Why business prenups (aka Shareholders’ Agreements) are essential
You’ve got a brilliant idea, set up your company, and you and your partners are ready to go! You’ve each got a shareholding, you’re super aligned, and nothing could possibly go wrong… But have you actually talked about what happens if, in 6 months, the business needs quite a bit more cash? Or if one of you moves to a new city and can’t work in the business anymore? Life changes and business can, unfortunately, be unpredictable.
The great news is that you can make a rule book (aka shareholder’s agreement) so that when things pop up – you all know how to deal with them. Because it’s staying aligned that will make all the difference to your business’ success.
This article explains why a shareholders’ agreement (your business prenup) is essential for every business with multiple owners.
What is a shareholders’ agreement?
Shareholders’ agreements are like a set of rules that record how shareholders will work together and make decisions. What are the initial contributions to the business? Who has the right to appoint a director? Will the shareholders work in the business? What are their roles and responsibilities? How will decisions be made? What if further funding is needed? What if one person wants to leave the business? What if someone dies? If someone leaves are they free to set up a competing business?
Why is a shareholders’ agreement so essential?
While it’s not a legal requirement to have a shareholders’ agreement, here are the key reasons having one is so important if your company has more than one shareholder:
Everyone has an opinion, and unfortunately, they won’t always be the same! Especially because everyone may have different drivers and motivations. For example, if two shareholders work in the business and the third doesn’t, you’ll need a fair way of deciding how much they get paid for their work. Put simply, a shareholders’ agreement outlines ‘who does what’ and how decisions are made so everyone knows their roles and responsibilities.
Simple misunderstandings can sadly sometimes develop into bitter (and expensive) disputes that can destroy a business. A good shareholders’ agreement will include processes for resolving disputes (such as mediation, appointment of an independent expert or a buy-sell provision) so you don’t end up in court with substantial legal bills and massive disruption to your business.
If some shareholders have less say in the company because they have a minority shareholding, a shareholders’ agreement can protect their rights and interests. A constitution does not always give this protection because a constitution can (in most cases) be amended by agreement of 75% of the shareholders (ie. the 75% majority shareholder(s) could change the constitution to remove the minority shareholder protection).
A robust and clear decision-making process prevents gridlock and ensures a company can function efficiently. A shareholders’ agreement should outline who can make different types of decisions so you don’t get stuck (eg, CEO vs board of directors vs shareholders). A shareholders’ agreement will often contain a list of different types of decisions that a company might need to make and then state who can make that decision (and how that decision can be made). These are often called ‘reserved matters’.
Sometimes, shareholders want to leave the company, or they’re forced to leave because of death or incapacity. Under New Zealand law, a shareholder can sell their shares to anyone, at any time, for any price. However, most privately owned companies want some restrictions on the ability of shareholders to sell their shares (it’s nice to know who you’re going to end up in business with!).
A shareholders’ agreement can state shareholders can only sell their shares in limited circumstances. It will often require a shareholder to first offer their shares to the other shareholders before being able to sell to an outside person or business (this is known as ‘pre-emptive rights’). This allows the existing shareholders to prevent a share sale to an outside party they don’t want to be in business with (who may not share the company’s culture and values or have the same expertise as the selling shareholder), such as a competitor or family member.
Other ‘permitted’ circumstances can include if all the other shareholders agree to the sale, if ‘drag-along rights’ or ‘tag-along rights’ are exercised, related party transfers (such as from a shareholder to a trust or company), death or incapacity of a shareholder, compulsory transfers on default or insolvency, or IPO.
Companies need money to operate, and at least initially, this comes from the shareholders in the form of equity/capital contributions or debt (shareholder loans). A shareholders’ agreement sets out these initial contributions so it’s clear what has been contributed in exchange for the initial shares, the terms of any shareholder loans and expectations on the shareholders to contribute to further funding. This ensures that everyone understands what is expected of them financially.
An area that often causes contention between shareholders is the potential for dilution of ownership and control due to the company issuing new shares to raise money (either to existing or new shareholders). Capital raising allows businesses to raise funds for various purposes, such as expansion, research and development, or debt repayment. However, when a company issues new shares, it increases the total number of shares, reducing the percentage ownership of existing shareholders. This can impact the balance of power within the company. If shareholders are concerned by potential dilution, a shareholders’ agreement can provide clarity and fairness by addressing this issue in several different ways.
Key points
A shareholders’ agreement (your business prenup) is crucial for any company with multiple owners (and no one will judge you for requesting one). It clarifies roles and responsibilities, prevents messy and expensive disputes, helps you make decisions, and stops you from ending up in business with a complete stranger! You all start with the business’ success as your number one goal – keep that focus with a robust roadmap to guide you through the distractions.
Natalie Fennell is a cofounder of On Your Terms
