What are ten important things to consider when making shareholder agreements for small businesses?

Peter Adediran’s specialist niche area of practice is small-medium businesses and start-ups intellectual property law – both contentious and non-contentious – and Information Rights. His focus is digital works including mobile apps and website projects. Read more on PAIL’s ® Resource Library

 
Shareholder agreements in small businesses and start-ups. What are ten important things to consider when making shareholder agreements for small-medium businesses? Everything important about a shareholder agreement from a family and friends perspective. Shareholder agreements in small-medium businesses and start-ups. What are ten important things to consider when making shareholder agreements for small-medium businesses? Everything important about a shareholder agreement from a family, friends and professional investor perspective.
 

Introduction

 
You probably have an idea of what a shareholder agreement is. However, why should you have a shareholder agreement before issuing even a single share in a small business? Why pay for a professional to prepare a shareholder agreement when you are family or very close friends, it does not make sense? Well, it does if you want to give your business the best chance of success.
 
A good friend and you get together to start a business. Both of you are very close, perhaps you are even a couple or married. If all is smooth-sailing, you never disagree, total congruence in your business relationship, congratulations. If, however, as is the case with most people, you disagree from time to time, then you need a way to resolve the conflict. You could easily disagree regarding the day-to-day running of the company; or how you manage the company’s strategic intent and functions. How will you divide the company’s shares between you? What of transferring the company shares to other people? How about the rights you have as individual shareholders attached to your shares? Disagreements on financing and much more challenges.
 
First off, it depends on what the issue is. You and your fellow shareholder or shareholders can resolve all of the problems mentioned, with a shareholder agreement. So, let’s all take a collective sigh of relief — something like (Aaah!).
 
Don’t get too relieved. Even if you have an excellent idea of making a shareholder agreement, you might still end up in disagreements.
 

 …a shareholder’s agreement regulates how a company is going to be run, and how important decisions affecting the company will be made. Whoever holds the balance of decision-making power in the shareholder relationship will implement their strategy. The best-drafted shareholder agreements can manage the inevitable fall out of a disagreement over strategy, but they will not be able to prevent one.

If you’re starting a business or are in one with fellow shareholders, here are ten possible things to consider. Here’s to a harmonious small business shareholder relationship.
 

1. Decide what is the most fundamental issue

 
The essential topics to agree on in a start-up or small business shareholder relationship include: the business strategy, financing, controlling interest rights, minority interests’ rights, directorships and shares.
 
However, it is as important to understand the context in which legal mechanisms are used to fix problems as it is to understand legal solutions. At the core of a start-up or small business,  is the core business strategy. If there is disagreement on the fundamental business strategy, then the chances are that the shareholder relationship might not be a good fit from the outset. No shareholder agreement can ever fix a fundamental disagreement between shareholders in the strategy of a business.
 
What is meant by business strategy is the overall business objective. The business objective is different from the tactics of how to get there.

We’ll use a hypothetical case study of an online dating mobile app start-up.

There are two founders of a mobile app start-up.

For founder A, the primary competitive advantage objective of the app is to become a low-cost dating app for the masses, differentiated by developing a few features that are of superior quality to anything else in the market.

If Founder B agrees on these competitive advantage objectives, then both shareholders can agree on the tactics of how to get there. However, if Founder B prefers an invite-only dating app focusing on exclusivity, that is enhanced, and differentiated from competitive products by loading it with many features, then these differences in competitive advantage strategy mean the founders of the business are bound to run into non-negotiable disagreements.

Founder A’s strategy is betting on low-cost leadership, mass appeal and that users give more weight to capability, and less weight to usability, whilst Founder B is pinning all hopes on the competitive advantage of exclusivity for the ultra-rich, and that users get fed up with lots of functionality that either do not work correctly or are not satisfying.

How does all this affect a shareholder’s agreement? Well, a shareholder’s agreement regulates important decisions affecting the company. Whoever holds the balance of decision-making power in the shareholder relationship will implement their strategy. The best-drafted shareholder agreements can manage the inevitable fall out of a disagreement over strategy, but they will not be able to prevent one.
 

1. Make a list

Before consulting a solicitor, you need to make a list of all matters that are important to you and your fellow shareholders.

In this list, you will briefly identify all the issues that are important to each shareholder. Make sure all shareholders approve the list. The list will deal with the issues mentioned in 1. Above such as financing, management of shares, controlling interests and minority interests.
 

1. Financing

 
For a company cash is not king, it’s cash-flow that is king. Indeed, operating cash flow is the lifeblood of any small business. Cash flows show how much money is available to keep the business running. It is therefore important that any provisions in the shareholder agreement dealing with finances ensure that actions of the shareholders do not negatively impact the cash flow of the business. Financing is of primary importance including:

• the buy-back of shares or any other dealings in the shares of the company such as the transfer of shares

• alteration of any rights attaching to any class of shares

• creating any option or right to acquire any shares

• sell company property or assets

• buy, or lease assets

• entering into large contracts that could bankrupt the company

• borrowing money secured against the company

• giving guarantees or surety

• lending or granting credit

• merging or being acquired by another company or the acquisition of any interest in the company’s shares or security convertible into shares or creating a subsidiary.

1. Controlling Interests Rights

Shareholders can own different proportions of the shares in a company. Generally, the key percentages are:

• 75%

• over 50%

• over 25%; and

• 5%.

Since different classes of shares can carry different types of voting rights the position can get very mathematically complex particularly in large public companies.
 

Special Resolutions

 
For a special resolution, 75% of the shares. Any substantial change like the business of the company or business organisation. Altering the company’s articles, for instance, is a considerable change.
 

Ordinary Resolutions

 
To pass an ordinary resolution 50% + 1 of the shares with voting rights are needed.  The more routine management matters are dealt with by this resolution. Removing a director, for example, requires an OR. Directors can also pass day-to-day management resolutions that don’t need an OR or SR without calling a shareholders meeting.
 

Person with Significant Control

 
The percentage proportion of shares with voting rights that a shareholder owns can determine whether they have significant control of the company. Companies House defines the person with significant control of a company as having

• more than 25% of shares in the company

• more than 25% of voting rights in the company

• the right to appoint or remove most of the board of directors

If  you own over 25% – you can block any special resolution.
 

1. Minority Rights

Shareholders with 5% of the shares with voting rights can require the company to call a general meeting. Following the take-over of the company, you can prevent the compulsory purchase of your shares. You can prevent the compulsory purchase of your shareholding following a takeover of the company. An application can be to the Department for Business, Energy & Industrial Strategy   for an inspector to investigate the company.

Notwithstanding the above, shareholders who do not have a significant controlling interest in the company, usually do not have a say in the running of the company. The shareholder agreement can protect minority shareholder interests so that they have input on the important decisions that impact the business.
 

1. Drag along rights

 
Often the majority shareholder might like to sell their shares to an outside investor. They might face resistance from other shareholders, because the outside investor may want to make several fundamental changes to the management of the company, as well as the investment diluting the percentage of share ownership. A shareholders’ agreement can also include a clause concerning drag along rights. If a majority shareholder wishes to sell their shares, a drag along clause will force the other shareholders to sell their shares to the investor.
 

1. Tag along rights

 
The majority shareholders might have found an outside investor for some of their shares and want to exit causing a dilution in the minority shareholders interest.

The outside investor may also want a change in the company’s articles and the shareholder agreement. You can provide additional protection for minority shareholders by including tag-along rights. If a majority shareholder is selling his shares in the company, the minority shareholder is entitled to “tag along” their shares to the investor on the same terms.
 

1. Directorships

 
Its directors do day to day management of a small business. Directors are the management team and have operational control of the company. In small companies, there is usually no distinction between the board of directors and the management team. In small businesses, shareholder agreements need to consider the importance of family members with certain specific shareholding interests. Usually, there will be a need to limit the number of directors and providing for non-executive directors and a directors’ election mechanism.
 

1. Fair Value

 
When a shareholder triggers a buy-sell provision under a shareholders’ agreement, there needs to be a provision as to how the shares are valued. The buyer and seller agree to the share price. However, what if the buyer and seller cannot agree on a fair price? In this case, the agreement will normally state that the fair value for any shares in the business to be transferred is the amount the auditors consider to be the fair value, based on certain assumptions, and valuation methods.

In other words, the difference in share value can be dramatic depending on the assumptions and the valuation methods used. Therefore assumptions and valuation methods should be carefully drafted. It would be best if you also took care of wording such as fair value. Is it a ‘market’ or ‘fair’ value? Is there a time limit on the share valuation? Time can affect the valuation of shares. Is the auditor’s assessment binding or is just an opinion? It can sometimes cause real frustration among family members to find out that the result of the valuation process is merely advisory.
 

1. Consult a professional

 
In conclusion, our firm focuses on small and medium sixed businesses in which shareholder relations are often sensitive.

In a small-medium business, the primary function of a shareholder agreement is to avoid or resolve conflict amongst shareholders who are either family or close friends.

In this type of situation, it is wise to call in backup due to the delicacy of potential conflict in relations with each other. It makes sense to consult a lawyer specialising in small-medium businesses. Often as friends or romantically involved partners you’re the opposite of impartial, which can affect decision-making skills, cause bias and unnecessary friction in the personal relationship aspect.

Involving a lawyer earlier on will provide that arms-length objectivity required for a business relationship. Additionally, a professional who is skilled in drafting these agreements will know how to avoid the pitfalls, find workable solutions to potential disagreements, and protect the interests of all shareholders.
 

Need to Create Shareholder Agreement?

 
If you need to create a shareholder agreement for a start-up or small-medium business, or a tailored understanding for a potential investor, or friend, you’ve come to the right place.

We’re experienced digital project lawyers here to make sure your business gets the protection you need.

Ready to launch your start-up business, or establish the small-medium business project, on the right foot? Get in touch with us today.

By Peter Adediran

04.02. 2019
 

This article deals with questions small-medium business owners, entrepreneurs and start-ups should be asking concerning protecting their shareholder relationships. If you are seeking advice on how to protect your business relationship with a family member, friend or institutional investor, you must take the opportunity to go and seek professional legal help from a solicitor or barrister. The information and any commentary on the law contained on this web site are provided free of charge for information purposes only. Every reasonable effort is made to make the information and analysis accurate and up to date, but no responsibility for its accuracy and correctness, or for any consequences of relying on it, is assumed by PAIL®Solicitors. The information and commentary do not and are not intended to amount to legal advice to any person on a specific case or matter. Obtain an accurate, personal opinion from a lawyer about your case or matter. Do not to rely on the information or comments on this site. We bear no responsibility for the content or accuracy of linked sites.