There are few ventures as exciting as starting a new business. However, bringing together the collective expertise of your team will inevitably result in disagreements, conflicts, and clashing visions. This is why a shareholder or partnership agreement must be an essential part of your business. Without an agreed-upon instrument to govern potential disputes, new businesses can often find themselves disintegrating right out of the gate. Below, we’ll cover some of the primary reasons no business should operate without a shareholder agreement.
In general, partners or investors have “free rein” when drafting their agreements, but it is always advisable to get it professionally drafted. A commercial lawyer is the best person to do this. It is advisable to tell the lawyer what shared understanding you and your partners already have and ensure this is the basis of your agreement. By considering the interests, concerns, and desires of each partner, you can ensure the dispute resolution process is carefully tailored to minimise hardship and ill-will. A well-drafted agreement will provide an incentive for partners to negotiate rather than litigate. All parties will know in advance what a formal dispute resolution will look like, hopefully sparing everyone the unnecessary distress and cost of a nasty dispute.
There is no right or wrong when it comes to drafting your agreement but below are some clauses that are often included.
- Process for admitting or terminating partners, directors or shareholders;
- Decisions that require unanimous resolution, such as a merger or acquisition;
- How is authority delegated and to whom, voting rights;
- Timing of partner or Directors meetings;
- Expectations of partners/directors, especially with respect to working hours, leave, outside commitments, setting of salaries etc.;
- Dividend policy – to ensure working capital is not depleted;
- Buy/Sell agreements and Key Man Insurance;
- Compulsory retirement.
This is a vital question future partners must ask one another: what shall we do when a dispute arises? Minor disputes are often resolved by one party “caving in” to the other parties wishes. If this occurs frequently enough resentment can build which can become destructive. Having well-established roles and responsibilities should eliminate most of these situations.
But what about a major dispute? Left unresolved, they can destroy the business, friendships and cause unnecessary distress. A shareholder agreement should set out a process for resolving disputes – with the final step being that a third party is brought in to decide and whose decision is binding.
What will you do if a partner suffers incapacity or death? Or the business relationship degrades beyond the point of repair? In the early stages of establishing a business, the impact of these events is seldom considered. Yet it is at that time, when everyone is friendly and ‘level headed’, that reaching agreement on a way to deal with these circumstances is most likely. Not having a way of addressing unexpected crises can often result in serious damage to your business.
Your agreement should explain how such a situation is to be handled, who can buy or sell a financial interest in the business, and under what terms and conditions. The biggest cause of dispute in these situations is determining what is a ‘fair’ value. Your agreement should have an agreed valuation method or note that a specified a third party will provide a valuation and that all partners agree to accept their valuation.
A key strength of many agreements is the inclusion of trigger events. Agreement clauses can be triggered automatically, binding all interested parties to the pre-negotiated resolution with minimal friction.
For example, agreements often contain “exit” clauses in the event of an irreparable dispute. One example of this is the “shotgun clause” (or “Texas Shootout“). It is typically triggered when bickering shareholders cannot agree and allows for a shareholder to offer a specific price per share for the other shareholder’s share; the other shareholder(s) must then either accept the offer or buy the offering shareholder’s shares at that price per share.
Other Buyout Provisions
Another powerful clause is the “Drag Along” provision. This allows a majority shareholder to force the sale of company interests over the objection of minority members, assuming all aspects of the clause are satisfied. Minority members are often protected through provisions requiring, for example, identical terms of sale for all selling parties, or requiring a certain percentage of shareholder interests to agree before the clause can be executed.
To protect the minority shareholders, the drag along provision will usually require the majority shareholder(s) to ensure that the minority shareholder(s) is able to sell the shares on the same terms and conditions. Additionally, shareholders will often include “Right of First Refusal” protections in their agreements, allowing even minority shareholders some power in governing how and to whom shares will be dispensed. Clauses like the drag along ensure your business can respond quickly to new opportunities, circumstances, or disagreements without suffering a lengthy dispute process.
I have seen many bitter disputes that would have been avoided had the parties entered into a shareholder’s agreement in the beginning. They are the key to flexibility and stability of your business while minimising the risk of lengthy dispute resolution processes and financial loss. These are just a few examples of provisions that should be considered in an effective agreement. If you would like to know more about guarding the interests of yourself, your partners, and your business, contact us at proCFO.
About David Officen
David is the Founder and Managing Director of proCFO.
David combines an accounting and consulting background with commercial experience both as a manager for large commercial businesses and as the owner of private and family businesses.