Rules of the Club: Shareholders’ Agreements and Articles of Association
Corporate Advisory Solicitors for Startups & Small to Medium Sized Enterprise
Setting up a business is like starting a club. A few dedicated individuals with a common interest come together to pursue an activity or achieve a purpose. And, as anyone who is a member of their local sports or drama club will know, all clubs have rules, whether they be around dress code, admission criteria, membership fees, or how (and who) to appoint to key roles within the organisation.
Businesses are no different. Companies are always subject to certain obligations under company law. However, like clubs, they also have their own internal rules; their own internal constitution which governs how the company will be run, and how the various individuals involved in the company will interact with each other.
In this week’s newsletter, Dragon Argent’s corporate advisory solicitors in London have taken a look at these constitutional rules (or by-laws) which are found in the company’s articles of association, a public document that sets out the fundamental contract between the company and its shareholders. A company may also enter into a shareholders’ agreement with its shareholders, a private document that sits alongside and complements the articles. Together these documents form the rules of the club.
If you have ever seen a set of articles or a shareholders’ agreement you will know that they often run to dozens of pages and contain arcane and impenetrable legalese, seemingly irrelevant to the day to day running of a business.
However, they are extremely important documents which – if not drafted carefully – can significantly impede a business’s progress. If done properly, these documents can facilitate a balanced and fruitful relationship between the owners and the operators of the company. Let’s look at an example.
Rules in Practice
Barry and Robin are the directors and joint founders of a software company. Robin is a marketing expert, and Barry is a technical specialist who devised the original software concept. To help kick-start the business, Maurice, an angel investor, invests £300,000 into the company and takes a 10% stake, leaving Barry and Robin with 45% each. The company has adopted vanilla articles of association and has not entered into a shareholders’ agreement.
Now let us imagine any of the following scenarios occurring:
A few short months after the investment, Barry starts to lose interest, resigns, and moves to Australia (sitting on his 45% shareholding).
The business becomes successful, and a third party makes a very attractive offer to buy the whole company. Barry and Robin are keen to accept the offer, but Maurice holds out and refuses to sell.
Barry and Robin decide to change their business plan and – to Maurice’s horror – use the investment funds to buy and run a pub.
Maurice sells his shares to a competitor of the company with whom Barry and Robin have longstanding personal animosity.
Maurice dies and leaves his shares in his will to 20 of his relatives, many of whom are uncontactable or uninterested in the business.
Without a shareholders’ agreement in place, any of the above could feasibly happen and leave the aggrieved parties with little to no recourse or remedy. A well-drafted and properly considered shareholders’ agreement would ensure that there are mechanisms in place to deal with these eventualities:
If Maurice puts £300,000 into a company whose value and direction is dependent on retaining its founders, then those founders need to be incentivised to stay or – put another way – disincentivised from leaving. Provisions can be included in a company’s constitution which claw shares back from a founder in the event that he leaves within a certain period. Barry leaving in the way that he did – while still consequential for the business – would result in him essentially being stripped of his shares.
If an opportunity to exit presents itself and the majority of shareholders wish to take that opportunity, then provision can be made in a company’s constitution by which any unwilling minority shareholder can be dragged along into the sale.
A company is run by its directors, not (directly) by its shareholders, and certainly not by its minority shareholders. However, as the primary funder of the business, Maurice may well expect to be consulted – and to hold a veto – over certain major decisions, which pivoting to the leisure and hospitality sector would certainly be. An investor will often wish to include in a shareholders’ agreement a list of “reserved matters” which the board cannot undertake without that investor’s consent.
Most shareholders’ agreements contain restrictions on share transfers. In this instance, at the very least Barry and Robin would want first right of refusal to buy Maurice’s shares off him. They may also want a veto over certain parties (especially competitors) becoming shareholders.
Contractual provisions can be agreed upon which enable a company to keep control of its cap table in the event of the death of a shareholder. Twenty new names on the shareholder list would leave the company with an unwieldy cap table and a logistical headache if ever those new shareholders are needed to sign documents or approve decisions.
The above represents only a small handful of the many issues that may arise during the lifetime of a company. While one cannot, of course, pre-empt and predict every hurdle that a business (and its investors) must overcome, a thorough and robust set of constitutional documents can start a company off on the right foot.
For help with creating a shareholders agreement, or any other contractual matter, speak to one of our startup lawyers - we offer a full range of legal services specifically tailored to small businesses, SMEs, and startups.
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