Do I really need a shareholders agreement?

If you own a company with someone else, the short answer is: in most cases, yes.

A shareholders agreement is not simply paperwork for large companies or sophisticated investors. For a privately owned business, it can be one of the most important agreements the owners put in place.

Why?

Because businesses change.

People disagree. One shareholder may want to sell while another wants to stay. Someone may stop contributing to the business. A founder may become seriously ill. The company may need more capital. A relationship can break down. A new investor may come on board. Or someone may receive an offer to buy the company that the other shareholders don't want to accept.

When everyone is getting along, these issues can feel remote.

The purpose of a shareholders agreement is to decide how they will be handled before they become a dispute.

What is a shareholders agreement?

A shareholders agreement is a private contract between some or all of the shareholders of a company and, commonly, the company itself.

It establishes rules governing the relationship between the shareholders and can deal with matters such as:

• who controls the company;
• how major decisions are made;
• who can appoint directors;
• what happens when shareholders disagree;
• when dividends can be paid;
• how additional funding will be raised;
• whether new shares can be issued;
• whether shareholders can sell their shares;
• what happens if someone wants to leave;
• what happens if someone dies or becomes incapacitated;
• how the business can be sold; and
• how disputes will be resolved.

The exact terms should reflect the particular business and the relationship between its owners.

A company owned equally by two founders has very different risks from a business with one 70% shareholder, two minority shareholders and an external investor.

A good shareholders agreement is therefore not just a standard document with the names changed. It should be designed around how the business is actually expected to operate.

Isn't the company constitution enough?

Not necessarily.

Australian companies must have rules governing their internal management. Depending on the company, those rules can come from the statutory replaceable rules in the Corporations Act 2001 (Cth), a company constitution, or a combination of both. ASIC describes the replaceable rules as the default governance rules for many proprietary companies.

Those rules cover important matters such as directors, shareholder meetings, voting, shares and dividends.

But they are not designed to deal with every commercial issue that can arise between the particular owners of your business.

A shareholders agreement allows the owners to go considerably further and agree in advance on questions such as:

• What if one founder wants to leave?
• What if we are deadlocked 50/50?
• What if someone stops working but still owns half the company?
• Can one shareholder sell their shares to a competitor?
• Can the majority force a sale of the entire company?
• Can a minority shareholder participate in that sale?
• What decisions require unanimous approval?

Those are often the questions that matter most when a shareholder relationship breaks down.

1. Who actually controls the company?

Owning shares and running the company are related, but they are not exactly the same thing.

Shareholders own shares in the company, while directors are responsible for managing the company's affairs. Shareholders also exercise voting rights on matters requiring member approval, generally according to the rights attached to their shares.

A shareholders agreement can establish a clearer governance structure.

For example:

• Who can appoint a director?
• How many directors will there be?
• Does each founder have the right to appoint one?
• Who chairs board meetings?
• Does the chair have a casting vote?
• What decisions can management make without shareholder approval?

This becomes particularly important when ownership percentages are not equal.

A shareholder with 60% of the company might expect to control every decision. The 40% shareholder may have agreed to invest on the understanding that certain major decisions cannot happen without their approval. If that understanding is important, it should be documented.

2. Which decisions require everyone's agreement?

Not every business decision should require a shareholder meeting.

At the same time, there are some decisions that an owner may not want another shareholder making alone.

A shareholders agreement can establish a list of reserved matters that require a particular level of approval.

Depending on the company, those might include:

• borrowing above a certain amount;
• taking on major debt;
• issuing new shares;
• bringing in a new investor;
• changing the nature of the business;
• buying or selling major assets;
• entering unusually large contracts;
• changing directors' remuneration;
• paying dividends;
• commencing major litigation;
• entering related-party transactions;
• selling the business; or
• winding up the company.

The appropriate approval threshold might be a simple majority, a higher percentage or unanimous consent.

This allows the owners to distinguish between running the business and changing the business.

3. What happens when shareholders disagree?

This is one of the most important parts of a shareholders agreement.

Consider a company owned 50/50 by two founders. One wants to reinvest profits and expand. The other wants dividends. Neither can outvote the other. What happens?

Without an agreed mechanism, the company can become effectively paralysed.

A well-drafted shareholders agreement can include a deadlock procedure. Depending on the business, this might involve:

• requiring the shareholders to meet and attempt to resolve the issue;
• escalating the dispute to mediation;
• referring particular issues to an independent expert; or
• ultimately triggering a mechanism allowing one shareholder to buy out the other.

The goal isn't to assume the relationship will fail. It is to ensure that the business still has a way forward if it does.

For 50/50 companies in particular, a deadlock provision deserves careful attention.

4. What if someone wants to sell their shares?

Suppose you started a business with a trusted colleague. Three years later, they decide to leave. Can they sell their 50% stake to anyone they choose? Could they sell it to your competitor? Could you suddenly find yourself running the company with a stranger?

A shareholders agreement can restrict transfers of shares and establish a process that must be followed before an outside buyer can come in.

One common mechanism is a right of first refusal or pre-emptive process, which may require the departing shareholder to first offer their shares to the existing shareholders.

The agreement can also address how shares are valued and how long the other shareholders have to decide whether to buy them.

These provisions create a balance between two competing interests: a shareholder should have a realistic way to realise the value of their investment, but the remaining shareholders should have some control over who they end up owning the business with.

5. What happens if the whole company is sold?

This is where drag-along and tag-along provisions become important.

Imagine three shareholders own 60%, 25% and 15%. A buyer offers an attractive price for 100% of the company. The 60% shareholder wants to accept. The other shareholders refuse.

A properly structured drag-along clause may allow the required majority of shareholders to require the remaining shareholders to participate in a genuine sale of the entire company, subject to the agreed terms.

Now reverse the situation. The majority shareholder receives an offer to sell their controlling interest. The minority shareholder doesn't want to remain in a company controlled by the new owner. A tag-along clause can potentially give that minority shareholder the right to participate in the sale on the applicable agreed basis.

Drag and tag provisions can therefore become extremely important when an eventual business sale is part of the shareholders' strategy.

6. What if a shareholder leaves the business?

This issue causes a surprising number of disputes.

Suppose two people each own 50% of a company and both work full-time in it. Five years later, one shareholder resigns. They stop working. But they still own 50% of the company. The remaining shareholder is now running the entire business while the former working shareholder continues to hold half of its equity.

Was that what everyone intended? Maybe. Maybe not.

A shareholders agreement can include leaver provisions dealing with what happens when a shareholder who is also an employee, director or founder leaves the business.

The agreement may distinguish between circumstances such as:

• resignation;
• retirement;
• dismissal;
• serious misconduct;
• death;
• permanent incapacity; or
• an agreed departure.

It can then specify whether there is a right or obligation to sell shares and how those shares will be valued.

These provisions need careful drafting because the financial consequences can be significant. But without them, everyone may discover too late that they had completely different assumptions about what "leaving the business" meant.

7. What happens if the company needs more money?

A growing company often needs capital. Perhaps it wants to hire staff, acquire a competitor, develop software, purchase equipment or expand into another market. Where does the money come from?

A shareholders agreement can establish principles around:

• shareholder loans;
• additional equity;
• external finance;
• issuing new shares;
• whether shareholders are required to contribute;
• what happens if one shareholder contributes and another does not; and
• how dilution is handled.

This is particularly important where the shareholders have very different financial resources. One founder may be capable of putting another $200,000 into the company. The other may not. That should not first become a topic of discussion when the company urgently needs the money.

What about issuing new shares?

Issuing additional shares can change the balance of ownership and control. If you own 25% of a company today, a substantial new share issue could reduce your percentage interest.

The Corporations Act itself contains rules dealing with share issues, including a replaceable rule concerning pre-emption for existing shareholders in proprietary companies. But the governance arrangements applying to a particular company can modify how these matters are handled.

A shareholders agreement can establish a tailored process for future capital raising. That becomes particularly important for businesses that expect to bring in investors.

What if a shareholder dies?

It isn't pleasant to think about when starting a business. But it matters.

If a shareholder dies, what happens to their shares? Does the remaining shareholder continue running the company with the deceased shareholder's estate? Is there a mechanism for the surviving shareholders to buy the shares? How will the price be determined? How will the purchase be funded?

These issues can also interact with wills, estate planning, insurance and succession arrangements. For businesses with a small number of active owners, succession planning should therefore be considered alongside the shareholders agreement.

Do I need one if I'm going into business with family or friends?

Especially then.

Many businesses begin with relationships built on trust. Two friends have an idea. A husband and wife start a company. Siblings take over a family business. Colleagues leave employment to launch something together.

Nobody wants to begin that relationship by planning for a dispute. But putting an agreement in place isn't an expression of distrust. It is a way of making sure everybody has the same understanding of the deal.

Questions such as these are much easier to answer while the relationship is good:

• How much is everyone expected to work?
• Is everyone taking a salary?
• When will profits be distributed?
• Who has authority to spend money?
• What happens if someone stops contributing?
• Can another family member become a shareholder?
• What happens if somebody wants out?
• Who ultimately controls the company?

If people cannot agree on those questions at the beginning, that may itself be useful information.

We're already operating without one. Is it too late?

No.

A shareholders agreement can be put in place after a company has already started trading. In fact, many businesses operate for years before recognising that their original arrangements no longer suit the size or value of the company.

But there is an obvious advantage to dealing with it earlier. When everyone is getting along, negotiations are about creating sensible rules. Once a serious dispute has already started, every clause can become part of the dispute itself.

The best time to negotiate what happens when somebody wants to leave is generally before anybody wants to leave.

Can we just download a shareholders agreement template?

You can find templates.

The more important question is whether the template solves the problems your company actually has.

Consider two businesses.

Company A: two founders, 50/50 ownership, both work full-time, neither has contributed substantially more capital than the other.

Company B: four shareholders, one founder owns 55%, two senior employees each own 10%, an investor owns 25%, only two shareholders work in the business, the investor has negotiated special approval rights, and the company expects another capital raising within 18 months.

Those companies should not have identical shareholders agreements.

The value of the agreement is not simply having a document called "Shareholders Agreement". The value is having rules that reflect the ownership structure, financial contributions, roles of each shareholder, decision-making arrangements, expected future investment, exit strategy and specific risks of the business.

Does a shareholders agreement replace the Corporations Act or constitution?

No.

A shareholders agreement operates within a broader legal framework. Australian companies remain subject to the Corporations Act 2001 (Cth). The company's constitution and any applicable replaceable rules also need to be considered. ASIC notes that a constitution governs the company's internal management and operates as a contract involving the company, its shareholders, directors and secretary, as well as between shareholders.

Those documents should be considered together. If a shareholders agreement says one thing while the constitution says something materially different, problems can arise. Part of preparing or reviewing a shareholders agreement should therefore involve checking the company's existing constitution and corporate structure rather than treating the agreement as a standalone document.

So, do you really need a shareholders agreement?

There is no universal answer for every company. But if two or more people have a meaningful ownership interest in a private business, there is usually a strong commercial reason to consider one.

The more valuable the company becomes, the more important the rules between its owners become.

A shareholders agreement can help establish:

• who controls what;
• how important decisions are made;
• how shareholders enter and leave;
• how the company raises money;
• what happens during a deadlock;
• how shares can be sold;
• what happens when a shareholder dies or stops working; and
• how an eventual sale of the company can occur.

More importantly, it requires the shareholders to have these conversations before the answers become urgent.

Put the rules in place while everyone agrees

The easiest time to negotiate a shareholders agreement is generally when the shareholders are optimistic, aligned and focused on growing the business. Once the relationship deteriorates, reaching agreement becomes considerably more difficult.

Trilogy Law Group advises business owners, founders and investors on shareholders agreements, company structuring, business transactions and shareholder disputes. Whether you're starting a company with a business partner, bringing a new shareholder into an existing business or reviewing an agreement that no longer reflects the company, getting the structure right now can prevent much larger problems later.

Experience. Solutions. Outcomes.

This article contains general information only and does not constitute legal advice. Corporate structures and shareholder arrangements differ between businesses. Legal advice should be obtained regarding your specific circumstances.