When trying to establish a start-up with business partners, one piece of expert advice you will often hear is that you should draw up a shareholders’ agreement, and for good reason. Beyond attracting clients and gaining a strong foothold in your niche field or industry, ensuring that your company has legal safeguards in place is something you should prioritise.
A shareholders’ agreement can help you in this regard as it outlines the rights and expectations of all shareholders. As well as many other key issues, it also details how your company will be run and financed. With a signed shareholders’ agreement, you can help ensure the success and survival of your start-up for years to come.
Common Mistakes Companies Make When Drawing Up a Shareholders’ Agreement
Drafting a shareholders’ agreement is not exactly rocket science. However, since many start-up owners like yourself have little or no experience of this type of legal document, you might be at a loss as to what you should include.
Most online blogs and articles on this topic focus on the benefits of having a start-up shareholders’ agreement. Unfortunately, only a few discuss the mistakes you should avoid when drafting one. To help you out, this article will explore what you shouldn’t do when setting up your own shareholders’ agreement. Let’s take a look at some of the mistakes you need to avoid.
1. Not having a shareholders’ agreement at all
Because you and your partners will be excited about starting a new business, you may naturally feel you can simply postpone the drafting of a shareholders’ agreement to a later date. In fact, you might even think that it is prohibitive or not important enough.
However, most legal experts will tell you that, based on their experience, not having a shareholders’ agreement in place from an early stage will cost you more in the long run. Disputes can eat up valuable company time and resources, and there is no guarantee that they will be resolved at all. If you arrange to have a shareholders’ agreement from the outset, you can avoid any situations that could put your company in jeopardy.
In our experience, the most common disputes happen in family-run businesses and when the shareholders are best friends. These are also the least likely to think they need a shareholder agreement, because they never expect to fall out.
2. Using a templated shareholders’ agreement
Although they can have similar structures, no two business entities are the same; there are always little details that make them different from one another. As such, it is essential to have a bespoke shareholders’ agreement that is specific to your start-up. This way, if a situation arises that is unique to your organisation, the customised shareholders’ agreement will help ensure that no damaging disputes will arise because of it.
Not only this, but we have lost count of the number of times a limited company comes to us asking for a partnership agreement, or even presents us with a partnership agreement they found online. It is clear that they simply downloaded a template online that they thought would be enough. A partnership is, in fact, a whole different legal entity and having the wrong document in place will only lead to more confusion, not less.
3. Not putting your shareholders’ agreement in writing
It cannot be stressed strongly enough how important it is for companies with multiple owners to have a written and signed shareholders’ agreement. Whilst oral agreements are considered legally binding, if there is no written document to refer to, you will have to rely on one person’s word against another to settle any disputes, which can be both expensive and time-consuming.
A written shareholders’ agreement will pave the way for a faster and cheaper resolution of disputes. Litigation and court visits can also be easily avoided. With a written shareholders’ agreement clearly outlining the terms and conditions, you can prevent disagreements from taking too much of your company’s time and resources.
4. Failing to take the future into consideration
Another mistake many business owners make is not considering the future. For example, it is commonplace for shareholders to dilute their holdings the first few years of the business, since shares are often exchanged for cash to raise capital. This means a major shareholder could lose control of the company in the future as the voting power of the first group of shareholders shrinks proportionately every time shares are allotted to new shareholders.
Therefore, when drafting a shareholders’ agreement, it is important to consider future changes within the company. This is to protect your shareholders’ interests and ensure that no one will feel as if they have been treated unfairly.
5. Not including a provision concerning the death of a shareholder
In most cases, a shareholder’s shares would form part of their estate when they die. This means that the remaining shareholders could suddenly find themselves running the business with the deceased’s beneficiaries, which may be their parents, siblings, friends – but it is unlikely to be anyone with knowledge of, or interest in, the business.
With no clear plan or alternative solution in place, it could put the business at risk of being paralysed or even failing.
To avoid confusion that could lead to business paralysis, a shareholders’ agreement should include provisions about what happens to the shares in the event of death.
Key Clauses and Provisions to Include in a Shareholders’ Agreement
To prevent disputes and other issues from harming the business in the future, here are some important terms and provisions you should consider including in your start-up shareholders’ agreement.
Cross-option provisions define the rights and obligations of the shareholders when they buy or sell their shares in specific circumstances, such as insolvency, death or retirement. These provisions are considered to be the most important; they set out who can buy the shares in these circumstances, and how that process takes place.
When adding a cross-option provision to your shareholders’ agreement, you should include a price or mechanism for the valuation of the shares. Many businesses also consider taking out life insurance, to pay for the value of the shares in the event of a shareholder’s death. Once the start-up business becomes more valuable, it may be impossible for the remaining shareholders to raise enough cash to buy out the deceased shareholder’s beneficiaries – this is the point at which the life insurance should kick in.
Entry and exit of shareholders
There will come a time when shareholders will want to sell their shares and move on from the company. Provisions must be incorporated to define how a shareholder can accomplish a successful exit from the business, as well as what they can and cannot do when disposing of their shares. For example, terms can be included to ensure that an outgoing shareholder will not be able to sell their shares to a third party or competitor.
Another consideration to bear in mind is what would happen to shares when a shareholder exits the company in unfortunate circumstances; for example, if he/she is fired from the company after engaging in fraudulent activity as a director.
In the case of new shareholders, there should be a provision requiring them to sign a deed of adherence before shares are transferred or allotted to them. This ensures their conformity to the same shareholders’ agreement that had bound the original shareholders.
Funding and financing of the company
Your shareholders’ agreement should also include provisions on how the shareholders can contribute to the working capital of the business. It should also set out the terms for what should be done if there are shareholders who do not contribute according to their shareholding.
Procedures for directors and board meetings
Shareholders’ agreements often contain stipulations about how and when the shareholders and directors meet. They also define how meetings are called and how quorums can be formed. To avoid any disputes, provisions should be added to determine when unanimous voting is required and when only a particular percentage of votes are needed to approve a certain resolution.
“Drag” and “tag along” clauses
“Drag” and “tag along” clauses are useful for shareholders who want to leave the company but are unable to do so due to particular circumstances. For instance, if the majority shareholders want to sell their shares to a third party but the buyer won’t buy unless 100% of the company shares are being sold, a “drag along” provision can make the sale possible by “dragging along” or forcing the minority shareholders to sell their shares to the third party under the same terms offered by the majority shareholders.
Disputes can lead to the failure of any company. As such, specific provisions should be incorporated to ensure that disagreements are resolved quickly and efficiently. For example, there can be terms for resolving disputes without the need to dissolve the company (which could happen in severe cases), for seeking mediation, and even for giving shareholders the option to buy each other out should they fail to reach an agreement. This is particularly important when there are only two shareholders with an equal shareholding, as a deadlock scenario can easily occur if the two do not agree on certain matters.
Identifying shareholder value
Company valuation is a highly subjective matter as each shareholder may consider some things more valuable than others. Provisions can be included in your agreement to ensure that you and your partners are on the same page when it comes to this type of issue. For example, you could put more value on intellectual property, such as patents, trading names, website domain names, and manufacturing methods, because they are unique to your organisation.
A shareholders’ agreement is vital to the success and survival of any company. Not only does it help prevent and resolve disputes, but it also lays the foundation on which your business will be governed. This is why if you want your start-up to succeed, you should make it a top priority to draft this document as soon as possible.
If you don’t know how to draw up a shareholders’ agreement, we can help. Speak to us at BEB Contract and Legal Services today. We can prepare a shareholders’ agreement that will meet your exact requirements.