What is a Shareholders’ Agreement and Why Adopt It?
Shareholders’ disputes are one of the most common causes of business failures. It is particularly true when doing business in Asia, where foreign investors often face cultural differences, local commercial practices and specific legal requirements. Adopting a shareholders’ agreement can reduce such risks.
Legally speaking, a shareholders’ agreement is a contract concluded between the founders of a company, in order to (i) define their respective rights and responsibilities, and (ii) organise the management of the said company. It is not intended to govern the day-to-day operations of a business, but instead addresses certain key issues in that respect.
Shareholders’ agreements supplement the articles of association of a company. They shall comply with their mandatory provisions but can freely adjust their non-mandatory provisions. Besides, their provisions shall comply with the legal requirements of the given jurisdiction in which they are implemented. Since these requirements might vary from one jurisdiction to another, it is not recommended to use the same template for different countries. Hence, there is no standard shareholders’ agreement and such contract shall be tailor made.
Some of the most common issues of a shareholders’ agreement include the following:
Issuance of New Shares and Anti-Dilution Rights
Unless prevented from doing so by specific provisions, majority shareholders can generally (legally) decide to dilute minority shareholders by issuing additional shares in the company. Anti-dilution rights reduce the efficiency of such “trick” by requiring the company to offer any newly issued shares to existing shareholders first, in proportion to their existing shareholdings.
Transfer of Existing Shares and Exit Options
Many provisions can be adopted in order to prevent the transfer of shares to undesirable third parties (including competitors). In most cases, shareholders’ agreements require shares transfers to be approved by the company and grant existing shareholders an option to purchase the transferrable shares. Meanwhile, restrictions on transfers generally do not apply if the beneficiary is a wholly controlled affiliate, a shareholder’s family member or a trust. Common restrictions on share transfers include rights of first refusal, tag-along and/or drag-along options.
Management of the Company
Usually, a majority of shareholders (51%) can appoint and remove members of the board of directors. Such power allows effective control of the company. It may not be fair to minority shareholders, especially if they hold substantial shares (up to 49%). Instead, shareholders’ agreements can grant minority shareholders the right to appoint a director, which enables them to retain some control over the company’s governance.
Besides, the approval of shareholders is legally required for essential decisions, which by nature affect or change the original company set-up. It includes decisions dealing with capital increase or decrease, change of registered address, change of denomination and liquidation etc. However, shareholders may decide which strategic decisions shall be taken by the board of directors and/or by the shareholders. A detailed list of key decisions, together with special majority requirements, can be adopted in a shareholders’ agreement, going beyond the legal requirements.
Business partners often share common and/or complementary skills, which originally justifies their collaboration. But what happens when such partners split up or want to develop parallel activities? Shareholders’ agreements can provide non-competition and non-solicitation clauses, which define in advance the limits under which shareholders may carry out competitive activities.
Sometimes, disagreements between shareholders lead to deadlock situations, where the company is unable to make any decision. It may seriously affect its ongoing business. In order to prevent it, shareholders’ agreements can provide exit strategies, upon which one or more shareholder(s) can be forced to buy out others. In such case, it is recommended to refer to independent expertise or to adopt a pre-determined formula to determine the value of shares of the exiting shareholder(s).
Unless pre-determined mechanisms have been adopted for their resolution, shareholders’ disputes can severely affect the viability of a business. The adoption of a shareholders’ agreement can help reduce uncertainties and ensure a fair outcome to potential disagreements.
Published on Hong Kong Lawyer in the October 2018 issue
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