A shareholder agreement is a formal and binding document that specifies the relationship between all parties of a company - the shareholders, directors, and owners. This agreement also lays out the terms of operation of the business and the rights & obligations of all concerned parties. Creating and understanding a shareholder agreement is crucial to the success of any business. Studies have indicated that the lack of a solid shareholder agreement is one of the common factors of business failure. Moreover, a shareholder agreement keeps business owners and shareholders protected from needless conflicts as the business progresses.
Although a shareholder agreement can be put into effect at any time in a business lifecycle, it is prudent to get this document in place right at the starting stages. When the company is formed and shareholders are identified, it is essential to have a shareholder agreement in place to ensure there are no disputes or confusion down the road. All shareholders and parties involved must unanimously agree to the clauses of the agreement and sign it for the document to be binding and effective.
A shareholder agreement establishes a clear-cut decision-making path and sets procedures in place for different scenarios. Let’s look at some of the important clauses that are a part of every shareholder agreement.
Pre-emptive rights: A key clause in a shareholder agreement is the right of current shareholders to buy any newly issued shares before it is opened up to third parties. This clause helps protect existing shareholders from losing their share value. Companies may issue new shares for various reasons, for instance, to raise additional capital. In such scenarios, existing shareholders have to be given first preference to purchase the new stock before others can claim them.
Pre-emptive rights also come into effect if a current shareholder wishes to transfer their shares. The other existing shareholders are offered the right to buy those shares.
Right of First Offer: The ROFO is a contractual obligation that comes into effect when an existing shareholder wishes to sell their shares. Existing non-selling shareholders have the right to make the first offer to buy the shares before the selling shareholder seeks out third-party offers. The selling shareholder does have the option of accepting or refusing the offer made. If they refuse the internal offer, the selling shareholder can sell their shares to a third party for a better price. Essentially, this type of clause benefits shareholders who intend to sell their shares.
Right of First Refusal: as with the ROFO discussed above, the ROFR is also in play when a shareholder wishes to sell their stock. In this case, however, the selling shareholder may first seek out third-party offers for their shares before they offer the shares to existing non-selling shareholders. The non-selling shareholders then have the option of accepting or refusing the offer given by the selling shareholder. This clause benefits the non-selling shareholders more as third parties may be less likely to enter the sale when the ROFR is in effect.
Ratcheting: The ratchet clauses or anti-dilution clauses are designed to ensure that a shareholder’s investment value does not reduce in case of an increase in share capital. These are further categorized into full-ratchet and weighted average clauses.
Full ratchet: According to the full-ratchet clause, if there is an increase in the share capital of a business, the existing shareholder’s stock is automatically multiplied in a pre-defined proportion, thereby maintaining their investment value. Although the full-ratchet protects early-stage shareholders, it can be potentially expensive for the business owner as they would need to compensate early shareholders when they wish to expand their share capital.
Weighted average: The weighted average clause on the other hand takes into consideration the comparison between the shares of an existing shareholder and the total outstanding shares required. This method allows an existing shareholder to raise their stock value at a rate that is the weighted average of the rate of new shares. The weighted average formula is used more commonly in shareholder agreements since it protects both the shareholder and the business owner.
Tag-Along and Drag-Along Rights: when different shareholders of a business encounter a conflict where some parties want to sell their shares and others don’t, the tag-along and drag-along rights offer an amicable way to resolve the dispute.
Drag-along rights: this clause ensures that if a majority of the shareholders (a pre-defined percentage) want to sell their shares, the remaining minority is required to go along with the sale under the same terms. This method allows a third-party buyer to obtain 100% of the business shares.
Tag-along rights: this clause, as opposed to the drag-along clause, offers the option to minority shareholders to ‘tag-along’ with a majority shareholder when they sell their shares. The minority shareholders can benefit from participating in the sale at the same price as the majority shareholder, thereby protecting them from being cut out of a good deal. The purchaser is obligated to buy all of the offered shares or none.
Affirmative Rights: affirmative rights are protective rights in the shareholder agreement that ensures the business owner and the board must always seek approval from the shareholder before they make decisions regarding certain business matters. These business matters are also previously documented in the agreement.
Liquidation Preference: this clause of a shareholder agreement states that in situations where the business is sold or liquidated, the shareholders are given priority to recover their investments before other matters are settled. Some agreements will also state a higher liquidation preference than the original investment, such as 2x the value. However, it is always advisable to set a fair liquidation preference so that owners and other parties receive a fair settlement too.
Arbitration and Governing Law: this clause is detailed in a shareholder agreement to ensure that, in the event of a variation between the shareholder agreement and the business articles, the terms stated in the shareholder agreement will prevail. This essentially implies that the business and its owners are also bound by the terms listed in the shareholder agreement.
Understanding these clauses and making the best choice for a business is an essential part of any entrepreneurial journey. There is always potential for things to go wrong and disputes to arise, regardless of how seamlessly the business operates. A thoroughly researched and adapted shareholder agreement will help ensure the smooth functioning of the business and protect everyone involved from lengthy legal battles and expenses.
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