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What is a shareholders agreement and what should it include?

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What is a shareholders agreement and what should it include?

Karen Edwards, Head of our Corporate & Commercial Team, discusses the importance of including certain provisions within shareholders agreements; such as deadlock clauses and minority shareholder protection rights.

What is a Shareholders Agreement?

A shareholders agreement is a contract made between the shareholders of the company to govern their relationship going forward and safeguard against any disagreement arising in the future.

It encourages shareholders to discuss issues at the outset; whilst shareholders may assume that nothing can or should go wrong because everybody gets along, they may in fact have different ideas about how things should be done.

What does a shareholders agreement do?

Although the company’s articles of association will help to some extent, a fully considered and well drafted shareholders agreement can act as a safeguard and give shareholders more protection against problems arising. Without one in place, shareholders will have to rely on the provisions of the Companies Act 2006 which may be inappropriate or inadequate for their specific requirements.

What does a shareholders agreement cover?

A shareholders agreement can cover a whole host of matters. Typically, it will:

  • set out the shareholders’ rights and obligations;
  • regulate the sale of shares in the company;
  • describe how the company is going to be run, from banking arrangements to payment of dividends and salaries;
  • provide an element of protection for minority shareholders and the company; and
  • define how important decisions are to be made.

What should a shareholders agreement include?

Here we discuss in a little more detail the most fundamental provisions needed to protect the shareholders and the company.

1. Financing the company

The parties can agree when shareholders are required to invest further monies in the company. If there is no obligation to invest, and funding cannot be obtained elsewhere, this could result in the company becoming unsustainable.

Likewise, if a shareholder has personally lent money to the company, in the absence of written agreement, that loan would be repayable on demand and therefore if the lending shareholder asked for immediate payment, this could lead the company into financial difficulty.

It is therefore important to make sure there are appropriate funding requirements in place.

If loans have been made to the company by shareholders, the shareholders agreement could also deal with the repayment of such loans.

2. Minority shareholder protection rights

Why do minority shareholders need protection?

A minority shareholder (one owning less than 50% of the shares) will on their own have little control or say in the running of the company. Companies are generally run by majority decision and even if the articles of association include provisions that protect the minority, these can be changed via special resolution by holders of 75% of the shares.

Should minority protection rights be included in a shareholders agreement?

By including minority rights, shareholders can prevent certain material decisions being made unless a set percentage, or even all, of the shareholders agree. This could be decisions on the issue of new shares, appointment or removal of directors, taking on new borrowings or changing the main trade.

Care should however be taken in choosing what decisions this approach should be adopted for, as if a shareholders agreement requires all decision to be unanimous this could hinder the company from carrying out its usual business.

3. Deadlock

What is a deadlock clause in a shareholders agreement?

If there are an equal number of shareholders holding an equal number of shares, those shareholders may find themselves in a deadlock situation where the same number of shareholders vote for and against a proposal.

Whilst the best way to overcome this is obviously to discuss the issue and try to reach agreement, it is good to have an agreed method by which to resolve the dispute if discussions are unsuccessful.

The usual procedure essentially allows one party to either sell their shares or buy the other party’s shares. If no party wishes to part with their shares, the shareholders agreement can stipulate that the company is to be sold or wound up.

What happens if a deadlock clause is not included in a shareholders agreement?

Without an agreed method in place to deal with deadlock situations, shareholders may find themselves trapped within a company where working relationships are untenable.

4. Transferring shares

What are share transfer provisions in a shareholders agreement?

A shareholders agreement should set out the rules governing share sales and transfers so that if a shareholder wishes to sell or transfer his shares, the continuing shareholders have a first right of refusal over those shares.

It can also stipulate that where the shares are ultimately offered to a third party (after any pre-emption rights are exhausted), that third party has to be approved by the continuing shareholders.

Why should transfer provisions be used?

In the absence of the relevant provision, the company could find that it has an unwanted third party acquiring shares and this could cause problems, especially if the sale is to a competitor or someone else that the shareholders do not want involved with the company.

5. Deemed transfer provisions

What are deemed transfer provisions in a shareholders agreement?

Certain situations should also bring about an automatic transfer of a shareholder’s shares. For example, the shareholders agreement can stipulate what will happen if a shareholder dies.

Shareholders should consider putting a cross option agreement in place which requires each of them to take out a life policy written in trust for the other shareholders. In the event of a shareholder’s death, the remaining shareholders can use the proceeds to buy the deceased’s shares. This allows the continuing shareholders to keep control of the company.

A deemed transfer could also be triggered on, for example, a shareholder’s bankruptcy, long term incapacity or where they cease to be a director or employee. Thought should also be given as to how shares are to be valued where a shareholder has left the company on unfavourable terms. In some cases the shareholders might wish only to pay par value for those shares rather than market value.  

Why should deemed transfer provisions be used?

Without deemed transfer provisions, a company could find that it has a director who has left with bad feeling, or a shareholder who can no longer contribute to the business in the same way,  yet still they continue to hold shares.

6. Sale of the company

A third party may not wish to purchase shares in the company unless he is able to purchase them all. To the same extent a minority shareholder may not want to remain a minority shareholder in a company if the majority shareholder changes.

What are drag along rights?

A shareholders agreement can therefore include provisions that if an offer is made to a majority shareholder and they wish to accept the offer they can “drag along” a minority shareholder and force them to sell their shares, allowing the majority shareholder to realise their investment at a time and price which they feel is appropriate.

A shareholder agreement can also include provisions for dealing with shareholder breaches. Read our article on mitigating and tackling shareholder breaches here.

What are tag along rights?

Likewise, a suitable provision would also stipulate that if someone is willing to buy the shares of a majority shareholder, that majority shareholder can only sell the shares if the same offer is made to all shareholders including the minority shareholder.

This would effectively allow the minority shareholder to “tag along” with the majority shareholder so that the minority shareholder is not left behind. This also ensures that the minority shareholder receives the same return on their investment as the other shareholders.

A specialist Corporate & Commercial Lawyer's view

Karen Edwards, Head of the Corporate & Commercial team at Frettens, said: "Whilst there is no legal requirement to have a shareholders agreement, it is a good idea to have one in place.

You may be surprised when you actually sit down to discuss these issues with your fellow shareholders, that you have different opinions. It is much better to have these conversations at the outset, so that everyone involved knows where they stand."

Corporate & Commercial solicitors in Bournemouth, Christchurch and Ringwood

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The content of this article, blog or video is not intended as specific legal advice. For tailored assistance, please contact a member of our team.