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Protection of shareholdings, articles and shareholders agreements

The arrangements for share capital, rights, obligations and protections for shareholders are the constitution of the company.   Adequate protection of shareholders and the business are the foundations for growth in value of the shareholding. Shareholder rights are set out in the articles of association and shareholder agreements.  

Based on our experience in advising private companies on how to structure their articles and shareholders agreements and knowing what investors will be looking for, we have prepared a summary of how share capital can be protected under the articles of association and shareholder agreement. 

Outline on protection of shareholdings:

back to topDistinction between articles of association and shareholder agreements

One of the key distinctions between shareholder rights preserved under the articles of association and those preserved under a shareholders agreement is that the company's articles of association are a public record filed at Companies House.  A shareholders agreement is a private document entered into between the company and its shareholders.  Investors are often keen to ensure that details of their investment is not public and require rights and obligations to be set out in a shareholders agreement.

Share capital protection issues to consider for articles of association and shareholders agreements:

The articles of association will set out the rights and obligations attaching to the shares.  Companies can implement a number of different classes of shares with separate rights and obligations relating to matters such as voting, dividend, transfer and disposal of shares and obligations for funding.

back to topBoard of directors - shareholder considerations

The value of share capital depends on a variety of factors one of which is the composition and power of the board.  Shareholders should consider: 

back to topShareholder meetings

Shareholder rights are an important part of the company's constitution. Various rights are conferred under the Companies Act and by other statutes. A shareholders agreement or the articles of association can add to these rights and in some cases vary the statutory rights:

Share capital protection issues to consider for articles of association and shareholders agreements:

  • Is a quorum for shareholder meetings required?
  • If so, is the quorum to be based on numbers of shareholders or numbers of shares held?
  • What will be the quorum?
  • Consider if there needs to be a quorum if 51% of holders of voting shares can pass an ordinary resolution and 75% of holders of voting shares can pass a special resolution
  • Should the voting for passing of shareholder resolutions be - simple majority of 51%+ or special majority of 75%+

back to topTransfer of shares

Most private companies want to ensure shares do not end up in the hands of undesired third parties. It is usual to include quite detailed share transfer provisions in a shareholders agreement or the articles of association.

Share capital protection issues to consider for articles of association and shareholders agreements:

  • Will transfers of part of a shareholding (as opposed to the whole of the shareholding only) be permitted?
  • If a shareholder wishes to transfer his shares, should the Company have ‘first refusal' to buy back the shares if it is in the position to do so?
  • Will there be restrictions on shareholders transferring shares?
  • With pre-emption provisions, a transfer of shares cannot occur unless the transferor invites current shareholders to purchase the shares in question on a pro rata basis to their current shareholding in the Company.
  • Where pre emption provisions apply, will a shareholder wishing to offer shares for sale be required to stipulate the price of the shares which he wants to sell at or should the shares only be offered at fair value, as agreed or determined by an expert?
  • Will shareholders (who are individuals) be permitted to transfer to a privileged relation (spouse/widow or lineal descendants) or to a family trust?
  • Will shareholders (who are corporate entities) be permitted to make intra-group transfers regardless of pre-emption?
  • Will shares be capable of transfer to an employee benefit trust EBTs or pursuant to employee share schemes or EMI options?

If share rights are set out in a shareholders agreement, should any new shareholder (other than a purchaser of 100% of the shares) be bound by the shareholders agreement.  If share rights are set out in the articles of association new shareholders will be bound unless the articles are amended.

Drag Along (‘Bring Along')

Drag Along provisions are useful to protect majority shareholders and enable third party purchasers to take full control of a company. It is recommended especially for private companies and owner managed businesses that drag along rights are included in the articles of association or shareholders agreement as such rights can make the company more marketable upon sale.

Under a Drag Along provision where one shareholder or a number of shareholders acting together and holding a certain % of shares sells shares to a third party, the remaining minority shareholder(s) must also sell their shares on (substantially) the same terms to the third party.

Tag Along (‘Piggy Back') Tag Along

Tag Along provisions are useful to protect minority shareholders. Under a "tag along" provision, a shareholder, or a number of shareholders acting together, holding a certain % of shares cannot sell theirs shares to a third party unless it procures that the third party buyer buys the shares of the other shareholders at the same price. Tag along rights as well as drag along rights are frequently included in articles of association or a shareholders agreement.

Compulsory sales of shares

There are a wide variety of reasons why shareholders need or want to dispose of shares. In addition there are circumstances where a company will want to force the sale of shares - known as compulsory sales. Any shareholders agreement or the articles of association should deal with circumstances where sales must be sold and if shares have to be sold as less than market value, for example in the case of "bad leavers" then such requirements must be set out in the shareholders agreement.

Typical scenarios to cover in the articles or shareholders agreement include: 

  • Death of the shareholder
  • Mental incapacity of a shareholder
  • Where an individual shareholder becomes bankrupt
  • Where a corporate shareholder goes into liquidation
  • Where there is a change of control of a corporate shareholder
  • Where a shareholder committing a material breach of the shareholder agreement
  • Where a shareholder being an employee or director leaves the employment of the company

Fair value of the shares

The value of share capital is dependant upon the price at which shares can be sold.  In the case where there is a share disposal of the entire issued share capital the price is set by the buyer.  However in cases whether part of a shareholding is disposed of the price is often negotiated.  Articles of association and shareholder agreements usually provide some indication as to how the shares should be valued in any given event - fair value.

Share capital protection issues to consider for articles of association and shareholders agreements:

Is fair value for shares to be determined:-

  • By agreement of the buyer and seller; and
  • Failing agreement to be determined by independent accountants or share valuation experts?
  • Should detailed provisions relating to the calculation be included?
  • Is there to be a discount for minority share holdings?

back to topShareholder approvals

The Companies Act sets out certain transactions which require shareholder approval.  If a special resolution is required at least 75% of the shareholders must approve the resolution.  If an ordinary resolution is required at least 51% of shareholders must approve the resolution. 

Ordinary resolutions and special resolutions

Companies can increase the percentage of shareholder approval required for activities requiring an ordinary resolution under the Companies Act providing that specific provision is made in the articles of association or shareholders agreement.  The percentage of shareholder approval required for activities requiring a special resolution under the Companies Act can be increased to more than 75% by specific provisions included in the articles of association or shareholders agreement.  Companies and their shareholders and directors need to consider:

  • Will the required level of approval be unanimous?
  • Will the required level of approval be a majority of shareholder holding the required percentage of shares?
  • What percentage of director approval is required?

Activities which may special shareholder approval under the shareholders agreement or articles of association?

  • Issue of new shares?
  • Should there be pre emption on any further issue of shares?
  • Variation of rights of shares?
  • Transfer of shares within a specified period of formation?
  • Admission of new shareholder?
  • Alteration of constitutional documents?
  • Formation of subsidiaries?
  • Loans/borrowing/mortgages/guarantees above specified limits?
  • Strategic business plans/operating budget?
  • Capital expenditure commitments above a certain level?
  • Declaration of dividends?
  • Granting of any loans?
  • Geographical expansion?
  • Pricing/trading terms?
  • Commencing/settling litigation?
  • Appointment or removal of auditors?
  • Alteration of accounting policies?
  • Any merger, joint venture or material cooperation agreement with third parties?
  • Acquisition/disposal of the whole or a material part of the assets or business?
  • Entry into of other material contracts?
  • Licensing of Intellectual Property rights?
  • Arrangements upon dissolution; distribution of assets; outstanding contracts at the point of termination?
  • Any petition or resolution for winding up?
  • Change of company name?
  • Agreements outside the ordinary scope of the business of the company

Restrictive covenants

Shareholders and investors may wish to preserve the value of share capital by placing restrictions on shareholders competing with the company both whilst they are shareholders, and once they are no longer shareholders.  Restrictions are usually placed on shareholders who are also employees or directors of the company.  Restrictions can be included in the articles of association or shareholders agreement. 

The directors' service agreements and employment contracts will also usually contain restrictions.  Under current UK employment law restrictions contained in directors' service agreements or employment contracts will be harder to enforce than restrictions contained in the articles of association or shareholders agreement.

Share capital protection issues to consider for articles of association and shareholders agreements:

  • Include prohibition on carrying on a business in the UK the same as or competing with that of the company?
  • Include prohibition on soliciting or endeavouring to entice away from or discourage from dealing with the company any person who was a customer or potential customer?
  • Include prohibition on soliciting or endeavouring to entice away from the company an employee, agent, independent contractor or consultant of the company?
  • Include a prohibition on revealing any confidential information regarding the company?
  • For what period should the restrictions be in place after a shareholder has ceased to be a shareholder in the company?

back to topDistribution of profit

Integral to the question of share capital and protection of shareholder rights is the question of how dividends are to be paid and profits distributed.  Many companies implement different classes of shares to enable dividends to be voted at different rates to different shareholders.  Different classes of shares and share rights attaching to each separate class must be dealt with in the articles of association. 

back to topDeadlock provisions

Shareholders need to be aware of the provisions for dealing with deadlock between either the board of directors or the shareholders.  Many shareholder resolutions require the approval of at least 51% of shareholders holding voting shares which means in some companies, depending on the shareholder population, deadlock can arise.  Share capital value is reduced if the company is in deadlock. 

Dispute resolution provisions can avoid the very costly option of shareholder litigation.

Share capital protection issues to consider for articles of association and shareholders agreements:

  • Where there is a deadlock/inability to agree on material issues at board level, will the Chairman have the casting vote?
  • Will independent non-executive directors be appointed to decide the outcome of a management deadlock?
  • Will there be a specific right, after a period, to call for liquidation of the company?
  • Will there be a specific right to serve a transfer notice with "Russian Roulette" formula? Under Russian Roulette the one party must either buy the other party's shares or sell its own.

back to topInformation to shareholders

The articles of association but more commonly the shareholders agreement can provide for specific provisions about what information is to be made available to shareholders. This is often a requirement where there are external investors wishing to protect their shareholding.  Typical information which the articles of association or shareholders agreement can require includes the requirement for a shareholder to receive: 

  • Annual audited accounts?
  • Monthly management accounts?
  • Cash flow reports/forecasts?
  • Draft annual budget?
  • Immediate written details of any offer made to acquire shares?
  • Annual presentation of business plan?

Funding obligations of shareholders

Shareholder rights and protections include the question of whether a shareholder will be obliged to provide future funding or invited to partake in new share issues.

Share capital protection issues to consider for articles of association and shareholders agreements:

  • Are shareholders be obliged to make further investments in the company?
  • Is further investment, through new share issues or via loan?
  • On what terms will shareholders be required to fund the company?
  • Will the investment/funding obligations be borne pro rata to the shares held by the shareholders?
  • Will shareholders be expected to provide personal guarantees for the company's liabilities (for example, bank overdrafts)?

Conclusion

In summary, shareholder rights and share capital requirements are dealt with in the articles of association of the company and or the shareholders agreement.  Shares can carry different rights such as voting or dividend rights and the rights attaching to transfer and disposal can vary between the different classes of shares.

Articles of association and shareholder agreements are necessary to protect shareholder rights and to set out the terms on which the shares are held.  Issues connected to the taxation of shareholders should always be considered.

This paper is designed to provide a summary of the issues addressed. Therefore, it is not intended as a detailed commentary on the relevant law and any comments made should not be acted upon without first taking specific legal advice.

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