Shareholder agreement - what's important, what's essential?

The starting point for considering what you must include in your shareholder agreement and what you consider potentially important (so start off being undecided on) is based on your ownership structure, stage of your business and business type and sector.

Some of the more common private company shareholder structures include :-

• 50:50 equal shareholdings - require strong deadlock provisions, as decision gridlock is a significant risk. Approximately 43% of UK business partnerships start with equal ownership, and these have a notably higher rate of disputes without any or suitable shareholder agreements. (Source: British Chambers of Commerce Business Ownership Survey, 2023)

• Family businesses - need provisions for succession planning and separating family and business issues. According to the Institute for Family Business, only 33% of UK family businesses survive to the second generation, often due to inadequate shareholder arrangements. (Source: Institute for Family Business, UK Family Business Sector Report, 2022)

• Founder-investor relationships - need balancing founder control with investor protections. Early-stage agreements often include vesting schedules to ensure founder commitment.

• Multiple minority shareholders - key issues include establishing robust protection mechanisms for minority interests, particularly voting rights on key decisions.

The relevance of timing for shareholder agreements

Only 26% of UK SMEs have formal shareholder agreements in place at formation according to the UK Small Business Survey, Department for Business and Trade, 2023 and 57% implement agreements after experiencing a shareholder dispute (Source: Dispute Resolution Survey, Centre for Effective Dispute Resolution, 2022).

Without a shareholder agreement, startups risk serious disputes down the line - over ownership, decision-making, profit sharing, or exits. Verbal understandings can quickly break down, leading to costly legal battles or even the collapse of the business. A well-drafted agreement protects everyone’s interests and helps avoid conflict before it starts.

According to research by the UK Chamber of Commerce, shareholder disputes cost UK SMEs an estimated £1.4 billion annually in legal fees, lost productivity, and business disruption. Companies with well-drafted shareholder agreements resolve disputes in approximately one-third the time compared to those without.

The essentials for any shareholder agreement

• Company Governance and Management - sets expectations for how the company will be run and decisions will be made, preventing disputes before they arise. Includes decision-Making Processes, directors, (appointment rights, and removal procedures), decisions requiring different majorities for different types of decisions, deadlock resolution (where shares are owned 50:50)

• Share Ownership and Transfer Restrictions - determine who can become a shareholder and under what circumstances shares can change hands. Particularly important when contemplating future investment rounds or potential exits. Key provisions include pre-emption rights, transfer restrictions, drag-along rights, tag along rights and leaver provisions. Consider including pre-emption rights on new share issues to prevent dilution and share valuation mechanisms for various transfer scenarios.

• Dividend Policy and Finance - clear policies on how company profits will be distributed, how additional capital can be raised, and what financial information will be shared with shareholders help manage expectations and prevent disputes.

• Confidentiality and Intellectual Property - protecting confidential information and intellectual property is vital to maintaining competitive advantage, especially when shareholders may also be employees or directors with access to sensitive information and it may be unclear who owns intellectual property. Non-compete and non-solicitation clauses are also very important.

• Dispute Resolution - options include compulsory mediation/arbitration clauses, clear timelines for each stage of dispute resolution, possible buy out processes and valuation mechanisms.

• Death, Incapacity, or Bankruptcy of a Shareholder - what happens to a shareholder’s shares if they die, become incapacitated, or are declared bankrupt. Often include share transfer provisions allowing remaining shareholders or the company the option (or obligation) to buy back the shares, valuation methods for pricing those shares fairly and life insurance arrangements to fund a buyback in the event of death.

Growth stage clauses for shareholder agreements

As businesses mature, the composition and priorities of the shareholder base often change. What worked for founders rarely works for a growing company with multiple investors. The personal circumstances of shareholders may also change – founders may wish to step back, external investors may want to exit, or shareholders may simply no longer share the same vision for the company. Provisions that address these evolving dynamics are crucial for long-term stability. Issues to consider and include in a shareholder agreement for a growth business typically include :-

• New shareholders joining with different expectations

• Changing circumstances of founding shareholders - define clear paths for shareholders to exit

• Inactive shareholders blocking progress - Include mechanisms to remove problematic shareholders

• Clearly defining how the agreement can be modified - consider the likelihood of the business need for substantial new investment diluting existing shareholders, plan for future funding rounds and issues such as rights for potential investors, such as to attend board meetings.

• Anti-dilution protections? - to protect founding shareholders while allowing growth.

• Valuation issues - a common source of shareholder disputes, particularly in private companies where there is no public market to establish value. When a shareholder wants to exit, when new shares are being issued, or when a company is being sold, different shareholders often have very different views on what shares are worth. Robust valuation provisions such as methods appropriate to your industry or different methods for different circumstances can prevent deadlocks and ensure fair treatment while avoiding costly disputes that often end up in court.

• Succession and Exit Planning - all shareholders will eventually exit the business, whether through sale, retirement, death, or incapacity. Yet many shareholder agreements fail to adequately address these inevitable transitions. Without proper succession and exit planning, companies can face existential crises when key shareholders depart. Well-crafted provisions such as cross-option agreements, successor nomination rights, staged exit mechanisms and key person insurance provisions are all important to consider.

Common pitfalls to avoid with shareholder agreements

• Overlooking tax implications of share transfers and company structures

• Creating unworkable deadlock provisions that could paralyze the business

• Setting unrealistic restrictions that courts may not enforce

• Ignoring digital assets and intellectual property

• Failing to address remote working and international operations

• Overlooking data protection implications of information sharing

• Creating conflicts with banking or investor covenants

Contact us to discuss how we can help, whether you need advice on a shareholders agreement, have decided you need an agreement drafted or reviewed or you need to update an existing shareholder agreement based on changed circumstances.