How to Create an Effective Shareholder’s Agreement?

Ashish M. Shaji

21 Nov, 2020

While setting up your business with others, if you seek more protection and confidence about your relationship with them in the future, then you must look to first draft a Shareholder’s Agreement (SHA). It is one of those indispensable legal documents that shall protect your business and your investment in the company. Some people will have it easy thinking nothing will go downwards in the future and may ignore creating the agreement; however, one must be prepared for the worst. If some unforeseen contingencies arise in the future, one may end up with absolutely nothing. Therefore a well-drafted Shareholder’s Agreement should be the priority lest shareholders complain later. This article sheds light on various aspects relating to the Shareholder’s Agreement, including its importance and key contents.

Meaning of Shareholder’s Agreement

As the name itself suggests, a Shareholder’s Agreement (SHA) is an agreement between the shareholders of a company. It describes their rights and obligations. The agreement can be between a particular class of shareholders or between all of them. It is a legal document that lays down the regulations upon which the company shall run. The agreement clearly defines the roles and responsibilities of the key players in a company. It lays down the foundation on which a company is built.

The SHA document sets out the details of a corporation in order to avoid any confusion in the future with respect to the rights of the shareholders. The main motive of the SHA is to safeguard the shareholder’s investment in the company and to institute a fair relationship amongst the shareholders. A detailed SHA contains the particulars about the ways of managing the business, handling disputes between the shareholders and responsibilities, and the advantages of each shareholder in the company.

Importance of a Shareholder’s Agreement

This agreement comes in handy to resolve any dispute between the shareholders and the company. One cannot take things for granted, and anything may go wrong at any time; therefore, owing to such uncertainty, the Shareholder’s Agreement helps not only in resolving the disputes but also facilitates a healthy relationship between the shareholders and the company. The agreement safeguards the investment made by the shareholders, and it enumerates the terms and regulations for the shareholders and any other party in the company.

The SHA must be regulated owing to the fact that all shareholders are not the same. It must be drafted knowing that every person is different, and thus their opinions on various matters would also be different. They may agree to some opinion or may not. It would be better if the agreement is put in place when the company is formed. This may lead to an understanding of the shareholder’s expectations of the business.

Having an SHA also helps in ensuring confidentiality in a business. The shareholder’s during the course of the business may have access to certain confidential information about the company. In order to ensure that such information is kept by the shareholders, an SHA with confidentiality provisions is the best way. The importance of the agreement can also be deduced by the protection that it grants to the investors who take a risk on their investment and to the minority shareholders by ensuring that certain decisions need the assent of all the shareholders. If a company doesn’t have an SHA, then the minority shareholders may have a little say in the functioning of the company. The control of the company may rest with one or two shareholders in that event. One being a minority shareholder and having an SHA will ensure that he or she has the right to say in the important decision of the company.

When should the Shareholder’s Agreement be set-up?

Generally, a Shareholder’s Agreement (SHA) can be set up at the beginning itself; that is when the company is formed and issues its first share. It can help to know that there is an element of common understanding between the shareholders about the expectations of the business. It can be expected that at that point, the shareholders may have a similar mind regarding what they offer and receive from the company. 

There may raise a situation where the investors may defer the discussion of SHA to complete setting up the business with an intention to discuss on a later date. However, the appropriate opportunity may not come due to other works related to the company, and even if they may discuss it later, it could happen that their expectations towards the business may have changed, thus making it difficult to agree with the terms of the agreement.

The opinion regarding the best time to set up the SHA may differ from person to person. Some would think that there is no so-called specific time and that it can be set up during the improvement of the company.

Key contents of the Shareholder’s Agreement

A Shareholder’s Agreement will directly affect the decisions made in a company; that’s why it must be well drafted. The management must work under the set guidelines of the SHA. There are some key inclusions that must be incorporated in an SHA. The key inclusions in the agreement are specified below.

• A Shareholder’s Agreement (SHA) is a business contract; therefore, all the shareholders must be named correctly. The name, address, and other relevant information of shareholders must be clearly mentioned in the agreement. The agreement shall also contain the names of officers of the business and the one who is going to manage shareholders.
• The agreement should be drafted in a way that outlines the responsibilities of the shareholders explicitly so that the business runs smoothly. The agreement must be specific about any action that the officers or shareholders may take in the name of the company. It shall act as a guide in case an issue comes up. One can go back to the agreement to understand what steps need to be taken to tackle the problem or the issue.
• Another key inclusion to be made in the agreement is regarding the voting rights of the shareholders. When the company is smaller, the shareholders may be the same, but as the business grows, there may be a diverse group of people who manage the company. The agreement shall establish the voting rights of the shareholders. It should mention the kind of vote that is necessary for the decision to be made as some decisions require only the majority of the shareholder’s while other decisions may require a higher percentage of majority vote for the decision to take effect. Therefore, the voting rights must be clearly laid down in the Shareholder’s Agreement.
• As the business grows, the company may take crucial decisions with respect to purchasing property or ways of paying back loans taken for business. The shareholder agreement can provide you protection against decisions taken by a few members of the company. The clearer the agreement, the easier it will be to make decisions.
• The SHA must be drafted in a way that includes all the aspects that you want the agreement to cover. It must include the terms and conditions applicable to change the original SHA. In order to change the original agreement, 100% of shareholders must agree. Thought it would be difficult to ensure all the shareholders agree on changes; therefore, the agreement must be made right at the beginning itself.
• When a business runs for years, there may come a time when the stocks may be sold or transferred to another shareholder. In such a situation to protect your share in the company, you can lay down the process and the restriction on such transfer in detail. The SHA may contain such a provision that regulates the transfer or sales. This would ensure that each shareholder can control their investment and protect them from any unwanted influence. With a clause in the agreement that restricts outside people from becoming the shareholders, you can regulate the transfer or sale.

By restricting who can purchase or inherit shares in a company, shareholders can be protected. You don’t want a situation where a new outside shareholder came in and purchased shares and created issues with existing shareholders.

• Further, the agreement should include the legal obligations and rights of the parties. The agreement should be successful, which lays down the rights and obligations of the parties to a contract and follows the same. The legal obligations must be in writing of the person who signs the agreement. However, it may not be possible to get rid of every single future dispute, but a well-drafted SHA can ensure that the disputes are settled in a civil manner.
• The agreement should contain an essential clause of buyout rights that specifies that in case a shareholder is incompetent due to certain events like death, disability, bankruptcy, or marital dissolution, then the existing shareholder or the company can buy the shares of that shareholder. It may further contain a clause known as expulsion wherein the existing shareholders may expel an undesirable shareholder and may acquire their shares.
• Another critical content of the Shareholder’s Agreement is the financial responsibilities of the shareholders. When you have just started the business, you may ignore the financial aspects of the agreement; however, it is vital to understand that the amount of money every shareholder must contribute to the business initially should be determined.
• The agreement must include how the dividends shall be distributed among the shareholders. Dividends are the profits out of business, and the way it shall be calculated will be decided by the agreement. It is a vital part of the SHA. One can pay dividends every six months or once a year. The investors would be eager to know the ways of earning money from the investment they make and how the money would be distributed.
• Methods of dispute resolution must be clearly mentioned in the agreement. Apart from the mode of resolution, the place of dispute resolution and the powers and duties should also be defined in it.
• Finally, it shall be wise of the SHA creator to mention the exit strategy, which means what would happen if the business is to be dissolved and how the shareholders will get back their investment in such a situation. Here an important thing to note is that in case only one shareholder wishes to exit the agreement, then such an exit must not affect the shareholders adversely that want to stay.

What is the procedure of drafting a Shareholder’s agreement?

The procedure followed for preparing an SHA is specified below.

1. Consult a professional advocate who has good drafting skills.
2. Specify him the need for such an agreement.
3. Once the advocate understands the objective of the agreement, he shall draft a sample of SHA accordingly.
4. Once the draft is prepared, the advocate shall send it to you for your review.
5. The entire process may take around 3 to 4 days.

Things to remember while drafting a Shareholder’s agreement

The following points must be considered whilst drafting a Shareholder’s Agreement (SHA):

1. The purpose of drafting an SHA must be clear to ensure that the balance of interests is created.
2. The terms and the regulations of the agreement must be clear so that any confusion or doubt is easily addressed.
3. The duties, rights, and obligations of the shareholders and the company should be enumerated in a concise way.
4. The SHA should be airtight, considering the mutual benefit of the companies and shareholders.
5. The procedures, policies, and guidelines with respect to certain events in the agreement should be coherent and compact.
6. The matters listed in the SHA should be in accordance with the relevant laws of that place.

Conclusion

With a view to enhance the functioning of the company and to provide structure to the relationship between the shareholders and the company, the concept of Shareholder’s Agreement was introduced. It is a fundamental foundation upon which the business is set up, and protection that it provides to the interests of everyone involved is really the icing on the cake. However, it must be well-drafted else if it’s drafted poorly; it may lead to disputes that may cause the relationship between the shareholders and the company to be affected, thereby causing a significant loss in the business. Hence, the balance between the interests of shareholders and the company’s interests must be maintained while drafting such a critical agreement.