Key ways to protect yourself in a shareholder agreement

The starting point in terms of shareholder protections will always be whether you are a minority shareholder. If so, you ought to negotiate hard for protections in either a shareholder agreement or by changing the standard company 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 but key issues to consider to protect yourself as a shareholder in most small to medium size businesses : -

• Clauses to force compulsory transfer of shares - If an employee director stops working for the company do you want that person keeping the shares?  Retaining shares is often not in the employer’s nor the remaining shareholders’ interests.  But, without a shareholders agreement forcing the transfer of shares the ex-employee or director will be allowed to retain shares indefinitely.
• Share valuation mechanisms - In a shareholders agreement there can be a variety of formulas for share valuation. The benefit of share valuation clauses is they minimise the risk of shareholder disputes. The most common disputes arise over the value shareholders can demand for their shares if they either want to exit or are forced to transfer shares under a compulsory transfer provision.
• Anti-blocking - To stop a shareholder blocking investment or sale because a shareholder can otherwise refuse to sell his shares even if other shareholders think the sale is a good deal. This risk can be removed with a shareholders agreement using 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 speeded up via the shareholders agreement. In practice if a director is not performing, delay in removing him can be commercially damaging to the business.
• Enhanced control and limitations on director powers - It generally pays to have considered and to have documented in the shareholders agreement the position on whether directors are required to be actively involved in the running of the company and practical issues such as who determines salary and bonuses and whether there are there certain actions the shareholders need a power to veto?  There will be no veto powers unless you have included them specifically in the shareholders agreement (or the articles but this is then public).
• 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 weigh up preserving capital against using new share capital for funding.
• Restrictive shareholder covenants on exit - A shareholder does not owe any fiduciary duties to other shareholders.  This means that if you do not build into a shareholder agreement restrictions, a shareholder may use knowledge and contacts gained to directly compete via another company. A way to prevent this is to include restrictive covenants on the shareholder in the shareholders agreement.The length of time after ceasing to be a shareholder that the restriction can apply does have to match the business needs.  But periods of up to 2 years are not uncommon.  Different restrictions can last for different amounts of time. We can talk to you have what would be suitable 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(s) can call on another shareholder to buy more 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 force a shareholder(s) to sell  shares. Like a call option, this option is usually subject to certain conditions. The key condition here is usually price, the fall back being fair value determined by an expert. We can advise on valuing shares in private companies.