Why Have a Shareholders’ Agreement?.

No, it doesn’t, and the following points need to be remembered:

1 Changing the Constitution

The constitution of a company comprises its Memorandum of Association (effectively the charter which describes what the company can do) and its Articles of Association (this is the rule book for the company’s internal affairs and decision making).

A change in the constitution will generally need the support of shareholders who hold 75% of the voting share capital; this is the percentage of the votes needed to pass a special resolution.

2 Issuing of New Shares

Before new shares are issued the authorised share capital of the company may need to be increased and the Board will also need authority to issue the shares (Section 80 Companies Act 1985).

Under the general law (Section 89 Companies Act 1985) new shares must first be offered for 21 days to the existing shareholders pro rata to their shareholdings (a so-called rights issue). This general requirement can be waived for any proposed share issue by the passing by shareholders of a special resolution: for a special resolution to be passed those holding 75% of the votes cast must generally vote in its favour.

It is common for the Articles of Association of a private company to exclude this general requirement and a minority shareholder may want to remove the exclusion.

3 Winding-up the Company

A resolution to wind-up the company will need the support of shareholders who hold 75% of the voting share capital; this is needed to pass an extraordinary resolution.

4 Buy-back of Shares

A company is allowed to buy-back its shares but needs the authority of a special resolution (75% shareholder support).

The answer to this question is ‘perhaps’.

The reason for wanting a Shareholders’ Agreement will generally be to assert veto rights: so that contrary to the general law the powers of the Board to run the business (or the shareholders to exercise their own power – see below) are curtailed.

This may be fine in legal theory but the commercial context of the business of the Company must first be understood.

A business that will need new funding may be crucially dependent on a minority investor regardless of the percentage of ordinary shares initially held. An astute investor may also have loaned money (rather than just invested share capital) and that loan may have become repayable with the result that the investor is in a very strong position commercially: he could require the winding-up of the company so that his loan can be repaid. The business may also be critically dependent on the business knowledge and skills and client relationships of a single Director. The exercise of a legal right to dismiss such a person may in practice be impossible without causing irreparable harm to the business.

The shareholders (and their advisers) must first understand these commercial and economic realities before deciding whether a Shareholders’ Agreement is needed.

If I hold 75% of the votes, Can i insert a drag along provision when I choose to sell?

Any change to the Articles by special resolution must be exercised in the best interests of the company. Case law has established that a change to the Articles, to insert a compulsory acquisition provision, may be challenged in the Courts under this rule.

After all, buying someone out against his wishes runs counter to the general rules on ownership: the owner decides when he sells. Indeed, the Companies Act procedures include the right for the minority to apply to the Court to stop the procedure. It is best, therefore, to insert such provisions in the Articles before the minority shareholder acquires his shares.

A tag along right is the right of a minority shareholder to block the sale of a 50.1% interest unless a like offer has first been made for the 49.9% interest.

Generally, a majority shareholder will be happy to concede the inclusion of a tag along right perhaps as a quid pro quo to the drag along.

Care must be taken though in the framing of the tag along right. From the majority shareholder’s perspective, it should be the right to insist only on a like for like offer. So, the minority should not be able to insist on cash if the majority offer is one in shares and if the offer is of deferred consideration (or an earn out) the tag should be similarly limited.

A complex area can be the business which is to be jointly owned 50/50 by two shareholders.

There may be sound commercial reasons (see previous section) which dictate that it would be “better” for one of the partners to have a controlling interest. This could be achieved by the holding of one extra share or by that person’s appointment of an extra Director to represent his interests, or to be appointed as Chairman of the Board. A chairman has generally had a second (or casting) vote in the event of equal votes on any issue. For companies incorporated after 1 October 2007 this is no longer permitted.

Where 50/50 ownership is commercially right then a “deadlock structure” may achieve rough justice. This subject is covered more fully below.

Two other key provisions of company law should be remembered by all shareholders:

1 Secret Profits

Directors have very strict fiduciary duties and if they make a secret profit (e.g., by diverting a contract or business to themselves) they can be made to hand over that profit.

2 Unfair Prejudice (Section 994 Companies Act 2006)

The general law provides protection for a minority shareholder against the majority shareholders acting in an unfair manner.

Conduct covered might include:

• Paying excessive Directors’ remuneration
• Not paying dividends if the financial performance would justify it.
• Issuing shares for the purpose of diluting a minority shareholder’s interest.
• Terminating a director’s employment in a quasi-partnership company.
• Buying or selling assets from or to the Directors at an overvalue/undervalue.
• Failing to follow the constitution.

These are just examples of conduct of which the minority may complain.

The Court has very wide powers in relation to cases of unfair prejudice but the most usual is an order for the shares of the outgoing shareholder to be bought at fair value. Injunctions to restrain unlawful conduct may also be available.

The existence of these remedies can act as a powerful weapon for the minority shareholder albeit generally only for those with the financial resources to assert their legal rights.

If I am a controlling shareholder, what does all this mean?

The voting thresholds described above need to be borne in mind when shares are being allocated or issued.

If a founder allows someone to obtain a 10.1% shareholding, he may be blocked from selling the company: a buyer may not be interested in less than a 100% acquisition.

The existence of the unfair prejudice protection also means that the majority shareholder must be careful not to act unfairly: if he does the minority shareholder may end up with the right to require that his shares be bought at fair value as determined by an independent accountant. This may be much more than the majority shareholder wants or is able to afford.

First of all they do not have to be included. The Articles can either allow free transferability (those of a company whose shares are publicly traded must allow this) or give the Directors a veto on transfers to persons of whom they do not approve.

Secondly, where they are included certain “permitted transfers” may be allowed outside those pre-emption provisions. In addition to drag and tag along transfers “permitted transfers” may include those to family members or perhaps, in the case of founders, transfers between founders.

Where family transfers are permitted but buy-back rights are included in relation to the shares of leavers, the Articles will generally apply the buy-back to the family-held shares too.

What about valuations on share transfers?

There are two alternatives. Either the seller is allowed to specify his price, or the seller must agree the price with the Board failing which a valuer will be engaged.

In the case of buybacks (or compulsory transfers) there is really no alternative to using a valuer in the event the price cannot be agreed with the Board.

Historically the Articles have generally provided for an Auditors’ valuation although the well-advised minority shareholder has tried to secure valuation by an independent accountant.

Except for Small and Medium-Sized Enterprises (i.e., those that qualify to file abbreviated accounts at Companies House) an April 2005 ethical guideline means that Auditors will generally not be able to undertake such valuations.

What are Russian Roulette clauses (or Put/Call Articles)?

This is a mechanism sometimes included in the Articles of a company owned 50/50 to act as a deadlock breaker. They work on the basis that if there is a deadlock (e.g., evidenced by the failure to pass a resolution at two consecutive Board Meetings) the deadlock breaker can be triggered.

Either party can offer to sell his shares at a price specified by him and, if the second party does not agree to buy, he must sell at the same price.

Such provisions may sound fair and may produce a rough form of justice for two corporations with equal buying power. However, where one party is (or becomes) impecunious the provision may allow the financially stronger to buy the shares of the weaker at a considerable undervalue if he cannot raise the funds to buy.