Shareholder agreements – A practical guide

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Shareholders of a small private company usually rely on their personal relationships with each other to manage the business.

Death, disability or the bankruptcy of one of the shareholders could require a transfer of the shareholder’s stock to existing shareholders, as opposed to the deceased shareholder’s beneficiaries inheriting those shares.

Buy-Sell provision

A buy-sell provision in a shareholder agreement provides that the remaining shareholders have the first (or pre-emptive) right to purchase those shares.

Management

A shareholder agreement usually includes a shareholder’s right to participate in the management of the company or appoint a director, if that shareholder holds in excess of a specified number of shares in the company.

Dispute resolution clauses

The shareholder agreement should include a dispute resolution clause, to avoid shareholders issuing legal proceedings, at least to start with.

A typical dispute resolution clause will appoint an agreed valuer to value the shares for purchase or sale and referral to a qualified consultant or mediator to attempt to resolve the dispute at mediation.

Sections 232 and 233 of the Corporations Act 2001 (Cth) provide a shareholder with rights to pursue any fraud or oppression.  Click here to access s 232.  Click here to access s 233.

Shareholder exit strategy

A shareholder agreement should provide an exit strategy for shareholders wanting to sell their shares, including the appointment of a valuer to value the stock intended to be sold.

Can a majority shareholder force a buyout?

A special resolution is usually required for a majority shareholder to purchase a minority shareholder’s shares.

The special resolution requirements will vary for each shareholder agreement, depending on the number of shareholders and the type of shares issued in the company.

A minority shareholder can still seek legal redress under sections 232 or 233 of the Corporations Act, in respect of any ‘oppressive conduct’ (see above).

Derivative action

A derivative action is when a shareholder sues on behalf of the corporation to protect the business.  The corporation itself does not issue the claim.

A shareholder can pursue a derivative action when he or she believes that the corporation’s management is participating in fraud, dishonesty or personal financial gain at the expense of the business.

Share sales (right of first refusal, tag along, drag along)

right of first refusal clause gives each of the shareholders the right to purchase shares owned by another shareholder who wants to exit, prior to any third party purchasing those same shares.

Tag along clauses are designed to protect minority shareholders in the event that a majority shareholder decides to exit and sell his or her shares. The minority shareholders will have a right to be bought out, on a pro rata basis, along with the majority shareholder.

Drag along clauses allow a majority shareholder to ‘drag along’ a reluctant minority shareholder in the event of an exit.

Director and officer rights

The right to appoint directors provides an assurance that the board includes directors who represent the interests of each shareholder, including minority shareholders, and some control over how the business is operated.

Pre-emptive rights

With pre-emptive rights, a minority shareholder is guaranteed the right to purchase any new shares issued.

This protects the shareholder’s percentage of ownership. However, it can also delay investment from third parties.

‘Shotgun’ clause

A shotgun clause gives a shareholder the right to buy or sell his or her shares to another shareholder if that shareholder cannot resolve an issue regarding the company’s operations or sale.  The share sale price is usually based on a fair value sale price, meaning by way of agreement or valuation by a valuer agreed between the parties.

Piggyback rights

When a majority shareholder sells its shares, a minority shareholder has the right to be included in the deal.  This protects the minority shareholder’s investment, should the company be sold.

Piggybacking requires that any party considering the purchase of the business is able to buy 100 percent of the outstanding shares.

Non-compete clause

A shareholder is usually required not to compete with the business for the entire period of share ownership, and for a defined period after sale of the shares.

Investment

In a small business, minority shareholders may require that they approve any significant expenditure of capital/money to protect their investment in the business.

Making a contingency plan for buying out an unhappy shareholder is a prudent way to avoid a lawsuit.

Shareholder Agreement Checklist

The following questions should be considered before entering into a Shareholder Agreement:

  • Who can be a shareholder?
  • How will the business be governed?
  • Who can be a director?
  • What will happen if or when a shareholder resigns, retires, gets fired or dies?
  • How much will each share of stock be worth?
  • Can shareholders take stock with them if they leave the company?
  • Do majority and minority share values have the same proportionate value?
  • How much should the business pay to a departing shareholder to purchase their shares?

Please contact SRM Lawyers to answer any query you have relating to your business and shareholder agreements.

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