5 Dos and Don’ts for a Shareholder’s Agreement

A Shareholder’s Agreement is an agreement between the shareholders (or members) of a Company. It is used to govern the relationship of shareholders, particularly when disputes arise, as well as to supplement the rights of shareholders in law.

When setting up a Company, Shareholder’s Agreements are essential. This is because when the parties are first setting up the Company, they are likely to be harmonious and trusting of one another. This is often quite different from when the Company has grown, capital is at stake and disputes occur. Shareholder disputes often happen years or even decades after the shareholders have acquired shares in the Company. Having in place a good Shareholder’s Agreement is like purchasing insurance against your legal risks.

5 DO’S IN A SHAREHOLDER’S AGREEMENT

1. DO ENSURE YOU HAVE THE REQUISITE CAPACITY

Corporate lawyers pack their clauses with warranties and representations that each party will represent that it can do what it says it can. The reason is simple. When it is time for a party to perform its obligations, the party can often excuse itself by saying it cannot perform. The risk may be distributed amongst all parties to the contract instead of just the defaulting party. This can be avoided ahead of time by having the requisite checks in the first place. The more caution spent ahead of time, the less costs are spent involving lawyers when parties are dissatisfied. For example, if a particular licence is needed to perform a business, parties should ensure they know who should obtain that licence.

2. DO CONSULT YOUR LAWYER/CORPORATE SECRETARY ABOUT SHARE ISSUES

A good reason why lawyers and corporate secretaries are necessary advisers to a shareholder’s contract is because share subscriptions, cancellations and issuances are complicated procedures. If done in the wrong order or incorrectly, an improper share transaction could invalidate a shareholder’s rights, dilute control or put the shareholders in a state of limbo. Certain share transactions or acts of the Company are invalid without the calling of Shareholder General Meetings. Many of these rules are procedural and would be arcane to the uninformed.

3. PREPARE CLAUSES FOR FORCED ACQUISITION

While parties are in a Company together, there is no easy way for parties to acquire each other’s shares in the event the parties wish to part ways. If parties cannot agree to a buyout, this may result in parties having to go to Court to force a sale under the threat of winding up the Company and ceasing business. Again, this is wasteful. Parties should consider this possibility and have in place a mechanism for the transfer of shares ahead of time so that they are each aware of the process for acquisition.

4. SEEK PROTECTIONS FROM DILUTION

Anti-dilution protections serve to protect existing shareholders from the involuntary dilution of their stake in the company. Examples of this are “pre-emptive rights”, which require additional shares be offered to the existing shareholders before the shares are available to third parties, or “rights of first refusal”, which require an outgoing shareholder to offer shares to remaining shareholders before they can be sold to a third party. Without these provisions, shareholders may find themselves diluted, resulting in them holding a smaller share of the profits in the company, or even losing control.

5. DESCRIBE YOUR FUNDING

Shareholder’s Agreements should specify how the shareholders fund the acquisition of their shares. This helps settle what funding is or is not part of the Shareholder’s Agreement. This is particularly useful where non-monetary funding is agreed to be part of the shareholder’s contribution, such as Intellectual Property or “Sweat Equity” involving services. Funding may be made in stages. Shares may also be vested or issued over a period of time.

5 DON’TS IN A SHAREHOLDER’S AGREEMENT

1. DON’T COPY A SHAREHOLDER’S AGREEMENT TEMPLATE BLINDLY

It goes without saying that no two Shareholder’s Agreements are alike, and even boilerplate terms have to be reviewed as good practice. Copying blindly can have disastrous effects on the determining the contents of the contract later on. An example that Silvester Legal LLC worked with was a person who circulated multiple versions of a Shareholder’s Agreement to various investors without informing his lawyers. As a result, it became difficult for him to track which version was signed with whom. When litigation arose, the shareholder was sued by many investors who each adduced a different version of the Shareholder’s Agreement. This effort could have been saved if he had properly understood the terms of the Shareholder’s Agreement he was circulating.

2. DON’T RELY ON THE COMPANY CONSTITUTION TO PROTECT YOU

A company Constitution provides some legal rights that are drafted in a one-size-fits-all manner. These rights are often drafted minimally as well and do not provide the full protection of a more bespoke Shareholder’s Agreement. Moreover, company constitutions are available for public inspection, meaning there is no privacy when seeking terms. Constitutions also require the calling of special meetings in order to obtain the required amendments.

3. DON’T CONFUSE A SHAREHOLDER’S AGREEMENT FOR AN MOU OR A TERM SHEET

A Shareholder’s Agreement is a legally binding document. A Memorandum of Understanding (“MOU”) or Term Sheet is not. The difference is that an MOU records “understandings” between parties which parties believe should guide their actions but for which parties do not wish to be sued for non-compliance. An MOU is usually used as the framework for a proper Shareholder’s Agreement at a later time. On the other hand, a Term Sheet is also not a Shareholder’s Agreement, but a record of the important terms of the Shareholder’s Agreement at a glance. One cannot enforce a Term Sheet, because its existence implies the existence of a valid Shareholder’s Agreement to enforce. If such a Shareholder’s Agreement does not exist, the Term Sheet does not have legal effect either. There several exceptions to the documents described which are better explained by your lawyer.

4. DON’T INCLUDE OTHER RELATIONSHIPS IN YOUR SHAREHOLDER’S AGREEMENT

Shareholder’s Agreements can sometimes be construed as including a quasi-partnership arrangement into the agreement. Depending on the terms, they may also include a fiduciary relationship or a duty of care through the back door. Such a relationship may impose additional duties or liabilities on the parties without them realising. For instance, if parties A and B are treated as partners, any person may sue party A for party B’s wrongs or debts, even though party A had done nothing wrong. There may be good reasons to have these other relationships between the parties. However, in such cases, those relationships should be documented separately.

5. DON’T VIEW THE SHAREHOLDER’S AGREEMENT IN ISOLATION

Remember that the Shareholder’s Agreement is just one tool in a business protection toolkit. It sits in an ecosystem of various laws and regulations, as well as the constitution of a company, external contracts, as well as the operations of the company. A Shareholder’s Agreement may be rendered ineffective by its interaction with one of these other factors, or result in outcomes that are undesirable to other parties. An example would be in a venture capital scenario where the sale of SAFEs or CAREs requires the disclosure of any previously secretly held Shareholder’s Agreements. Alternatively, a Shareholder’s Agreement provision may be struck for falling afoul of the Company constitution.

The above details just some of the Do’s and Don’ts for Shareholder’s Agreements. In the weeks ahead, we will be going deeper into this topic. In particular, Silvester Legal LLC will share some of the cases that we have conducted for our clients in this critical area of commercial law.