Shareholder Agreements: Do You Need It and What to Look Out For?

In this day and age, it is common for shareholders of a company to enter into an agreement (and commonly into a Shareholders’ Agreement (“SHA”)) on how the company is to be governed. A SHA can be simple or comprehensive, and helpful, regardless of area of business, e.g., fintech, investments, biotechnology, manufacturing or even professional services.

Q1. What’s a Shareholders’ Agreement?

A SHA is a framework governing the relationship among the shareholders and operations of a company. A SHA specifies shareholders’ rights and obligations, regulates the management of the company, ownership of shares, privileges, voting and various protective provisions for shareholders. The aim of an SHA is to set out and bind shareholders to rules in anticipation of issues that could become problematic in the future. SHAs should ideally be entered into at the inception of a company between the founders and may include the business plan, investment amounts and roles and responsibilities of the parties. SHAs are also commonly entered into upon a restructuring, additional investments or change of direction.

Q2. Articles of Association v Shareholders Agreement – don’t they serve the same purpose?

While the articles of association is the fundamental constitutional document of a company, they are often standard forms used by corporate services companies based on the Hong Kong Companies Ordinance, Cap. 622.

Moreover, Articles of association are public documents,  making them inappropriate for addressing matters such as investment amounts, governance, share transfer restrictions and other sensitive or confidential matters.

A SHA will cover many aspects of the relationship between the shareholders and can address issues unique to those shareholders or that company.  The SHA will often be entered into at the same time, or reference further agreements to  be entered into between individual shareholders and the company, such as employment or management agreements, supply agreements and technology transfer agreements (e.g., intellectual property licences, patents, trademarks or copyrights) among others.

Q3. Start Up, Financing and Pre-emption Rights – what do I need to know?

A SHA may contain the company’s initial business plan and financing, including the timing, investment amounts and number of shares subscribed by shareholders. Because the initial investment may be insufficient to meet the company’s growth needs, the SHA may set out requirements for further funding, such as additional share subscriptions, shareholder loans or bank or other third-party financing.

In the case of bank financing, certain shareholders may wish to have protections in the SHA that they will not be required to provide any guarantees or collateral in the financing.

Comparably, when additional funds are sought through new share subscriptions, shareholders may want to ensure the ability to maintain their percentage ownership in the company by including in the SHA a pre-emptive right to proportionately subscribe to any new issue of shares.

Q4. Board and Shareholder Governance – how can shareholders protect themselves?

Directors have both the authority and responsibility to run and operate a company, and typically important decisions are made by majority vote of the directors. Without specific provisions in the articles of association or a SHA, the rights of a shareholder are limited.

For protection, minority shareholders ideally would have representation on the board of directors, which would provide the right to participate in the company’s decision-making and access important information not otherwise available. Additionally, a SHA could include provisions requiring certain actions of the company, e.g., taking on new debt, sale of intellectual property or a major asset, entering a new business line, annual operating budget, to obtain a supermajority or unanimous approval vote of the directors or shareholders.

Q5. How about Share Transfers?

It is common for SHAs to govern share transfers. Share transfer restrictions exist to protect the company and the other shareholders from, for example, unknown or unwanted third parties that could become shareholders. Typically, in the event one shareholder wishes to sell his shares the other shareholders would have the right to purchase the shares. Share price would be dependent on the particular circumstances. In the event the non-selling shareholders do not exercise such rights to purchase, those shares could end up in undesirable hands.

Additionally, compulsory transfers may be required when a shareholder dies; is convicted of a crime; is dissolved or liquidated (if the shareholder is a company); files for bankruptcy; materially breaches the SHA or a duty to the company.

Q6. Tag-along, Drag-along, Buyback and rights of first refusal – what are these?

Drag Along Rights: In the case of a sale of shares by a majority shareholder, the SHA may provide for drag-along rights, enabling the majority shareholder(s) to require minority shareholders to join in the sale of their shares. Buyers of a company often wish to obtain full ownership or control of the company and drag-along rights allow the majority shareholder(s) seeking to sell his or her shares, to provide the buyer with the right to acquires the shares of the other shareholders. The minority shareholders would be protected by entitlement to the same price, terms and conditions as the majority shareholder(s).

Tag Along Rights: Tag-along rights protect minority shareholders so, in the event a majority shareholder sells its shares, the other shareholders have the right to join the transaction at the same price, terms and conditions in proportion to their respective share ownership. This protects minority shareholders from being forced to accept a deal on lesser terms or being left as a minority shareholder in the company with a new majority shareholders.

Rights of First Refusal: In the event a shareholder wishes to sell her shares, these rights allow other shareholders the right to purchase existing shares held by another shareholder before it can be sold to a third party. Typically, the price would be the same as that agreed between the selling shareholder and the third party and the remaining shareholders would be entitled to purchase the shares proportionate to their existing shareholdings in the company. Alternatively, the company could be allowed the right to buyback such shares, subject to a number of statutory requirements.

Q7. What about a shareholder leaving and starting up a similar (sometimes competing) business?

Shareholders involved in the company’s operations often have full access to a company’s trade secrets, technical operating procedures, customer and supplier lists, pioneering research and development, financial details and other sensitive or confidential information. A SHA will often include non-disclosure and non-competition clauses that bind shareholders to confidentiality and prevents them from starting a competing business or working for, with or on behalf of competitors. A non-solicitation clause could also be inserted which restricts or prevents a shareholder from engaging in any business with any company or person that, was or is, a client or customer of the company.

These are a few of the areas to be addressed by shareholders in a SHA. Each company and its shareholders will have particular needs, issues and areas of concern and a SHA can provide a structure and process for address and resolution.