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Don’t forget the Shareholders Agreement

Published: February 19, 2013 by Fundhouse

This article discusses the reasons why a shareholders agreement is necessary and what the main aspects of it typically are.

The cobbler’s children have no shoes is a well known saying designed to point out that experts often ignore the advice they give their clients.  We are such a case in point.  We only recently created a shareholders agreement and we have been in business for over five years.  That’s not our finest hour.

The truth is that we felt awkward creating such a document. We felt it went against our mutual goodwill to formalize what would happen given certain possible future events.  A bit like a “pre-nup” with a spouse.  Who wants to consider divorce when you are in a new relationship?

Interestingly, with hindsight, we were wrong to be concerned.  We found the shareholders agreement could enhance goodwill between us by helping us clearly understand eachother as shareholders.   And, it was hardly a divorce document.  Most of it is positive and targeted at good outcomes.

We are not lawyers, but perhaps that gives us a good opportunity to discuss this topic in plain English.  So, what is a shareholders agreement?

It is an agreement designed to put all shareholders on the same page by binding them together, legally.  It covers the following sorts of topics and we have a brief description attached to each:

Voting: what shares get what votes

Quite often some shareholders have voting rights will others don’t.  Voting is important because it impacts aspects like capital spending, remuneration or the appointment of directors.  It also gives people a sense of ownership even if their vote is not material.  But when some parties can vote and others cannot, then the psychological impact of owning the non-voting shares can create a negative feeling towards ownership and evolve into a “them-us” situation.

Minority protection

Imagine you owned 5% of a business and someone else owned 95%.   As a shareholder you have very little power if you are not comfortable with the direction the business is going in.  To cover this, you may wish to be able to appoint a director to the board to cover your interests.  Or you may wish to have a say in the salaries and incentives if the majority shareholder is also an employee.  Understand your minority protections.

Look at the balance of power

Say you have 2 founder shareholders of 50% each.  As soon as they issue one share to a third party, such as a staff member, the balance of power shifts.  All of a sudden the new shareholder can have a swing vote (whoever the new shareholder aligns with in voting will have majority vote).  The shareholders agreement, per se, will unlikely reflect who owns what percentage, but it will help you gather evidence about where the power sits in the business and that is important.

Share price:

It is important to understand the price at which shares are bought and sold.  The simpler the price calculation, the better.  But be aware that if new shareholders acquire shares below market value, they may have to pay tax on the difference (upfront)!

Who has the rights to buy (and sell) shares

Lets say you own your shares in your practice, but you want to sell them.  The chances are that your business partners would want first option to avoid you selling them to a party like a competitor.  Equally, what if you became incapacitated – what would happen to your shares then?   For employees who own shares of a company, they are often forced sellers of the shares if they leave the company’s employ.  Usually the company has the first right on such shares and buys them back and cancels them.  A company usually has a standard call on your shares – what if you are dismissed or fired, as an example?  These are all scenarios worth understanding in advance.

Financial assistance

What if a staff member buys shares but cannot afford them immediately?  Can they finance them and do they have full rights before they are paid off?  The rights are an important consideration: if a staff member buys shares for R1m and the share value goes to R10m, yet they have not honoured their loan repayment on the R1m.  Should they be able to sell their shares at R10m?  What if the reverse happens and the share price goes down and the loan is way more than the value.  What happens then?  These are all important considerations.

Sale of the business in whole or in part

What if the business is sold?  Majority shareholders could quickly buy back the shares from the minorities before cashing in on the sale.  Its important to know whether the shares you own would be included in such a sale and what protection you have against a minority buy out at a very cheap price.

What company are you a shareholder in?

It is important to understand whether you share in one aspect of the business or in the whole business.  Often shares are in a subsidiary company when the real value sits in the group.

Besides binding shareholders, such an agreement is very useful for the following:

  1. It helps everyone clear up any misunderstandings about many aspects that affect the business (who has control, who can appoint directors, what the strategy is, whether you are aiming to sell it one day etc.).
  2. There is typically less of a dispute around aspects like share ownership, voting and price when it’s all stated clearly in a binding document.
  3. The value created by the business can be easily calculated with reference to the share price.  People can know what their exit price is at any point.  This can be a double-edged sword – but by and large it is a good thing because people are motivated when they can see the actual value of their ownership.
  4. You are able to make plans over the long run by having a very stable reference point for the existing and any new shareholders.
  5. You can create an ownership oriented incentive scheme that is binding and easily understood.