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Quietly Self-Harming: The Strange Obsession With Shareholders Agreements

Shareholder’ agreements (‘SAs’) are one of those legal documents, like NDAs, that most businesspeople have heard of - and take for granted that they should be using.

However, as ever with the law, each case must be treated as unique. If I had a Bitcoin for every business owner whom I’ve talked out of self-harming with an SA, I’d be writing this article from the Caribbean. Sadly, as I’ve only ever received the proverbial penny, I’m writing from Brighton.

Firstly though, a quick reprise. Companies are mostly run by their directors acting collectively - the board. However, the law says that ultimate control of a company lies with the owners: the shareholders. The key word here is “ultimate”, since the law gives directors a lot of strategic advantages over shareholders, such that shareholders can often have the devil’s own time in trying to assert their authority. But because of that ultimate control, SAs are perennially popular.

SAs in their purest form are agreements between shareholders on how to wield their authority. SAs usually require collective shareholder agreement before decisions can be taken on important things like voting rights; pre-emption rights (who gets first dibs when a shareholder wants to sell, or where new shares are to be issued); seats on the board, senior salaries; taking/making loans over a certain size; etc., etc.

Often the topics covered stray into matters that are really for the board to decide, or which should be governed by the company’s Articles of Association. But as the major shareholders usually constitute the board, it still works - and getting the company to sign the SA too ties the board’s hands anyway.

I often advise business owners to avoid an SA because of shareholder expectations. SAs to many have the primary purpose of emasculating the power of the majority shareholder - Gulliver voluntarily agreeing to be tied down by the Lilliputians.

Doing this is often a mistake from the majority owner’s perspective. SAs, especially those requiring unanimous shareholder consent before things can be done, can effectively give minor shareholders the same right of veto as the majority owner - a level of power which is usually not justifiable, and which is hostage to shareholders’ differing goals, priorities, and levels of commitment. Too often companies start as egalitarian kibbutz: shoulder to shoulder to build something exciting – it’s when the money finally appears that the cracks usually begin to show!

So, majority owners really do need to ask whether it’s a good idea to voluntarily give a right of veto over their business to perhaps a huddle of semi-engaged shareholders each owning single digit percentages.

I’ve referred to “pure form” SAs because frequently SAs become more: a dumping ground for other matters which need to be recorded in writing: employment terms in particular. This is usually a bad idea. The employment provisions tend to be half-baked, and may corrosively blur the distinction between shareholder, employee and director (the latter being an office as well as potentially an employment role). Also, an individual’s employment terms will forever be on view to other shareholders - and changing those terms can become a nightmare, possibly requiring the involvement of shareholders who should have no input at all.

SAs are also often home for terms that should be in a share purchase agreement (‘SPA’). SPAs set out the terms under which somebody purchases new or existing shares. As with employment terms, the parties usually have a strong desire to lump everything into a single agreement - partly out of convenience, but also to save money (since drafting one longer agreement is usually cheaper than drafting various stand-alone agreements - well, cheaper in the short term anyway………).

The main disadvantage of folding an SPA into an SA is again the risk that it is half-baked. Too often lawyers are instructed to draft an agreement which is comprehensive, whilst at the same time being not too long, detailed, off-putting, legalistic or too complex.

This is a circle that can only be squared in fantasyland. In practice, almost invariably optimism wins out and clients opt for ‘quick and dirty’ over ‘belt and braces’ (thus ensuring a steady stream of work in later years for dispute resolution lawyers).

Another reason it can be a bad idea to mix in employment provisions, share purchase terms, etc. is that SAs are meant to be standard – each shareholder signs the same document, with future shareholders also agreeing to be bound by it. That can be most tricky if your SAs have been personalised.

In summary, if you are not the majority shareholder then almost invariably an SA is to your advantage. It may still be worthwhile even if you are the majority shareholder – but just don’t assume that voluntarily “doing a Sampson” is automatically going to be a good thing for you personally.

Please contact James O’Connell if you need any advice.