Shareholders’ agreements demystified

Sahill MerchantA number of people have been asking me in recent times about the merits of a shareholders’ agreement (SA).


The questions have been coming from both new start-up types as well as more established entrepreneurs running good sized businesses.


It has reminded me that many people don’t really understand what an SA does, how it differs from a company’s constitution, and whether they in fact need one.


Let’s be honest – this is really boring dry stuff. Entrepreneurs want to get on with the job rather than think through this drivel.


Most of us will never have to consider these issues once the lawyers charge us the earth to set all of this up for us.


However, when things go really wrong, or often when things go really right, your SA can become the most important piece of paper in your life.


What are the roles of various documents?


Let me say from the outset that this topic is legal in nature and I am not a lawyer. These are my opinions and you need to get proper legal advice.


Good, my professional indemnity insurers are now happy. However, I have dealt with my fair share of issues arising from these types of documents, and perhaps my experiences might prove useful.


A constitution covers how the company is governed. It normally sets out the rules relating to company directors and the board, as well as their obligations towards shareholders.


Importantly, it also covers the scope of their authority, including the ability, constraints and processes around raising new capital, and the rights and obligations attached to that capital.


Most companies don’t actually need a constitution and can instead use what are called replaceable rules.


You can check out the ASIC website for more details if you feel so inclined.


An SA is a contract between shareholders and the company, which covers the rights and obligations of shareholders among themselves and with regards to the company.


As an example, the pre-emptive rights process relating to issuing new capital (where existing shareholders get first dibs on buying new shares) should be in the constitution, while the pre-emptive rights process for when an existing shareholder wants to sell their current shares (and first must offer them to other existing shareholders) would sit in an SA.


The pre-emptive process may be the same, but the parties involved (company-shareholders versus shareholders-shareholders) are different.


Some lawyers think that the terms of an SA can be incorporated into a constitution, allowing you to have only one governing document.


I initially went down this path, only to find (after wasting money on legal fees) that things became too complicated and it was easier to split issues across both a constitution and an SA.


While there will inevitably be overlaps in the scope of both documents, it is quite normal for an SA to say that it trumps the constitution if there is a conflict between them.


An example of such a conflict might be where a constitution gives directors a right to raise new capital by a simple majority vote, only for the SA to nominate a particular shareholder as having a right to appoint a director, and creating the need for a special majority (which includes that director) in order to raise new capital.


In this scenario, a single director could potentially block the raise of new capital, regardless of what the constitution says.


So, do I need a shareholders’ agreement?


I recently sat down with seven very successful entrepreneurs. Two of them had SAs, one is looking to create one, and the others couldn’t care a toss.


To state the bleeding obvious, an SA is only relevant if you have shareholders. If you run a small family business or don’t have the need for external capital, an SA might not be relevant.


An SA is particularly useful where you are looking to raise outside equity finance, or where your business involves a number of partners who all have some stake in the company.


An SA can cover all sorts of questions, but here are a few of the more typical ones:


  • How can shareholders sell shares? Does first right of refusal go to existing shareholders and in what proportion (Pre-emptive rights)
  • Can shareholders transfer shares amongst related parties? (Permitted transfers)
  • What happens if the company receives an acquisition offer but one shareholder wants to block the sale? (Drag rights)
  • What happens if larger shareholders organise an exit for themselves but not for the smaller shareholders? (Tag rights)
  • How are disputes between shareholders dealt with?
  • Are there any restrictions on the actions of the Founders?


If these are issues that might be relevant for your business, then you might do well to have an SA.


My one big learning, which is a topic for another day, is that over the twisting journey that typifies most entrepreneurial ventures, visibility of the future (especially as it relates to shareholders and their relationships with each other) is almost non-existent.


Even the best drafted SA will have ambiguity and room for interpretation.


Yes, this is a very dry subject. But it’s funny just how often entrepreneurs spend hours pouring over these documents, or worse still, wishing they had spent more time thinking about them before they became the bane of their existence.


Sahil Merchant founded Mag Nation, a retail chain specialising in mainstream and niche magazines, in 2005. Prior to this, he worked for management consultancy McKinsey & Company and spent a year working at the World Economic Forum. He recently exited Mag Nation and now advises companies on how to embed ‘consumer-centricity’ into the way they work. He writes about entrepreneurship here and Tweets here.


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