5 reasons why you shouldn’t do business without a Shareholders Agreement

May 18, 2021

If you have ever spoken to a lawyer about going into business with another party, or navigated the legal process of establishing a new company, you would have no doubt heard that you should enter into a Shareholders Agreement.

Clients often ask us to explain the benefits of Shareholders Agreements, and how they can protect their business interests. Below we have set out just five (of the many!) reasons why Shareholders Agreements are essential for protecting yourself, your investment and your business, and ensuring the longevity of your business relationships.

1. A Shareholders Agreement gives you certainty about who you could be ‘in business with’ in the future

No one can predict what will happen in the future, which is why it is so important to ask yourself how your business will be impacted if ‘the unexpected’ occurs. Many people are simply not aware that there are a number of circumstances which could result in them being in business with someone other than their chosen business partner(s), including:

  1. Death of a Shareholder: When shares in a company are owned by an individual and that individual passes away, their shares will generally form part of their estate and may be devised under their Will. Similarly, where a shareholder is a company and the controlling shareholder of that company passes away, control of the shareholder company may pass to the beneficiaries of the controlling shareholder’s estate.
  2. Total and Permanent Disability: The shares owned by an individual shareholder may also be subject to the control of that shareholder’s family members or appointed representatives in circumstances where the shareholder suffers a total and permanent disability.
  3. Matrimonial Settlement: If an individual holds shares in their personal capacity and is subject to a matrimonial settlement, their shares may be transferred to their former spouse as part of the division of their marital assets.

Standard ’off the shelf’ company constitutions do not generally include provisions to protect the remaining shareholders should any of the above situations arise. In the absence of such provisions, shareholders may end up being forced into a business relationship with someone other than their trusted business partner.

A Shareholders Agreement can include provisions to protect the interests of the remaining shareholders in circumstances such as the above, including rights for the remaining shareholder(s) to acquire the relevant shares at a pre-determined value, and on terms that are reasonable in the relevant circumstances.

2. A Shareholders Agreement will ensure that the expectations of all shareholders are aligned from the outset

When setting up a new company, shareholders will usually have had extensive discussions with their business partners regarding how they expect the business to operate.  Generally, the shareholders may have agreed on the skills, expertise and effort that each shareholder will contribute towards the business’ success.

But what happens when a shareholder fails to ’uphold their end of the bargain’ and does not (or is unable to) devote their time, efforts and skills towards the business’ growth? Should a shareholder who is not contributing to the company’s business be entitled to reap the benefits of the other shareholders’ hard work?

Standard company constitutions will often be silent on this issue, leaving those shareholders who have ’upheld their end of the bargain’ in a difficult position, with very limited options.

If the shareholders have expectations as to how each shareholder will contribute to the company’s business, those expectations should be clearly set out in a Shareholders Agreement, together with a process for what should happen when things do not go as planned.

3. A Shareholders Agreement will give comfort to potential investors and ensure that the decision making powers of the Company can be exercised as intended

Depending on the nature of your business, there may come a time where capital raising or external investment is required in order to support the next phase of the business’ growth strategy.

When considering whether to invest in your company, prudent investors will often require certainty regarding the control and operation of the company. In some circumstances, investors may even seek to negotiate certain rights in respect of decisions made by the company, including requirements for certain business decisions to be subject to their prior consent.

Similarly, if the company undertakes substantial or successive investment activities resulting in the founding shareholders’ ownership of the company being diluted, founders may have certain expectations about the decision-making powers that they should be entitled to exercise with (or without) the consent of the broader investor group.

Standard company constitutions are not tailored to accommodate for these situations, and therefore may not reflect the intentions of the company’s founders and/or external investors in respect of voting rights and key decision-making powers.

Shareholders Agreements are essential for companies that are seeking external investment, and any Shareholders Agreements should be carefully reviewed and updated for any proposed fundraising round.

4. A Shareholders Agreement will ensure that all shareholders’ obligations and rights in respect of funding and profits are clear

At the time a company is established, shareholders will generally reach an informal agreement on the initial funding required and how this will be sourced, and may even discuss their expectations for how additional funding may be secured in the future.

If the shareholders have established the company based on their expectation that each shareholder will contribute equally to the funding requirements of the company – what happens if a shareholder fails to ’put their money where their mouth is’ and fund the business in the future, as required?

Standard company constitutions generally only set out a very basic framework in respect of funding the company, and will not include express contractual provisions that require a shareholder to keep the promises they have made to the other shareholders in in relation to capital contributions. Whereas, a Shareholders Agreement can be tailored to account for the shareholders’ agreed approach to funding, as well as providing protections to the other shareholders in the event that a shareholder cannot (or will not) contribute funding to the company as and when required.

A Shareholders Agreement can also include a tailored dividend policy to document the shareholders’ agreed approach to dividend payments and the retention of profits for re-investment into the company’s business.

5. A Shareholders Agreement can provide a plan for when things don’t go as expected

Last (but certainly not least!) is the issue that no one wants to think about when establishing a new trading company – what happens when things don’t go as planned?

Business relationships can breakdown for any number of reasons, some of which are foreseeable, and others that can occur suddenly and without warning.

It is crucial that shareholders have an honest and open discussion at the outset of the business relationship, about how their respective interests in the company should be managed in the event that they cannot reach agreement on any of the key operational decisions of the company.

We often find that shareholders do not seek legal advice regarding their options for resolving disputes until after a dispute has arisen, at which point the shareholder will discover that the company’s constitution does not provide them with the rights and protections they require in order to protect their investment and to ensure that the company’s business is not negatively impacted.

A Shareholders Agreement can provide a clear and specifically tailored process for dealing with disputes between shareholders, including procedures that allow shareholders to exit the company on mutually agreed terms when a dispute is unable to be resolved.

If you would like to know more about Shareholders Agreements or to discuss any of the key issues set out above, the KKI Commercial Team is here to help.