Key ways to protect yourself in a shareholder agreement

The starting point when considering shareholder protections will always be whether you are a minority shareholder. If so, you should negotiate carefully for appropriate protections, either through a shareholder agreement or by amending the company’s standard articles of association.

How to protect yourself in a shareholder agreement

Our general overview of minority shareholder rights may be of interest, but below are some of the less obvious yet important issues to consider when protecting your position as a shareholder in most small to medium-sized businesses:

• Clauses to force compulsory transfer of shares - If an employee director stops working for the company do you want that person to retain their shares?  Retaining shares is often not in the interests of the employer nor the remaining shareholders. However, without a shareholders agreement requiring the transfer of shares the former employee or director may be allowed to retain their shares indefinitely.
• Share valuation mechanisms - A shareholders agreement can contain different mechanisms for valuing shares. The benefit of share valuation clauses is that they minimise the risk of shareholder disputes. The most common disputes arise over the value that a shareholder can receive for their shares, whether they want to exit or are required to transfer shares under a compulsory transfer provision.
• Anti-blocking - A shareholder may otherwise be able to block an investment or sale by refusing to sell their shares, even where the other shareholders consider the proposed transaction to be in the company’s interests. This risk can be addressed through a shareholders agreement containing drag along provisions,
• Clauses and procedure to remove a director -  You may find it impossible, or at best difficult, to remove directors if you have not secured this power in the shareholders agreement. The process under the Companies Act can be supplemented or facilitated through appropriate provisions in the shareholders agreement. In practice, if a director is not performing, delays in removing them can be commercially damaging to the business.
• Enhanced control and limitations on director powers - It generally pays to consider and document in the shareholders agreement whether directors are required to be actively involved in running the company, together with practical issues such as who determines salary and bonuses and whether there are certain actions over which shareholders should have a veto. There will be no veto powers unless you have included them specifically in the shareholders agreement or, where appropriate, the articles of association. However, provisions in the articles are publicly available.
• Anti-dilution protections - Your investment can be diluted without your approval if you have not taken steps to protect your position contractually with the other shareholders. Directors and shareholders need to consider dilution carefully and balance the protection of existing shareholders against the need to issue new share capital to fund the business.
• Restrictive shareholder covenants on exit - A shareholder does not owe any fiduciary duties to other shareholders.  This means that, without appropriate restrictions in a shareholders agreement, a shareholder may use knowledge and contacts gained through the business to compete directly through another company. One way to address this is to include restrictive covenants that apply when a shareholder exits the business. The length of time for which the restriction can apply should reflect the legitimate needs of the business. Periods of up to 2 years are not uncommon, although different restrictions can apply for different periods. We can advise you on what may be appropriate for your business.

Put and call options over shares

A shareholders agreement gives the parties flexibility to create options over shares. The common options include :

• Call option for the company to issue shares – here, a shareholder is given the option to “call” on the company to issue further shares, i.e. create more shares for the benefit of the shareholder. Another variation of a call option is where the company or a shareholder can require another shareholder to sell or transfer shares.  The circumstances in which the call can be exercised are set out in the shareholders’ agreement.
• Put option over shares held – with a put option, a shareholder or the company can require a shareholder to sell their shares. Like a call option, this option is usually subject to certain conditions. The key condition is usually price, with fair value determined by an expert as a fallback where the parties cannot agree. We can advise on valuing shares in private companies.