders could put in place in their agreement.

An effective shareholders agreement, drafted and crafted by legal advisors is a useful tool to set the company forward for a bright future. There are issues that each party to the shareholders agreement would need to consider.

If you are planning on incorporating with your business associates or family members, ask yourself:

• What if one of the others wants to “leave”?
• What will happen to their shareholding?
• What if the shareholder wants to sell his shares to an undesirable third party?
• What value will the shareholding have after a number of years of trade?
• How will the remaining shareholders pay for the shareholding?
• What prospect does the company have of success if the shareholders cannot provide the necessary funding to the company?
• When will the shareholders receive a dividend?
• How will a deadlock be resolved if the shareholders have equal shareholdings?
• Does each shareholder have a right to a directorship position? Hopefully, these questions illustrate the importance of beginning discussions with your fellow shareholders, and the importance of setting out your agreement in a proper shareholders agreement.