Why are most shareholders agreements useless?

Shareholders in a private company should have an agreement setting out their rights and obligations in detail, to avoid disputes and give clear guidance if anything should go wrong.

Standard shareholders agreements

When preparing a shareholders agreement, most solicitors use a standard template and assume that “one size fits all”. They insert details of the company and the shareholders, but change little else.

Most standard templates are lengthy and impressive looking, covering everything from the procedure at shareholders meetings to what bank the company should use. But how useful are they?

When are shareholders agreements important?

At the time of signing a shareholders agreement, the shareholders are obviously on good terms. The company is run through goodwill between the shareholders and nobody needs to look at a shareholders agreement to tell them which bank or accountant to use, or how to have a meeting. In fact, after the agreement is signed, they generally put it somewhere and forget it.

The only times the shareholders are likely to look at the shareholders agreement are when a serious issue arises between them. The parties then dig out the shareholders agreement, dust it off, and read what it says about that issue. They will not be interested in all the verbiage about bank accounts and meetings, and will only be interested in finding a clear and practical solution to the immediate problem.

Resolving disputes

The most common issue where a shareholders agreement is important is when there is a dispute between shareholders. Running a company often involves disagreements between shareholders, which they are usually able to sort out by discussion. However, if the dispute is so serious that the parties need to apply the provisions of the shareholders agreements, their relationship is probably damaged beyond repair.

Right of first refusal

If there is a serious falling out between the shareholders, the only real solution is for the parties to go their separate ways. Most shareholders agreements cover this by providing for a shareholder to be able to sell their shares to third party with the other shareholder(s) having a right of first refusal, sometimes called a right of last refusal.

This means that the only way of getting out of the company is that you find somebody willing to buy your shares for an agreed price, you offer those shares to the other shareholders at that price and, if they do not accept, you can sell to that third party. If you cannot find a third party willing to jump through those hoops, then you are stuck as a shareholder with other shareholders with whom you can no longer cooperate.

In Tim Somerville’s 50 years of experience as a commercial lawyer, he has never seen such a clause operate successfully to achieve the exit of a shareholder. The reason is simple. No third party will agree to pay money to become a shareholder in a private company, if the other shareholders do not want them. If the other shareholders are happy for them to come in to the company, there is no need to go through the right of first refusal process.

Practical alternatives

If a shareholder wishes to leave, or a majority of shareholders wish to expel a shareholder, there should be a clear mechanism as to how this should happen. It will almost always involve a payment to the outgoing shareholder. If so, there should be a clear mechanism as to calculating that amount, such as a multiple of earnings before interest and tax (EBIT), or a multiple of gross receipts.

Many shareholders agreements state that the amount to be paid to the outgoing shareholder will be based on the fair value of the company as determined by the company accountant. There are countless different ways that accountants value companies. The uncertainty of having a clause like that should be avoided if possible.

There are several practical mechanisms that can be included in shareholders agreements to facilitate the exit of a shareholder, if a shareholder wants to leave, or the other shareholders want them to leave.

One alternative is a Savoy clause. This is where a shareholder who wants to leave offers their shares to the others at a price they nominate. The remaining shareholders have the right to buy the shares at that nominated price. However, they also have the right to force that shareholder to buy their shares at that price. This forces the outgoing shareholder to carefully nominate a reasonable price.

Death of a shareholder

The other main situation where a shareholders agreement is important is the death of a shareholder. If that happens, there should be a clear mechanism for their shares to be transferred to the other shareholders for a certain price or, if that is not practical, for the assets of the company to be sold and divided. Again, there should be a clear mechanism to determine the price, to avoid an unpleasant argument between the surviving shareholders and the grieving family of the deceased. The same provisions can apply to a shareholder becoming incapacitated.

Conclusion

Shareholders agreements are important, but there is no point if they just cover issues on which the shareholders would agree in any case. A shareholders agreement should cover the important issues of resolving disputes and transferring shares on death or incapacity of a shareholder. These provisions should be tailored to the specific requirements of the shareholders and the specific needs of their business.

For more information  contact Tim Somerville  or Andrew Somerville on (02) 9923 2321.