A standard company constitution will not always protect shareholders in the event of a dispute between members. This is where a shareholders' agreement, regulating the rights and obligations of shareholders, can help avoid the uncertainty of costly court litigation. While it is not compulsory under the Corporations Act, a considered and properly formulated shareholders' agreement is highly recommended for all companies.
So, what should you include in a shareholders' agreement?
Every shareholders' agreement should be individually tailored because every company is different. The specific provisions of each shareholder agreement should take into account the number of shareholders, the objectives of the shareholders, the funding arrangements, and the nature of the business or industry in which the company operates. However, there are also some basic clauses that every shareholder agreement should have.
- Alternative Dispute Resolution
As a pre-requisite to any court proceedings, it is advisable for all parties to try resolve their disputes through an alternative dispute resolution (ADR) process stipulated in the shareholders' agreement. These processes generally take less time and cost less money than proceedings in a court. ADR may include mediation, arbitration or conciliation. Note that a provision in a shareholders' agreement to resolve disputes through an ADR process will not preclude a court from hearing the dispute at a later date.
- Deadlock Provisions
Deadlock provisions deal with circumstances where shareholders cannot agree on the management of the company. The shareholders' agreement should set out a procedure to resolve a deadlock if one arises. There are a number of procedures that can be used to resolve deadlocks, including:
- Shotgun clause – enables a shareholder to serve notice on another shareholder requiring the receiving shareholder to buy his/her shares at a nominated price. If the receiving shareholder chooses not to buy those shares, he/she must sell his/her shares to the initiating party at the same nominated price.
- Chairman clause – enables one of the shareholders to become the Chairman in the event of a deadlock and have the casting vote on the dispute.
- Liquidation clause – if the deadlock continues for a set period of time, all the company's assets will be sold and the company will be wound up voluntarily. The shareholders equally share in the expenses of liquidating the business. This solution is generally a last resort where there is no alternative other than to liquidate.
- Pre-Emptive Rights
Pre-emptive rights impose certain restrictions on the transfer of shares. Pre-emptive rights may include:
- Right of first refusal – provides existing shareholders the first opportunity to purchase the shares from another shareholder of the same company before the shares can be offered to parties outside the company.
- Right to refuse transfer – the Board will have the discretion to refuse to register a transfer of shares to prevent unwanted parties from joining the company.
- Board consent to transfer – a shareholder wishing to transfer his/her shares will have to obtain the consent of the Board to transfer shares or transfer shares to certain parties.
- Mandatory Sale Events
The shareholders' agreement should specify certain fundamental changes in circumstance which will trigger a mandatory sale of that member's shares. Examples of such events include:
- A shareholder's death
- A shareholder's insolvency / bankruptcy
- Certain fundamental breaches of shareholders' agreement
- Temporary or permanent disability
- Cessation of employment
- Loss of professional certification (where this is required because the company trades, for example, as a doctor's surgery or a law practice).
- Share Valuation Methods
The shareholders' agreement must stipulate a method for determining the value of shares in relation to pre-emptive rights and mandatory sale events. Typical share valuation methods include:
- Fixed price – price agreed by the shareholders.
- Assets based – the value of the net assets divided by the current number of shares.
- Expert valuation – usually, valuation by an accountant
- Board valuation – those directors who are not directly involved in the transaction value the shares.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
