Commercial Law: Do I need a shareholders’ agreement?
Miscommunication about an unwritten arrangement nearly cost brothers $200,000
A case that was heard in the Federal Court in August 2019 involved three brothers who set up a family business, but did not put the arrangements of the business in writing. Instead, the brothers relied on ‘trust and familial good will’, in the words of Justice Derrington. Justice Derrington also said that although the business thrived for years, the brothers had a falling out ‘as is so often the case when family members do business together’.
The evidence showed the brothers had agreed that brother A and brother B would contribute unpaid time to the business and brother C would contribute capital, but not time (as he worked full-time). Consequently, brothers A and B were entitled to 47% interest in the business each and brother C was entitled to a 6% interest. It was further agreed that brother A would receive the first $100,000 of profit from the business because he contributed more capital than brother B.
However, brother A ended up claiming they all agreed that he would be paid for his time contributions to the business ‘when the cash flow permitted’ and that he would also be paid $200,000 ‘once lines of credit were established’. There is no evidence that this was actually the agreement, though. It was alleged that brother A began making ‘secret payments’ to himself which were not authorised.
No agreements were put in writing about the structure of the business or what would happen in certain circumstances, which meant the brothers were not armed to deal with the issue when it arose.
If the brokers had entered into a shareholder’s agreement before their dispute arose, all of these problems may have been averted.
This article will explain what a shareholders’ agreement is and why you should have one.
What is a shareholders’ agreement?
A shareholders’ agreement is a contract signed by the shareholders of a company, which regulates their obligations and rights, as well as what should happen if certain situations arise. Unlike a company constitution, (which is automatically binding on all members) a shareholders’ agreement is only binding on the shareholders who sign it – just like any other contract.
This can create a problem if an existing shareholder sells their shares and the new shareholder does not want to sign the shareholders’ agreement. To combat this problem, many shareholders’ agreements include a clause requiring existing shareholders to ensure any person who purchases their shares will sign a deed of accession. A deed of accession is a document that says the new shareholder agrees to be bound by the contents of the shareholders’ agreement.
Some other clauses that are commonly in shareholders’ agreements include, but are not limited to:
- circumstances in which a dividend will be paid;
- the process for transferring shares;
- dispute resolution (how will disputes between shareholders be resolved?);
- death or liquidation of a shareholder;
- shareholders’ rights to inspect company documents and premises;
- restraint of trade of shareholders;
- confidentiality provisions;
- a business plan; and
- matters which require unanimous or majority consent of shareholders.
How to write a shareholders’ agreement?
Since shareholders’ agreements are not compulsory, there are no requirements as to how they must be written. Ideally, a shareholders’ agreement will be customised for each individual company. Different types of shareholders’ may want different clauses included in the shareholders’ agreement, in order to suit their best interests.
For example, a majority shareholder, (a person who owns the majority of the total number of shares) would probably want decisions to be made based on a majority vote. This should be defined by a percentage of shares, (eg. 51% of the issued share capital). That way, the majority shareholder will be able to make decisions about the company without the consent of other shareholders.
On the contrary, a minority shareholder would probably prefer decisions to require a unanimous vote.
Another clause that a majority shareholder would probably want in the shareholders’ agreement is called a ‘drag along’ clause. A ‘drag along’ clause will say that if the majority shareholder sells their shares, 100% of the company shares must be sold. Essentially this means that if the majority shareholder wants to sell, the minority shareholders will have to sell as well. This is in the majority shareholder’s best interests because it means they will be able to sell their shares whenever they want to, without having to negotiate with the other existing shareholders.
One clause that can protect minority shareholder’s interests is called a ‘tag along’ clause. A ‘tag along’ clause means that if a majority shareholder wants to sell their shares, they cannot do so unless the minority shareholders also have purchases for their shares. In other words, the majority shareholder cannot sell unless 100% of the shares will be sold. This is in minority shareholders’ interests because it means the majority shareholder cannot sell their shares and leave the company in the control of someone who the minority shareholders do not agree to.
Pros and cons of a shareholders’ agreement
There are many benefits of having a shareholders’ agreement. As illustrated in the case study at the start of this article, it can assist in settling disputes by creating a dispute resolution process that must be followed.
A shareholders’ agreement can also potentially decrease the chances of a dispute arising because the very process of writing a shareholder’s agreement requires the shareholders to think about potential disputes and how they should be solved. By turning their minds to potential future issues, the chances of the issues arising may be lessened.
There can be some disadvantages to having a shareholders’ agreement as well. Some may argue it is better to simply have a company constitution because it is automatically binding on any new shareholder, whereas a shareholders’ agreement is not.
Another benefit of just having a constitution is that amending a company constitution requires the consent of 75% of shareholders (Corporations Act 2001 (Cth) ss 136(2) and 167AJ(2)(a)), whereas a unanimous decision is required to amend a shareholders’ agreement because it is a contract.
This can be problematic, though, because some clauses that should be in a shareholders’ agreement are not suitable for a constitution.
What next for your business?
- Looking to start up a business and want help with writing a shareholders’ agreement;
- Already have a business, but don’t have a shareholders’ agreement and think you need one;
- Have a shareholders’ agreement in place, but aren’t sure if it provides adequate clarity and protection; or
- In a dispute with other shareholders of your company and require legal assistance?
If you have any questions or concerns about shareholders’ agreements, please don’t hesitate to contact Lynn & Brown Lawyers for expert advice on commercial law.
Alternately, if you’re in a dispute with your fellow shareholders, we recommend seeking legal advice. In the case study outlined above, Justice Derrington said the failure of one of the parties to ‘utilise the services of a lawyer’ resulted in most of the documents he filed being inadmissible and/or not addressing the relevant issues. For this reason, we encourage you to contact Lynn & Brown Lawyers as we have decades of experience helping businesses resolve their disputes.
Want to know more? Explore our publications on commercial law, such as choosing a business structure that best suits your needs and are you keeping your clients’s data safe?
About the authors:
This article has been co-authored by Chelsea McNeill and Steven Brown at Lynn & Brown Lawyers. Chelsea is in her fourth year of studying Law at Murdoch University. Steven is a Perth lawyer and director, and has over 20 years’ experience in legal practice and practices in commercial law, dispute resolution and estate planning.