Bright business ideas are most often conceived when two or more bright minds come together and convert that idea into a living and breathing business. What generally starts out as a positive and creative relationship between business owners all too often becomes sour as the ‘great idea’ turns into a ‘great business’ and the financial success puts a strain on personal relationships. The main reason for disagreement between business owners is a failure to manage each other’s expectations from the outset. The best way to manage the roles, rights and expectations between business owners is by entering into a co-founders agreement (also known as a shareholders agreement).
What is a shareholders agreement?
A shareholders agreement is a legal document that sets out the rights and obligations of company shareholders with the primary aim of protecting the interests of the company. A shareholders agreement is formulated to address issues that may occur throughout the business’ life by deciding in advance how such issues should be dealt with.
What can be included in a shareholders agreement?
There is no one correct form, and each shareholders agreement will vary depending on the circumstances of the business and the shareholders of that business. Nevertheless, shareholders agreements most commonly cover the following areas:
- roles and responsibilities of shareholders – this goes a long way in managing your business partners’ expectations regarding how actively they will be involved in the business and the level of commitment required;
- exit strategies – for example:
- what happens if a shareholder wants out of the business within the first 1-2 years;
- what happens if one shareholder wants to sell their shares; and/or
- what will happen if there is a dispute between shareholders and one or both shareholders want out of the business,
- the price of any share sale/purchase;
- restrictions on outgoing shareholders competing against the company;
- the ability for founding shareholders to veto certain fundamental company decisions or alternatively the percentage of shareholders’ approval required to do so;
- payment of company earnings to shareholders; and
- shareholders indemnity for directors.
What are the rights of minority shareholders?
Minority shareholders, by definition, hold a small percentage of shares in the company. Shareholders agreements can be particularly beneficial for minority shareholders. A properly drafted shareholders agreement can provide a minority shareholder with the right to veto key business decisions irrespective of how many shares they own.
Such key decisions may include:
- a veto right (in case of a merger or acquisition, veto rights may allow a minority shareholder to block the transaction);
- first right of refusal in relation to new issue of shares or sale of shares by a third party (if a shareholder wants to sell its shares, the minority shareholder will have the opportunity to buy the shares before any third party outside the company); and
- the power to appoint directors.
Whether you are an investor acquiring a large stake in a company or helping a friend fund a new business idea, it is extremely important that in acquiring shares in a company you also obtain certain legal rights to protect your investment.
The benefits of a carefully considered shareholders agreement are particularly relevant to the founders of start-ups seeking to raise capital from investors given that the founder’s equity in the business will be diluted after each round of funding. A company founder can overcome this obstacle by creating a shareholders agreement that provides a director appointed by them with veto rights in respect of key business decisions irrespective of the percentage of company shares held by them.
The main criticism of shareholders agreements is that they are expensive to set-up and may cause an uncomfortable conversation with a prospective business partner at a time when business relationships are otherwise going well. However, starting a business requires a huge investment of time, effort and not to mention money. A shareholders agreement goes a long way in protecting that investment and is also a great method of managing shareholders’ expectations at the very beginning of a business relationship and not down the track when the main focus has got to be running the business.
If you need help drafting, understanding or entering into a shareholders agreement, or if you find yourself in a dispute regarding your shareholders agreement, give us a call now.