Top 10 Risks in Shareholders Agreements

This paper was co-authored by Kellie Cook, Senior Associate

All companies registered in Australia are required to have a constitution, which outlines the obligations and processes between the company and a shareholder. In contrast shareholders are not required to have a shareholders agreement, which outlines the relationship between each of the company’s shareholders.

If properly utilised and prepared shareholders agreements are a benefit to shareholders as they provide a framework for the shareholders to operate within. However if the agreement itself is not properly considered or fails to accurately reflect the intention of the shareholders, it will fail to provide the benefit sought.

Outlined below are 10 common risks associated with shareholders agreements.

1. Failing to have a Shareholders Agreement

Whether a person or entity is becoming a shareholder in a new company or an existing company, they should be mindful to check whether there is a shareholders agreement.

In the absence of a shareholders agreement, shareholders will need to rely solely on the company’s constitution to set out all of the administrative processes – if the constitution has been prepared in a mostly pro-forma or standard form, it is unlikely that it will provide all that is needed.

Minority shareholders in particular should be mindful that a company’s constitution can usually be amended by special resolution, which is by 75% majority – whereas changing a shareholders agreement requires the agreement of all shareholders, providing greater protection to any minority shareholder.

2. New Shareholders

It is important to ensure that a company’s constitution or a shareholders agreement provides that any new shareholder entering into an existing company is obliged to enter into and be bound by the terms of the shareholders agreement.

There is more than one way that this can be done. The constitution can provide that the company only registers a transfer of shares if a deed of accession has been signed by the incoming shareholder and provided to the company. Alternatively, there can be an obligation either in the constitution or shareholders agreement on the outgoing shareholder to obtain a signed deed of accession from any incoming shareholder, prior to settlement for the transfer of the shares.

3. Restrictions on Company’s Powers

The terms of a shareholders agreement cannot act to limit the corporate powers of a company under the Corporations Act 2001 (Cth) (Act). If a term within a shareholders agreement is deemed to limit such powers, then it is likely to be void.

Anyone involved in the preparation of a shareholders agreement should be mindful of the powers given to a company under the Act when completing a shareholders agreement.

4. Restraint of Trade

It is common with small to medium sized companies, where the shareholders also hold director or employee positions, that restrictions are included within the shareholders agreement on the types of activities and work that the shareholders can complete, to limit the risk of any shareholder undertaking activities that compete with the company – this can be both whilst the person remains a shareholder and for a period after they cease to be a shareholder.

Without the inclusion of this type of clause, there is a risk of dispute particularly when a person ceases to be a shareholder and seeks to start or work in a competing business. Any clause restraining a person’s activities needs to be carefully drafted to ensure that the correct entities are restrained, and so that the clause is enforceable if needed.

5. Management Decisions and Shareholder Obligations

Depending on the type, size and nature of the company the shareholders may wish to retain a level of control and involvement in the management and operation of the company.

Shareholder involvement in the company’s management is unlikely to be addressed in a standard constitution, so if this is a specific concern of a particular shareholder or group of shareholders, it needs to be set out in a shareholders agreement.

There are different ways of addressing this issue within a shareholders agreement, none of which are standard and will depend on the nature of the company’s business and the expectations of the shareholders.

If there are also certain expectations on shareholders then these obligations and expectations need be set out in a shareholders agreement, as it is unlikely that these will be covered within a standard constitution.

6. Financials

If any shareholder or prospective shareholder wants to have control over certain financial decisions or be provided with business plans or other financial projections at any time, a standard constitution would not generally include this right. A shareholders agreement can be used to state which decisions need to be referred to the shareholders, eg for decisions with a liability or cost in excess of a set amount.

If the shareholders want these types of rights in relation to decisions, but a shareholders agreement has not been entered into or has not been drafted specifically to cover off on this type of concern, then the company could make decisions that are not in line with the intentions of the shareholders.

There could be various requirements for different financial decisions or contributions, so that in certain circumstances unanimous agreement is required, whereas in other cases agreement by a lower percentage of shareholders is needed. This type of clause needs to be well considered by the shareholders to provide the involvement and protection they may be seeking.

7. Capital

There is more than one circumstance in which capital investment becomes a consideration for a company.

Where there is a start-up company, it will usually seek initial funding, which is generally as cash in exchange for the issue of shares. However, it is important to remember that not all shareholders provide cash as consideration for shares. There are other reasons for the issue of shares, including the transfer of assets or intellectual property or the provision of professional services integral to the company.

Companies also often require continued funding to support the company’s business and operations. The type of funding a company may require moving forward will depend on the circumstances of the company, however two common forms are cash in exchange for shares and security to allow for bank finance.

The options available for continued funding arrangements would be best set out in a shareholders agreement, so that when the company requires the funding all shareholders know and have agreed to either the process or the commitment they will need to make.

8. Issuing or Transferring Shares

A company’s constitution often details the process for issuing or transferring shares. Depending on the provisions included in the constitution together with the circumstances of the shareholders involved, it may be that the process needs to be further set out, or additional circumstances may need to be provided for in a shareholders agreement.

It is important to set out the process for issuing, transferring and valuing shares, so that the company avoids potential disputes and so that shareholders are aware of the process and can consider any risks.

9. Dispute Resolution

One of the main advantages of a shareholders agreement is to include a process to resolve a deadlock or dispute between shareholders. The risk of not doing this, is that the company and the shareholders may be left without any option but to apply to a Court for resolution, which process is time consuming and costly.

There are many different options with respect to how such a dispute can be resolved, and these would need to be properly considered and explained to the shareholders before a binding method is agreed upon and set out in the shareholders agreement.

Often dispute resolution provisions are a staged process, providing initially either for the parties to meet and act reasonably to resolve the matter or otherwise for non-binding mediation to be conducted by an independent party, so as to enable the shareholders to resolve the matter amicably.

Failing agreement between the parties through the above processes it may be that the shareholders agreement then enables an application to a Court, or provides for binding arbitration – so as to keep the contents of any dispute outside of the public arena. There are pros and cons to both proceeding to Court or arbitration, and these should be explained to the shareholders before a process is agreed upon.

10. Consistency with Constitution

It is important that any shareholders agreement is drafted with careful consideration of the matters that are addressed within the company’s constitution, so that the two documents governing the company’s affairs and the relationship between the shareholders are not inconsistent with each other. An inconsistency can lead to a dispute, the avoidance of which is the very purpose of entering into a shareholders agreement.

The above include just some of the common risks associated with shareholders agreements. This summary is not exhaustive and the actual terms and consideration to be included by shareholders in a shareholders agreement will depend on the nature of the business venture and the structure of the company – specific advice should be sought in all circumstances.

For more information on this update and shareholders agreements please contact partner Emma Leys on (08) 9321 3755.

The information published on this website is of a general nature and should not be construed as legal advice. Whilst we aim to provide timely, relevant and accurate information, the law may change and circumstances may differ. You should not therefore act in reliance on it without first obtaining specific legal advice.