How Shareholder Agreements Work

Shareholders are key stakeholders of a company as they own a portion of the company in the form of stocks. So in short, a shareholder shares the ownership of a business with various other shareholders. Since there is no limit on how many shareholders a company can have, it is important to keep everything in order between the shareholders and the company through a legally binding agreement.

A shareholders’ agreement is used to regulate the relationship between the various shareholders of a company. It highlights instructions regarding the rights and duties of shareholders. Once shareholder agreements are signed, it can help make sure that all shareholders get their rights and also abide by the responsibilities they owe.

However, a lot of companies that are just issuing stock often wonder what a shareholder’s agreement is and why they should create one for their shareholders. Once you know how this agreement works and what benefits it has to offer, you can better decide whether you should form a shareholder’s agreement or not.

What exactly is a shareholder agreement?

As explained earlier, a shareholder agreement is a contract between all the shareholders of a company. This is an agreement strictly between the shareholders and may involve the management of the company.

This agreement should preferably be made at the time of issuing the stock, however, a shareholders’ agreement can be made at any time after the issuance of stock. However, in order for a shareholder agreement to be considered valid, each and every shareholder needs to sign it. Even if shareholders aren’t facing any disagreements or issues now, there is always a possibility that they may see disagreements in the future.

By signing a shareholder’s agreement, the shareholders can make sure that they can prevent any future issues. A shareholder’s agreement doesn’t require a vote at a shareholder’s meeting, and it can be signed by each shareholder separately to be considered effective. Once every shareholder signs the agreement it becomes legally binding and therefore if any action goes against the agreement it can be challenged in a court of law.

How does a shareholders’ agreement work?

As mentioned in the previous section, the way shareholder agreements work is by preventing any disagreements that may arise in the future. So in absence of a shareholders’ agreement can give rise to disputes among shareholders because parties won’t have any contract to refer to.

With that said, here are some ways a shareholders’ agreement works to protect the rights of the shareholders and controls how shares and other company matters are handled.

Serves as a reference in case of disputes

Disputes among shareholders are not uncommon, and when disputes do arise they can be difficult to solve. However, a shareholders’ agreement can aid in solving disputes between shareholders by serving as a reference that all shareholders have agreed to.

Instead of waiting to see if the dispute solves itself, parties can use the shareholders’ agreement to figure out the appropriate course of action to come to reach a settlement.

Specifies the role of shareholders in decision-making

Normally, the decision-making power in a company resides with the board of directors. However, shareholders may want to hold some decision-making power related to matters that directly impact their interests. That is where a shareholder agreement comes in.

Shareholders can specify the decisions or matters that can not go through without the approval of shareholders. This application of a shareholder agreement comes in handy in a situation where the board of directors consists of members that aren’t shareholders.

By specifying the role of shareholders in decision-making, a shareholders’ agreement can make sure that they can have some control over key decisions of the organization.

Gives protection to minority shareholders

Minority shareholders often feel like they don’t have a voice when it comes to sharing related decisions of the company. However, a shareholders’ agreement can serve as a way to give power and protection to minority shareholders. In an event where the company wants to allot more shares, a shareholders’ agreement may require the consent of all shareholders to prevent dilution of the holdings.

This provision ensures that the minority shareholders can maintain the value of their stock. In addition, minority shareholders can also reserve a tag-along provision in the shareholders’ agreement. The tag-along provision makes sure that minority shareholders can sell their shares along with majority shareholders, usually at a higher price.

Gives protection to majority shareholders

Shareholder agreements are not just meant to protect the interests of minority shareholders it also offers protection to majority shareholders. The majority shareholders may get an offer where a party wants to buy all of the shares of the company. However, the sale can’t take place without the approval of all the shareholders. That is where a shareholders’ agreement comes in handy with the drag-along provision.

The drag-along provision in a shareholders’ agreement can force all the shareholders to sell their shares. This provision is used when a party is offering to buy the stock at a premium price and the majority shareholders want to make sure they avail of this offer.

Facilitates the transfer of shares

Another use of a shareholder’s agreement comes into play when shareholders wish to sell their shares. If the agreement contains a right of first refusal clause, it means other shareholders or the company gets the first chance to buy the shares in case a shareholder wants to sell them.

Before drawing up the final shareholder agreements, you may want to create a tentative term sheet. For more information about what is a term sheet, check out this video I have created. It will provide valuable information on how that can help.

Contains restrictions to protect the company’s interests

Shareholders have access to confidential information about the company, and therefore the shareholder agreement is used to put certain restrictions on shareholders. If a shareholder plans on exiting the company, they can’t start a business that directly competes with the one they are exiting from.

At the same time, the shareholder agreement also restricts exiting shareholders from working with the competitors of the company as an employee. By adding these restrictions, a shareholder agreement protects the interests of the company along with the shareholder’s interests.

What are some key components of a shareholders’ agreement?

A shareholders’ agreement is not a standardized document, and different companies may add or remove certain components from it to make it fit their needs. However, there are a few basic components of a shareholders’ agreement that are used by most companies. So without further ado, here are some key parts of a shareholders’ agreement:

Description

The description section is the very first component of a shareholders’ agreement, and it contains the description for all parties involved in the agreement. In general, the description section identifies shareholders and the company as the two major parties of the agreement.

Recitals

The recitals section is pretty straightforward, and it specifies the goals for creating the agreement. This section also documents the mutual understanding of the parties involved in the agreement.

Board of directors

This section contains instructions regarding how the board of directors will be replaced, how the board will function, and that the decisions made by the board will be based on the majority vote.

Company operations

The company operations section describes the decisions that require the vote of shareholders. This section may also specify how the board of directors will be elected.

Actions related to shares

You can find this section in most shareholder agreements as it specifies the rights of shareholders to sell, transfer and hold their shares.

Governing law

As mentioned in the previous section, a shareholders’ agreement is legally binding. This means it will be governed by state laws, and the governing law section specifies which laws govern the agreement.

Right of first refusal clause

The right of first refusal clause is a part of most shareholder agreements, and it specifies that the company holds the right to buy shares before the shareholder can sell them to an outsider.

These are some commonly used sections of a shareholders’ agreement, and you may add more sections to the agreement or exclude some sections based on the requirements of your company. As long as the agreement represents the interests of all parties involved, it will serve its purpose and will help maintain the relationship between shareholders.

What happens if a shareholders’ agreement isn’t used?

Shareholders’ agreement is highly beneficial, however, it is not always a mandatory document and therefore companies may choose not to use it. With that said, it is highly recommended for companies with multiple shareholders to have a shareholders’ agreement in place. If a shareholder agreement is not used, it can lead to a variety of different issues down the road. Some common issues that may occur if you don’t use a shareholders’ agreement include the following.

Disagreements

Even if everything is working out between the shareholders at the moment, it is always possible that shareholders may have a disagreement over certain points. If a company doesn’t have a shareholder agreement, the shareholders will not be able to resolve it easily due to a lack of reference.

The majority shareholders won’t be able to sell

Majority shareholders can use the drag-along clause stated in a shareholder agreement to sell all of the company’s stock. However, if there is no shareholders agreement, the majority shareholders won’t be able to sell the entire stock and minority shareholders may stop the sale.

Shareholders may hold on to shares after exiting

Shareholders that exit the company are forced to sell the stock, and someone shouldn’t leave the company and still hold on to shares. If a shareholders’ agreement is not in place, the company can’t stop the exiting shareholders or founders from holding onto the shares and causing dilution of the stock.

Exiting shareholders may directly compete with the company

Shareholder agreements prevent key shareholders or founders and employees from setting up a business that directly competes with the company. However, without an agreement in place, a shareholder is free to do whatever they want.

This can be a problem for the company because not only can shareholders use your company secrets to form their own business, but it can also increase the competition.

Minority shareholders may not have any power

A shareholders agreement gives minority shareholders the power to protect their interests. However, when this agreement is not in place, minority shareholders may feel helpless against any share allotments that aren’t favorable to them.

At the same time, minority shareholders may not be able to benefit from an opportunity where a buyer is willing to pay premium rates for buying shares from majority shareholders. Because, without a tag-along provision, majority shareholders aren’t bound to sell the shares of minority shareholders at the same higher rates as they may sell their own. So if you are a part of the minority shareholders, it is in your best interest to push for a shareholders’ agreement to avoid any potential issues and to protect your interests.

Deadlocks

In case of a deadlock between shareholders where both parties can’t reach an agreement, the company may end up getting wound up as a result. This is never a good outcome for the company and the shareholders.

So it is best to have an agreement in place to save time and expenses that may result from a complex deadlock.

The Board of directors may not involve shareholders

Shareholder agreements make sure that shareholders are involved in certain decisions. However, in the absence of a shareholders agreement, the board of directors may not involve shareholders when making any decisions.

So in short, a lack of a shareholders agreement can make it difficult for shareholders to protect their interests.

Conclusion

Shareholder agreements are a relatively simple document with great benefits for all shareholders of a company. The basic idea behind the formation of a shareholders’ agreement is to make sure all shareholders can resolve any disagreements and protect their interests based on the provisions in the agreement.

So if you were trying to understand what shareholder agreements are and how they work, this article should have answered many of your questions. Though it is always wise to lean on your startup advisors and legal counsel to craft an agreement that meets your needs.

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