Putting in place a solid shareholders' agreement when you start your business goes a long way to avoiding costly problems later. Many business owners start off with a shared vision for a new venture with their co-owners, but things inevitably change and views on such matters as strategy and management plans can sometimes evolve in different directions.
For instance, what if your company begins to generate significant profits and you and your co-investors can't agree on how they should be applied. Should you each take a dividend, or should the funds be applied as working capital?
A standard form company constitution will rarely cover all of the issues that a new business is likely to face. It often fails to accommodate the special intentions of the shareholders in respect of managing the venture. Further, a constitution can typically be amended by 75% of voting shareholders. A shareholders agreement on the other hand usually requires unanimity for any amendments.
While the Corporations Act 2001 (Cth) regulates the relationship between the company and its shareholders to an extent, it does not provide the level of protection that shareholders typically expect when investing in a venture. For instance, under the Corporations Act 2001 (Cth) a director may only be appointed with the approval of a majority of the shareholders. Many businesses prefer that each investor, or investors together holding a threshold percentage of the company, has a right to board representation.
A shareholders' agreement can help define expectations up front, including with respect to exit plans. It leaves little room for misunderstandings between the parties about what will happen if things don't develop as expected.
A shareholders' agreement usually sets out the specific rights and roles of each shareholder. For instance, particular investors may require board appointment rights, irrespective of the shareholding. It can also stipulate that "drag-along" or "tag-along" mechanisms apply in respect of sale of shares and set out particular situations in which a shareholder will be forced to sell its shares (for instance, death, insolvency, termination of employment).
A typical feature of shareholders agreements is a pre-emptive rights clause, which gives shareholders a right to maintain their proportionate shareholdings through successive capital raises by participating in the raise pro rata to their holdings. Founders need to consider whether the benefit of this right is outweighed by the practical difficulties it can cause in being able to introduce new investors (and their capital) quickly.
Acquirers rarely want to buy 90% of a company. The Corporations Act 2001 (Cth) addresses this issue in respect of listed public companies (and unlisted public companies with 50+ shareholders) by permitting compulsory acquisition of 100% of the shares in an entity once a shareholder reaches the 90% ownership threshold. A shareholders' agreement can simulate this in the private company context, making the business more marketable because the majority can deliver all the shares on issue to potential buyers. This incidentally gives those prospective acquirers comfort because they know the majority can deliver the target without the risk of significant due diligence and deal costs being wasted in the face of an immovable minority.
Disagreements between owners can undermine the operations of a company and prompt one or more parties to look for a way out. Many shareholders' agreements include mechanisms that facilitate resolution of issues and, failing resolution, for the valuation and transfer of a party's shares to the other shareholders.
If you are starting a business....
- Reflect on the key goals for your venture - is the intention to sell the business or run it for income-generating purposes for the long term?
- Explore with your co-owners their expectations for the direction of the venture
- Evaluate the management strategy you intend to adopt
- Clearly describe the roles and contributions of each owner
- Negotiate a shareholders' agreement early!
Not all these things may seem important at the time you are starting up your company but they become increasingly important as it grows and increases in value. A shareholders' agreement is an invaluable tool for you and your co-owners to articulate how you plan to run and exit your business. As you make plans for your new business, make sure a detailed shareholders' agreement is in the mix of your top priorities.