Background
In this article, we will consider an essential business succession strategy, shareholders agreements.
Overview
While buy sell agreements can be used to address most insurable risks (such as the death, total and permanent disablement or trauma of an owner), many risks faced by business owners cannot be insured against.
Shareholders agreements seek to minimise these ‘non-insurable’ risks by putting in place a framework for addressing potential issues such as:
- mechanisms for the voluntary entry and exit of other shareholders;
- agreeing the way in which the business is to be managed; and
- resolving potential disputes between shareholders.
In addition to offering some protection for the business from a business planning and succession perspective, a shareholders agreement will often outline the goals and objectives of the business, a clear direction the business is intending to take, the role each party will play within the business and each party’s responsibilities and obligations to each other.
Due to the range of issues to consider, there is no ‘one size fits’ all solution when it comes to shareholders agreements. Each agreement will usually be different and tailor made for the specific type of business and individuals involved. Fortunately, due to the level of detail these agreements go into, they are often an excellent blueprint for a wider business plan.
This article considers those issues which are generally relevant where the business is operated using a company, however these principles apply equally to businesses owned by partnerships and unit trusts and can be incorporated into partnership agreements and unitholder agreements respectively.
Pre-emption arrangements
The purpose of pre-emption clauses is to allow the remaining shareholders the opportunity to buy the exiting shareholder’s shares in the company before they are offered to an external buyer.
These rights can be drafted in a number of different ways, but quite commonly they would be in the form of rights of ‘first and last refusal’. This means the exiting shareholders must first offer their shares to the remaining shareholders before seeking an external buyer.
If the other existing shareholders decline to accept the first offer and then an external buyer is found, the existing shareholders are also allowed to make a last offer on the same terms as the proposed external sale.
In essence, rights of pre-emption are designed to ensure the remaining shareholders have ample opportunity to acquire an exiting shareholder’s interest, rather than potentially being forced into business with a third party they are not acquainted with.
As a variation on this approach, some shareholders agreements require any external purchasers to be approved by the remaining shareholders before they can acquire shares in the company.
Practically, it should be obvious that this approach can be problematic for an exiting shareholder where the remaining owners are unwilling to buy the shares themselves but are also unwilling to approve a new owner.
Rights of pre-emption can also apply in circumstances where the company is seeking to raise more capital by issuing new shares, or reduce its capital by redeeming existing shares.
‘Drag Along’ and ‘Tag Along’ Rights
‘Drag along’ and ‘tag along’ rights can be included in shareholders agreements to protect majority and minority shareholders when shares are being transferred or sold.
‘Drag along’ rights protect majority shareholders from minority shareholders who may attempt to frustrate the sale of a company. The provision allows for majority shareholders to force minority shareholders to sell their shares in the company to an outside buyer where the majority has agreed to sell their shares.
For instance, if shareholders owning 90% of the shares in a company have agreed to sell to a third party, ‘drag along’ rights would permit them to force the shareholders of the remaining 10% to sell their shares to the buyer as well.
In contrast, ‘tag along’ rights protect the minority shareholders where the majority shareholders agree to sell their share in the company leaving the minority shareholders with a new majority shareholder. This type of provision provides that a buyer can purchase shares from a majority shareholder only if they are willing to purchase the minority shareholder’s share on the same terms.
For instance, if shareholders owning 75% of the shares have found a buyer for their shares, minority shareholders could have the right to have their shares transferred to the buyer as well, to avoid finding themselves in business with a new shareholder.
Dispute resolution
One of the critical elements of a shareholders agreement is the process to be followed for resolving disputes between the shareholders.
Ideally, the shareholders agreement should have a ‘staged’ approach for dispute resolution whereby the dispute is initially referred for informal or formal mediation before more serious steps can be taken.
For example, the agreement may require any dispute to be referred to a trusted business adviser to facilitate an informal mediation, before further steps can be taken.
Where the initial attempts to resolve the dispute fail, the agreement may require the matter to be referred to arbitration or alternatively provide a mechanism whereby either party could choose to exit the business.
In either instance, the agreement should include a ‘deadlock breaker’ and ideally avoid the need for the shareholders to resort to litigation to resolve any disagreements.
Other clauses
Whilst this article has covered some of the key provisions for shareholders agreements from a business succession perspective, a number of other clauses will commonly be found, including:
- provisions around obligations to attend meetings and the voting rights of the shareholders;
- restraint of trade provisions which may prevent a shareholder from competing with the business; and
- confidentiality obligations which prevent shareholders from disclosing ‘trade secrets’ to outsiders or using them for their personal gain.
Ultimately the type of clauses that are required will depend on the nature of the business, the relationship between the shareholders and the level of energy the parties are willing to invest in ensuring the document is appropriate for their circumstances.
Conclusion
As is the case with buy-sell agreements, a shareholders agreement can protect a business from a voluntary exit of a principal.
Implementing a properly drafted shareholders agreement can be one of the most important steps business owners can take to ensure their business is protected from unforeseen, and un-insurable events.
