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As part of an external fund raise, a shareholders’ agreement will usually be insisted upon by the investors to limit the power of the founders

Introduction

Many SME founders at some point will be met with the question of whether a shareholders’ agreement is needed for their company.

The default position is that a company is governed by its articles. In the early stages of an SME’s life, standard articles will likely be sufficient to govern the rights of the shareholders of the company. At the most basic level, the articles will ordinarily permit a simple majority of the shareholders to appoint the directors of the company. It is then left to the directors to manage the company on a day-to-day basis.

It is not uncommon for founders to wear multiple hats as both a majority or sole shareholder and a director of their SME company.

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How to avoid a dispute

Things start to become more complex when multiple shareholders are introduced. This could be in the context of new significant minority shareholders investing and/or participating in the company or where a joint venture is formed, for example between two shareholders both holding 50% of the shares in the company.

In such cases, the standard position under the articles whereby a simple majority of the shareholders can solely and ultimately control the direction of the company may not be workable. We will briefly explore both scenarios described above.

Introduction of new significant minority shareholders

This could be the result of attracting new external investors to the company, for example as part of a Series A funding round. Alternatively, a founder may wish to go into partnership with an established and complementary operator, customer or distributor and as part of such deal, grant such partner a minority shareholding in the company.

It will not be unusual for such potential new shareholders to insist on a shareholders’ agreement as a condition of their investment and/or participation. The main purpose of the shareholders’ agreement would be to limit the power of the majority shareholders (i.e. the founders/co-founders) and ensure the new shareholders have visibility over, and have a say, in the running of the company.

To that end, the new shareholders may request the right to appoint a Company director and the right to veto certain significant corporate, commercial and operational actions. The extent of these veto rights will be a matter of negotiation but will usually be a function of the size of the minority shareholding. SME founders need to think carefully on the level of control they are willing to cede to such new incoming shareholders.

To assist with scrutinising the business, the new shareholders will want to formalise regular management reporting with financial and other updates being provided to the shareholders by the management team typically on a monthly or quarterly basis. Board meetings may also be formally diarised with perhaps 4-6 happening over the course of a calendar year.

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In a 50-50 company, a main issue will be how to resolve a strategic deadlock and ultimately an orderly divorce procedure

Founders may also be faced with other requests including:

  • Non-compete restrictive covenants should they leave the Company
  • a minimum holding period for their shares
  • a mechanism to forfeit some or all of their shares (or convert these into worthless shares) should they exit the company within the minimum holding period
  • anti-dilution protections whereby if a subsequent equity raise is done at a lower share valuation, the minority investor will be granted additional shares at no additional cost
  • general restrictions on transferring shares (including rights of pre-emptions for the new investors and/or other shareholders)
  • drag and tag along rights

Some of these provisions may end up being documented within an amended set of articles rather than in the shareholders agreement, but all of the above issues will often form part of the same package to be negotiated.

Joint ventures

When it comes to a 50-50 joint venture scenario, the shareholder dynamics will be different. Where both shareholders effectively have a right of veto on all company matters, an additional major issue to consider is how one resolves a deadlock.

It may be the two parties are able to agree a form of casting vote and/or delegated authority for one of the directors in relation to certain operational, financial and commercial decisions below a defined threshold.

Where this is not the case and for strategic matters such as raising outside equity or selling the company, if a deadlock cannot be resolved, ultimately a “divorce” procedure can be documented within a shareholders’ agreement, which results in one party buying out the other party.

One common mechanism is a “Russian roulette” procedure whereby each party has the right to make an offer to buy the other party’s shares for a certain valuation. The second party can either accept the offer or reverse it by buying out the first party’s shares for the same valuation (which the first party would be obliged to accept). Another mechanism involves both parties submitting “sealed” bids to a third party, with the party submitting the highest bid having the right to buy-out the other party.

Conclusion

This high-level article highlights a couple of common scenarios where an SME may need a shareholders’ agreement, as well as the issues that such an agreement may cover. In the context of raising equity from external investors, SME founders should ideally factor in the terms of a shareholders’ agreement and ensure they are confident that any loss of control that such an agreement may represent is more than offset by the financial and broader business support that the new investment will bring.

If you’d like help with a shareholders’ agreement, please get in touch.

Dan Chu - My Inhouse Lawyer
Written by Dan Chu
Principal at My Inhouse Lawyer

One of our values (Growth) is, in many ways, all about cultivating a growth mindset. We are passionate about learning, improving and evolving. We learn from each other, use the best know-how tools in the market and constantly look for ways to simplify. Lawskool is our way of sharing with you. It isn’t intended to be legal advice, rather to enlighten you to make smart business decisions day to day with the benefit of some of our insight. We hope you enjoy the experience. There are some really good ideas and tips coming from some of the best inhouse lawyers. Easy to read and practical. If there’s something you’d like us to write about or some feedback you wish to share, feel free to drop us a note. Equally, if it’s legal advice you’re after, then just give us a call on 0207 939 3959.

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