Seven reasons to update your shareholder agreement

The shareholder agreement is often one of those documents that startups sometimes forgo or even bootstrap by cutting and pasting from other documents without taking independent legal advice.  

Even if you put one in place when setting up your business, it can quickly get forgotten as you focus on growing your business.  Later, when you need to refer to it, the agreement could be out of date and misaligned with how the business operates in practice. 

Most recently, Covid19 has triggered changing circumstances for many business owners that may need reflecting in the shareholder agreement. Examples include shareholders wishing to leave, boosting the business with investment, cash flow challenges, and changes to salary and dividend payments as a result of government schemes during the pandemic. 

Covid19 has triggered changing circumstances for many business owners that may need reflecting in the shareholder agreement.

The shareholder agreement should adapt and grow with the business and it needs regular review and update to capture that evolution so that it can continue protecting all the parties, points out Tom Kemp, head of the commercial department with Ingram Winter Green in London. ‘There are several reasons that we commonly see prompt a review of the shareholder agreement. 

When a founder wishes to exit 

Changes in personal circumstances, an external event such as Covid-19, or breakdown in working relationships can result in a founder wishing to exit the business.  This will trigger the need to update the shareholder agreement if adequate measures are not already in place, or if the negotiated terms of the exit require changes to be made to the shareholder agreement.  

It may be necessary to update the agreement before a shareholder can exit if, for example: 

  • an exiting founder wishes to retain some shareholding, but on either a significantly reduced amount or restricted rights basisor 
  • if the remaining shareholder wishes to impose some other restrictions on the exiting shareholder to protect the ongoing business. 

Sometimes a shareholder who is also a director may not be acting in the best interests of the company, and either adding in or adapting a bad leaver provision into the shareholder agreement may need to be considered. 

There are many ways to structure an exit and it is important to ensure the shareholder agreement accounts for these strategies. If it does not, then it should be updated appropriately in advance of any exit occurring. This ensures an exit free from dispute and one that follows the proper shareholder resolution and stock transfer rules.  

Seeking external investment 

If you are considering raising investment for your business and bringing on board further shareholders, your shareholder agreement needs to allow for this.  It needs to appeal to investors while also protecting the original foundersIf there are restrictive covenants or provisions very favourable to one class of shareholders, changes to the agreement may become a condition for future investment.  For example, investors may wish to see changes to provisions which: 

  • prohibit any dilution for minority shareholders; or 
  • exclude tag along or drag along rights which ordinarily restrict sale of major shareholdings.  

Changes to shareholder rights to income 

Introducing more flexibility within your shareholder agreement may be critical to the business’s financial health.  

One way a business can ease financial pressures could be to adjust obligations to pay income to shareholders in the form of dividends or otherwise, if these obligations are currently rigid and mandatory.  

Succession planning 

If your directors or shareholders are multi-generational and certain shareholders are coming up to retirement, it is advisable to plan ahead for how they may transfer their shares voluntarily and update the shareholder agreement accordingly. If someone was to die prematurely, the share sale would be mandatory and the process becomes protracted and entwined with probate rules. 

Untimely illness 

Even if retirement is a long way off for all the founders, Covid-19 has shown us how life can be so unpredictable.  

Does your agreement have clear guidelines around decision making or an exit if a shareholder develops a longterm illness or becomes incapacitated for any reason? 

Consider updating your agreement now, so that you have one less worry should any of these unfortunate events become reality. 

Decision making in your business 

The way that shareholders make decisions or the types of decisions and corporate challenges that crop up will also change as your business evolves. Nine times out of ten, your articles or shareholder agreement will rely on the standard methods of passing resolutions, which are typically: ordinary resolutions (50% agreement); special resolutions (75% agreement); or unanimous resolutions. 

However, Covid-19 has demonstrated the need to respond quickly to a fastchanging world. If you have experienced shareholder deadlock or know certain decisions can be taken without shareholder resolution, adjusting your agreement to represent how your business is or needs to run practically may help prevent disputes. 

Resolving disputes 

Last, but not least, shareholder agreements usually get pulled out of the drawer when a dispute occurs between shareholders. Typical causes for dispute include income calculations, failure to follow due process or voting rights. Like most of the reasons discussed here, it is prudent to anticipate what can go wrong and check if your shareholder agreement needs to be amended before anything does go wrong.   

How we can help 

Shareholder agreements provide a form of insurance for the business, and they need to be reviewed often and holistically.  

We can help you navigate the variety of strategies and options specifically suitable for your business and ensure those are appropriately reflected in your corporate agreements. 

For further information, please contact Tom Kemp in the corporate and commercial team on 020 7845 7425 or email tomkemp@iwg.co.uk.   

 

This article is for general information only and does not constitute legal or professional advice. Please note that the law may have changed since this article was published.