By Chris Robinson, Corporate Lawyer, Excello Law

Private companies with two or more independent shareholders will often be told they should have a shareholders’ agreement. In the broadest sense that’s true: the relationship should be agreed in some form. A formal written agreement, in addition to the company’s articles, is not always necessary.

The default position is majority rule. A majority of the directors and a majority of the shareholders can do almost anything, especially if they hold 75% of voting shares. The exception is that they can’t force a shareholder to transfer their shares, except in very limited circumstances. A minority shareholder unhappy with the way the company is run has little comeback unless there is misconduct involved and, at best, gets their shares bought out at a fair market value.

For the majority shareholder, there’s not much wrong with democracy. The key thing is the ability to buy back the shares of a shareholder who stops being involved in the business because they leave, die or get pushed out. That’s usually put in the company’s articles, and obliges a departing shareholder to offer their shares for sale at a fair price, either to the other shareholders or the company itself. It’s up for discussion, but generally valuation is a straight proportion of the company’s value, without discount for the fact that it’s a minority shareholding, or the fact that there is no prospect of a sale. Drag-along rights are also important, forcing a minority to join in any sale of the company approved by the majority.

If those two things are in the articles, and the directors have good, strong employment contracts, any shareholders’ agreement will only take away the rights the majority shareholder already has through majority control.

A minority shareholder, however, has lots to gain. A shareholders’ agreement will typically give the minority shareholder a veto over a long list of actions, rights to participate in management and to be consulted. It can include a right to be a director, or to appoint one and entrench their position so they cannot be sacked. It may impose obligations on the majority to act fairly and to commit to a particular business plan. It will give the minority tag-along rights, giving them the right to be offered the same terms as the majority if the company is sold. The majority shareholder may even be obliged to provide funding, or be restricted from withdrawing their funding.

Giving minority shareholders a veto, especially over routine business decisions, can be dangerous. The business risks grinding to a halt, which is in no one’s interests. Better, then, that democracy rules and the minority take their chances. When shareholdings are equal or there is no overall control, any shareholder could find themselves on either side of the argument, and it’s better that the company continues to function whilst the shareholders argue. How far to take this approach depends on the circumstances: three equal partners investing considerably in a joint venture might want more protection than twenty 5% shareholders who are passive investors.

So what else would you find in a shareholders’ agreement? Restrictive covenants, restricting the ability of a shareholder to compete with the business after they leave may be important; though they can be in an employment contract. There is often a dispute resolution process requiring a shareholder to state a price at which they will either buy or sell, but these rarely work unless the parties have equal bargaining power, equal ability to run the company and the financial resources to buy out the others. Other inclusions could be “bad leaver” clauses, obliging shareholders to sell their shares cheap if they don’t perform their obligations.

So do you need a shareholders’ agreement? It’s foolhardy to go into a jointly owned company without considering the issues but in many cases you can dispense with an agreement and let the majority rule. If however, an investor is putting in a significant sum, or if minority shareholdings are large, an agreement can be essential to protect the value of their investment.

The wrong approach can lead either to shareholders walking away with too much, or the business grinding to a halt under the dead hand management of a minority shareholder veto. This means it’s important to consider options carefully and, if you decide you need one, get the right shareholders’ agreement for your circumstances.