The Startup Series | What are shareholders’ agreements and why should my business have one?

This is the third article in The Startup Series – a collection of short articles covering key concepts for early stage companies in Australia that are establishing a business or raising capital.

What are shareholders’ agreements and why should my business have one?

A shareholders’ agreement is a legally binding contract between some or all of the shareholders of a company (and usually the company itself) that governs how the business is owned, controlled and operated.

A shareholders’ agreement:

• sets out the rights, obligations and relationship between shareholders
• governs ownership, decision‑making and control of the company
• provides a framework for dealing with key events (e.g., disputes, exits and veto rights).

It is commonly described as a ‘rulebook’ for shareholders that anticipates issues and manages risk before disputes arise and operates alongside the Corporations Act 2001 (Cth) (Corporation Act) and the company’s constitution (if it has one).

While a shareholders’ agreement is not mandatory, it is strongly recommended for a company with more than one shareholder, particularly as the company scales and additional shareholders are added.

Here is what a shareholders’ agreement typically covers.

Board composition

Shareholders’ agreements will often:

• specify the minimum and maximum number of directors that will comprise the company’s board of directors (Board)
• provide that certain shareholders have the right to appoint (and remove) one or more directors.

In some cases, a shareholder will only retain the right to appoint and remove a director for so long as it holds a certain percentage of the company’s shares. In other cases, one or more classes of shares (e.g. Series A Preferred Shareholders) will have the right to appoint a director.

Shareholders who hold at least 10% of a company’s shares will often seek the right to appoint a director. This ensures they have a role in decision-making.

As an alternative to a director appointment right, some shareholders may seek the right to appoint a Board observer instead.

Decision-making and veto rights

Most shareholders’ agreements will provide that certain key decisions require the approval of a ‘super’ majority (or even unanimity) of the Board or shareholders.

For example, the shareholders’ agreement may provide that it cannot be amended unless 100% of the shareholders agree to the proposed amendments.

In other cases, certain key decisions may require the approval of one or more specific shareholders. This gives those shareholders a veto right over the company doing these things.

Veto rights can be the subject of considerable negotiation. In some cases, the list of matters requiring special approval can be voluminous.

It is important to strike a balance. The company’s management team needs freedom to run the company day to day. At the same time, the Board and shareholders must retain control over key decisions and actions.

Issuing and transferring shares

In Australia, a shareholders’ agreement will often provide that before any new shares are issued, the existing shareholders will have a pro-rata pre-emptive right to buy the shares before they can be offered to a third party. This right is mirrored in the Corporations Act 2001 (Cth), which provides (at section 254D) that before issuing shares of a particular class, a proprietary company must first offer them to the existing holders of shares of that class. As far as practicable, the number of shares offered to each shareholder must be in proportion to the number of shares of that class that they already hold. This provision will not apply where it has been displaced or modified by the company’s constitution or shareholders’ agreement.

Similarly, many shareholders’ agreements will provide that a shareholder can’t transfer some or all of its shares to another party unless that shareholder first offers the shares that it is proposing to transfer to the company’s other shareholders on a pro rata basis.

Tags and drags

A ‘tag right’ gives minority shareholders the ability to participate in a proposed sale of a block of shares on the same terms. In Australia, a tag right will often be triggered where one or more shareholders are proposing to sell more than 50% of a company’s shares to another party. If this occurs, the company’s other shareholders will have the right to sell their shares to the other party on the same terms (thereby ‘tagging along’ in the proposed transaction).

By contrast, a ‘drag right’ allows shareholders who propose to sell a significant percentage of shares to require remaining shareholders to sell on the same terms. This “drags” them along as part of the transaction. The threshold for exercising the drag in the Australian market varies, but it is typically a significant majority (e.g., 75% or more). In some shareholders’ agreements, the drag right is coupled with a requirement that one or more specified shareholders must be included in the selling group. This effectively gives those shareholders a veto right over a proposed exit event.

Good leavers and bad leavers

Leaver provisions are designed to regulate what happens when a shareholder exits the company.

‘Good leaver’ provisions:

• will typically apply where a shareholder who is employed or engaged by the company ceases their employment or engagement with the company
• will generally provide that the existing shareholder can be required to sell some or all of their shares for fair market value.

By contrast, ’bad leaver’ provisions typically apply where a shareholder takes some sort of action that may cause harm to the company (such as committing a material breach of the shareholders’ agreement). Where a bad leaver event occurs, the bad leaver will often be required to sell their shares at a discount to their fair market value. This penalises them for their conduct.

Dispute resolution and deadlocks

Dispute resolution provisions require the parties to a shareholders’ agreement to first seek to resolve any dispute under the shareholders’ agreement through one or more alternative dispute resolution mechanisms (e.g. mediation).

By contrast, deadlock mechanisms provide a mechanism for resolving decision making deadlocks at the Board and/or shareholder level (particularly in 50/50 joint ventures where this is more likely to occur).

Key takeaways

Shareholders’ agreements are an important tool for managing the operation of any company that has more than one shareholder.

For most Australian companies (particularly SMEs, joint ventures and startups), a shareholders’ agreement is:

• an important risk management document that helps prevent disputes and deadlock
• a governance tool clarifying control and decision-making
• a commercial protection mechanism that protects ownership and investment (e.g. through anti-dilution protections such as pre-emptive rights).

Without one, parties are generally left relying on:

• the Corporations Act replaceable rules
• a typically generic constitution, which rarely deals adequately with real-world disputes or exits.

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Authored by: 

Vaughan Petherbridge, Partner
Annabel Gray, Graduate