How to Make Your Partnership Work with a Shareholder Agreement

Definition of a Shareholder Agreement

A shareholder agreement is a contract between the company and its shareholders. Shareholders are the owners of the company. The shareholder agreement clearly delineates each party’s legal obligations and anticipates common scenarios that arise in running the day-to-day operations of a business.

There are several important components of a shareholder agreement, such as:

• identifying the structure of the company;
• stating how the shares are divided amongst shareholders;
• naming the board members, corporate officers, and key management employees;
• explaining the dispute resolution process;
• outlining shareholders’ obligations;
• delineating financial obligations of the shareholders (if any);
• explaining the voting mechanisms and veto procedures; and
• compiling a list of other important documents governing the company, such as bylaws and confidentiality agreements.

In addition to these suggestions, there may be other things that should be included in the shareholder agreement, depending on the size of the business, its financial structure, and the nature of the work. It is always advisable to use legal templates to make sure you do not leave anything out. You can also consult with qualified legal professionals before finalizing your shareholder agreement.

How a Shareholder Agreement Manages Risk

Business partners are always focused on how to make a partnership successful. However, disagreements and unforeseen situations are certain to occur, even when a business is led by cooperative professionals who are excellent communicators. A shareholder agreement is there to provide a structure for partners that will help them get through difficult situations. Many disputes can be resolved quickly if the shareholder agreement governs them. In this way, shareholder agreements help owners and corporate officers mitigate risk.

• Company Funding – A shareholder agreement should describe how the company will be funded and how the shareholders will divide profits. The shareholder agreement will identify the initial contributions of the shareholders, such as cash, resources, important business contacts, skills and knowledge, or intellectual property, and decide how the contributions will be valued. If the shareholder agreement creates procedures for buying and selling shares and dividend distributions, it helps partners avoid disputes over money and funding as the company matures.
• Protecting Minority Shareholders – Minority shareholders own less than 50% of a company. When you are starting a company, it is important that you consider what rights minority shareholders will have in the business. This is especially crucial in family businesses where several relatives have a small stake in the company. Families sometimes assume that they all agree on how to be fair to minority shareholders and that they can resolve any issues that come up on their own. Unfortunately, many family businesses become mired in disputes when there are not clear shareholder agreements protecting each person’s interest. A proper shareholder agreement will give minority shareholders the right to buy new shares as they become available, set an appropriate valuation method, and give the shareholders the ability to appoint company officials.
• Succession Plans – Shareholder agreements manage risk by deciding what happens to shares when a shareholder decides to sell, retires, or dies. Bankruptcy, disability, and retirement also impact a person’s rights as a shareholder. Proactive companies will ensure that the shareholder agreement anticipates these situations.

Protecting Ownership from the Board of Directors

Ownership of a company is distinct from the company’s management. Shareholders comprise the ownership, while the board of directors and corporate officers are the people who have a more direct role in making most decisions. Most shareholders are not active in the operations of the business and as a result can be isolated from what is happening. Shareholder agreements will define the rights and responsibilities of all parties in a corporation. In this way, the shareholder agreement can be used by shareholders to ensure that they have the ability to limit the power of directors and have a say in how a business is managed.

Establishing a Dividend Policy

A dividend is the amount of money paid to shareholders when the company makes a profit. Although it can be a while before a new company begins to make money, the time to think about dividend policies is in the beginning, before the company even turns a profit. A good shareholder agreement will include a dividend policy. Drafting the policy requires shareholders and officers to think about dividends and how they will impact how the company operates.

• Proportionality – The first thing that is included in the dividend policy is confirmation that the profits will be paid in the same proportion as the shares are held by the shareholders. This means that if one shareholder owns 15% of the company’s shares, he or she will generally be entitled to 15% of the profits.
• Schedule for Payment – Payment of dividends may be made periodically throughout the fiscal year or just once at the end of the year. When you are drafting the dividend policy, be sure to consider the impact that semi-annual dividend payments would have on the company. Since each dividend payout involves a shareholders’ meeting, accounting, taxes, and draining the company’s finances, most businesses prefer to pay dividends just once a year.
• Reserves – Shareholder agreements are a good way to establish when shareholders can expect to take a dividend. If shareholders take too much of the company’s profits, it will reduce the amount of money the business has in reserve. This could delay the company’s future growth. Moreover, disputes can arise if the parties have not decided on a threshold amount of money the company should have in reserve. Determining when to take dividends requires a careful balance between investment returns and financial good health. The shareholder agreement creates a roadmap for making these decisions.

The 50/50 Partnership

Large businesses with many shareholders are not the only companies who benefit from a shareholder agreement. Those of you who are in 50/50 partnerships also face challenges that can be resolved with a partnership agreement. As Will Caldwell, CEO of Dizzle, explained to Entrepreneur magazine, “a 50/50 partnership is like marriage: One partner can’t do something without the consent of the other.”

Caldwell recommends that 50/50 partners consider a shareholder agreement to help them navigate the tough questions. When two people hold equal halves of a partnership, they can be deadlocked when a conflict arises. One way to avoid a deadlock is to give a small share to a third party. The shareholder agreement then gives a stake in the business to a person that both partners like and trust. This can be a good opportunity to reward a person who has invested sweat equity into the company as an employee.

Including vesting schedules in a shareholder agreement also helps protect both parties from one partner leaving the business while still owning half of the company. Vesting schedules prevent a person from receiving their options in full right away. Instead, the vesting schedules are established to protect everyone’s interest.

Questions that Shareholders Should Ask

Before drafting a shareholder agreement, owners should ask themselves the following questions:

• How are we dividing the shares? (This is especially important in a startup company.)
• [If I am the founding member and largest shareholder], do I believe others are treated fairly?
• Do I agree with my ownership stake?
• If I wanted to end my involvement with the company, how hard would it be to exit?
• Will there ever be a way for me to buy more shares, and thus more control, of the company?
• Will the employees ever be given an option to buy stock in the company?
• Can I live up to all financial and other obligations of the proposed agreement?
• How is my investment protected?
• [If I am a minority shareholder], what mechanisms are in place to allow me to influence the company?
• What is my legal liability?
• What is the total financial exposure on the deal as presently structured?

Tag-Along and Drag-Along Rights

It is imperative that a shareholder agreement include provisions on treating shareholders equally. However, what does that mean in the context of a sale? This is a very important area to elaborate on in an agreement since the way minority and majority shareholders interact during a sale will often have far-reaching implications.

Tag-along rights are also called co-sale rights. They protect a minority shareholder by giving them the right to sell shares in the event of a sale, just like a majority shareholder. This means that in a takeover or venture capital deal, the majority shareholder must include the holdings of the minority during the negotiations.

On the other hand, a drag-along provision gives more rights to the majority shareholder. The majority shareholder can require the minority shareholders to sell their shares in the event of a takeover offer. That means the minority shareholder has no choice in the event of an offer.

Majority shareholders typically do not like tag-along rights. Before you complete your shareholder agreement, be sure that everyone considers how their shares will be impacted by these concepts.

Conclusion

When a company is founded, its owners decide how the company will be managed. In order to be completely organized, shareholders should think through the questions listed above before finalizing the shareholder agreement. Once everyone is satisfied, adopt a shareholder agreement and follow its guidelines. By agreeing on basic ground rules, you will save yourself and your partners time and headaches in the future.

How to Create a Shareholder Agreement

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