The power of a shareholders’ agreement

In our last post, we wrote about a founders’ agreement which is a form of shareholders’ agreement used at the initial stage of your business. As your business scales up — the founders’ agreement will usually be replaced by a shareholders’ agreement when you take on more shareholders.

Incorporating a company in the UK is relatively quick to do, but putting a shareholdersagreement in place may take quite a bit longer and is used to decide how the company will be run. A shareholders’ agreement is essential in protecting all parties, particularly those who are minority shareholders.

No matter what industry, all successful companies have to start somewhere and we’re sure many a founder has wished they had paved the way for their success a little better.

Imagine that you and your two university friends have developed and own a fantastic health company, “Fit and Fruity”. You’re the numbers man, Sally is a nutritionist with lots of health contacts and Mark has experience in marketing and advertisement. A year later, you’re doing well and decide to give away some shares in the company to your ten key employees to incentivise them to stay.

Here are some problems you may encounter if you don’t enter into a written shareholders’ agreement setting out e.g. the rights between the three shareholders, dispute resolution procedures and funding policies…

1. Unclear shareholder rights

Your employees overhear Mark mention that he received his first dividend and they are looking forward to receiving one as well. Unfortunately, this is not part of Fit and Fruity’s business plan.

A shareholders’ agreement (and articles of association) can be used to set out definitive rights of different types of shareholders to provide certainty from the moment you become a shareholder. For example, the founders may receive A shares with rights to monthly dividends and voting whereas the employees may receive B shares with a lower ranking right to dividends on an annual basis.

2. You may hinder future financing

Sally has read a blog about crowdfunding; she gets carried away and raises a lot of cash for the business without realising that the company’s existing loan arrangement prohibits funding from third parties without bank consent.

A shareholders’ agreement would be useful to prevent this as it can set out internal procedures for borrowing money and, for example, the amounts that can be borrowed without shareholder consent.

3. Weaker bargaining position with investors

Fit and Fruity has been approached by an angel investor who is keen to invest an attractive sum of cash for a 25% equity stake. They ask for copies of your shareholders’ agreement and articles of association as they would be willing to negotiate based on the current state of play.

Without a shareholders’ agreement and bespoke articles of association in existence Fit and Fruity will likely incur more time and professional fees in getting to grips with the concepts introduced by the new investor and it may have to concede certain points as it would be difficult to evidence the company’s existing practices. That said, it is very common for investors to prepare the first set of investment documents.

4. Disorganisation results in fines and penalties

Prior to investing, your angel investor is doing some background checks on the company and notices that Fit and Fruity has not filed its annual accounts. Not only will this result in fines but it looks unprofessional.

Like training for a marathon, running a business requires discipline and organisation. To prevent incurring any fines or poor credit ratings the shareholders’ agreement can serve as a useful aide-memoir to keep the company in order to e.g. obtain insurance, prepare accounts, file forms with Companies House, file tax returns and organise board meetings.

5. Unclear on working for competitors

Sally has been approached by a third party to offer consultancy advice on a monthly basis. You and Mark consider the third party to be a competitor but Sally contends that they do not operate in the same market as Fit and Fruity and that it would be a great opportunity for her.

Shareholders’ agreements are often used to set out clear parameters on working for competitors in the period where you are a shareholder and for a period of time thereafter e.g. two years; these are referred to as restrictive covenants. The agreement can also include a tailored definition of “competitor” to prevent any ambiguity.

6. Unclear procedure to resolve shareholder conflict

Sally and Mark are happy for the angel investor to take a 25% equity stake in Fit and Fruity but, based on the size of the investment, you feel this is too large. You have all discussed this and cannot agree a compromise.

It is very common for business partners to have different opinions (this isn’t always a bad thing) and it is often key to the success of the business. However, there are times when a third party mediator would come in handy. The shareholders’ agreement is a useful tool to set out methods of reconciliation and, in circumstances where you cannot agree to work together, the process for a shareholder to exit.

Now, take a minute and think about where you want to be in five years? If you would you like to be what McDonalds is to the fast food market or taking on the likes of Nike and Adidas in the sports arena — having this agreement in place is vital — so aim high!

Please contact the Trowers’ start-up team for more information about founders agreements. We have also produced a series of fact sheets to help start-ups, so click here to access our online resources.

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Trowers & Hamlins LLP has taken all reasonable precautions to ensure that information contained in this document is accurate, but stresses that the content is not intended to be legally comprehensive. Trowers & Hamlins LLP recommends that no action be taken on matters covered in this document without taking full legal advice.