Starting or acquiring a business with another person often begins with everyone focused on the same goal.

At that stage, it can seem unnecessary to spend time considering what will happen if circumstances change.

But businesses evolve. One shareholder may want to sell. Another may want to invest more money. The owners may disagree about the direction of the company. A shareholder may become seriously ill, die or stop working in the business. A new investor may want to come on board.

A shareholders’ agreement allows the owners to establish a framework for dealing with these issues before they arise.

For companies with multiple shareholders, it can be one of the most important documents put in place.

What Is a Shareholders’ Agreement?

A shareholders’ agreement is a private agreement between some or all of the shareholders of a company and, commonly, the company itself.

It sets out how the shareholders intend to manage their relationship and can regulate matters such as:

• management and decision-making;
• appointment of directors;
• voting;
• funding;
• dividends;
• shareholder loans;
• issuing new shares;
• transferring shares;
• bringing in new shareholders;
• what happens when a shareholder wants to leave;
• valuation of shares;
• death or incapacity;
• confidentiality;
• restraints;
• deadlocks; and
• the eventual sale of the company.

ASIC confirms that shareholder rights may arise under the Corporations Act 2001 (Cth), a company's constitution and a shareholders’ agreement, where one exists.

The agreement can therefore be tailored to the particular owners and commercial circumstances of the business.

Isn't the Company Constitution Enough?

Not necessarily.

Every Australian company needs rules governing its internal management. Depending on the company, these may be contained in a constitution, the replaceable rules in the Corporations Act, or a combination of both.

A constitution deals with the governance of the company and has statutory contractual effect between the company and its members, between the company and its directors and secretary, and between members themselves.

A shareholders’ agreement serves a different purpose.

It allows the shareholders to document more detailed commercial arrangements governing their particular relationship.

For example, the constitution may establish how directors make decisions, while a shareholders’ agreement can specify that certain significant business decisions require approval from all shareholders or a specified majority.

Where both documents exist, they should be prepared and reviewed together so that their provisions work consistently and any priority between them is appropriately addressed.

1. Who Makes the Decisions?

One of the most important issues is determining who has authority to make decisions.

Under the Corporations Act's replaceable rules, the business of a company is generally managed by or under the direction of its directors, subject to powers reserved to members by the Act or the company's constitution.

A shareholders’ agreement can go further by identifying important decisions that require shareholder approval.

These might include:

• borrowing above a particular amount;
• issuing new shares;
• acquiring another business;
• selling significant assets;
• entering major contracts;
• changing the nature of the business;
• appointing senior executives;
• entering related-party transactions;
• declaring dividends; or
• selling the business.

The required level of approval can also be specified.

Some matters might require a simple majority, while particularly significant decisions might require a higher percentage or unanimous approval.

This can be especially important where ownership is not divided equally.

2. Appointment of Directors

Shareholders and directors are not the same thing.

A shareholder owns shares in the company. Directors are responsible for managing or directing the company's business.

In owner-operated businesses, the same people frequently perform both roles, but this should not simply be assumed to continue indefinitely.

A shareholders’ agreement can address:

• which shareholders can appoint a director;
• how many directors there will be;
• how directors can be removed or replaced;
• who will chair meetings;
• whether the chair has a casting vote; and
• what happens if a shareholder ceases to hold a particular percentage of shares.

These provisions become particularly important as the business grows or new investors join.

3. What Happens if the Business Needs More Money?

Many businesses require additional capital after they are established.

The shareholders should consider in advance how future funding will be provided.

For example:

• must shareholders contribute in proportion to their shareholdings?
• will additional funding be provided as equity or shareholder loans?
• can the company obtain external finance?
• what happens if one shareholder cannot or does not want to contribute?
• can another shareholder provide the additional funding?
• will doing so alter the ownership percentages?

Without an agreed mechanism, a funding requirement can quickly become a source of disagreement.

A shareholders’ agreement can establish the process before additional capital is required.

4. Shareholder Loans

It is common for owners to advance money to their company.

The agreement should work together with appropriate loan documentation and financial records to clarify matters such as:

• how shareholder advances are treated;
• whether interest is payable;
• when repayment can occur;
• whether loans rank equally;
• what happens to shareholder loans when shares are sold; and
• whether repayment requires particular approvals.

This can become particularly important when shareholders have contributed different amounts to the business.

A 50/50 shareholding does not necessarily mean both shareholders have provided the same amount of funding.

Those two issues should be documented separately.

5. Issuing New Shares

Issuing additional shares can change the ownership and control of a company.

ASIC notes that companies must comply with rules governing changes to their share structure and notify ASIC of relevant share issues and other changes.

A shareholders’ agreement can provide additional contractual protections.

For example, existing shareholders may be given a pre-emptive right to participate in a proposed issue of new shares before those shares are offered to someone else.

This can help protect shareholders against unexpected dilution of their ownership.

The agreement can also establish the process for approving the issue and determining the price of new shares.

6. Can a Shareholder Sell Their Shares to Anyone?

This is another important issue.

Without appropriate arrangements, the remaining owners may have limited control over who becomes their future business partner, subject to the Corporations Act and the company's governing documents.

ASIC notes that share transfers are affected by the company's constitution and applicable company rules, and proprietary companies must keep their member details and relevant share changes up to date.

A shareholders’ agreement can create a structured process for transfers.

For example, a shareholder wishing to sell may first be required to offer their shares to the existing shareholders.

This is commonly described as a pre-emptive right or right of first refusal.

The agreement can specify:

• how notice must be given;
• how the price is determined;
• how long the other shareholders have to respond;
• whether shares can subsequently be offered to an external purchaser; and
• whether a new shareholder must agree to be bound by the shareholders’ agreement.

This gives existing owners greater control over changes in ownership.

7. How Are Shares Valued When Someone Leaves?

A transfer mechanism is of limited assistance if the parties cannot agree on what the shares are worth.

A shareholders’ agreement can establish a valuation mechanism in advance.

Depending on the business, this might involve:

• an agreed valuation methodology;
• an independent business valuer;
• a formula;
• market value determined according to specified principles; or
• another agreed process.

Different valuation rules may also apply depending on why the shareholder is leaving.

For example, the parties may choose different consequences for an ordinary voluntary exit compared with a serious breach of the shareholders’ agreement.

The valuation provisions should be drafted carefully. A poorly designed formula can produce an unintended result years after the agreement was signed.

8. What Happens if a Shareholder Wants to Leave?

Business owners' circumstances change.

One shareholder may want to retire, pursue another business or simply realise their investment.

The shareholders’ agreement can establish an orderly exit process.

It might provide:

1. notice of the intention to leave;
2. an opportunity for the remaining shareholders to purchase the shares;
3. a valuation process;
4. timeframes for completing the transaction; and
5. rules about offering the shares externally if the existing shareholders do not purchase them.

Having an agreed process can make an eventual ownership change much easier to manage.

9. What Happens if a Shareholder Dies or Becomes Incapacitated?

Death or serious incapacity can create significant uncertainty for a privately owned company.

Shares are valuable property and do not simply disappear when a shareholder dies.

The shareholders should consider what they want to happen in those circumstances.

For example, should the remaining shareholders have an opportunity or obligation to purchase the deceased shareholder's shares?

How will those shares be valued?

How will the purchase be funded?

Should life insurance or another funding arrangement be considered?

The shareholders’ agreement should also be coordinated with the owners' wills, estate planning and any buy-sell arrangements.

These documents should work together rather than create inconsistent outcomes.

10. Dividends and Profits

A profitable company does not necessarily distribute all of its profits to shareholders.

ASIC notes that company directors determine when and how dividends are paid, subject to the applicable legal requirements.

Different shareholders may have very different expectations.

One owner may want profits reinvested to grow the business. Another may rely on regular distributions.

A shareholders’ agreement can establish principles or approval requirements concerning:

• dividend policy;
• retention of profits;
• reinvestment;
• working capital; and
• distributions to shareholders.

While the agreement cannot override directors' statutory obligations, it can document the commercial expectations between the owners.

11. Salaries Are Different From Dividends

In many small and medium businesses, shareholders also work in the business.

It is useful to distinguish between:

• salary or remuneration for work performed;
• dividends arising from share ownership; and
• repayment of shareholder loans.

They are different concepts.

Two people might each own 50% of the company but perform very different roles or work different hours.

The shareholders’ agreement and related employment or service arrangements can establish how working shareholders are remunerated and how changes to that remuneration are approved.

This can help avoid an assumption that equal ownership necessarily means identical remuneration.

12. Protecting Minority Shareholders

A shareholder who does not control more than half of the voting shares can be concerned about significant decisions being made without their agreement.

A shareholders’ agreement can provide negotiated protections by requiring particular decisions to receive a higher level of approval.

For example, certain reserved matters might require 75% approval or unanimous consent.

These might include:

• issuing new shares;
• changing the company's business;
• taking on significant debt;
• selling major assets;
• entering related-party transactions; or
• selling the company.

The appropriate protections depend on the ownership structure and the commercial bargain between the shareholders.

Shareholders also have rights under the Corporations Act that operate independently of the agreement. ASIC identifies statutory shareholder rights concerning matters including company information, meetings and voting.

13. Protecting Majority Shareholders

The agreement should not focus exclusively on minority interests.

Majority shareholders may also require mechanisms that allow the business to operate effectively without a small interest preventing every significant commercial decision.

The challenge is finding an appropriate balance between:

• protecting minority investors; and
• allowing the company to make decisions and operate efficiently.

The appropriate balance will differ significantly between, for example, a 50/50 owner-operated company and a company owned 70/20/10 by three investors.

This is one reason shareholders’ agreements should be tailored rather than treated as generic templates.

14. What Are Tag-Along Rights?

Tag-along rights are designed primarily to protect minority shareholders when a major shareholder sells their interest.

For example, if a majority shareholder receives an offer from a third party to purchase their shares, a tag-along provision may allow minority shareholders to participate in the sale on the terms specified in the agreement.

This can prevent a minority shareholder from being left in the company with a new controlling owner they did not choose.

15. What Are Drag-Along Rights?

A drag-along provision addresses the opposite problem.

Suppose a buyer wants to acquire 100% of the company, but one small shareholder refuses to sell.

Subject to its terms, a properly drafted drag-along mechanism may allow the required majority of shareholders to compel the remaining shareholder or shareholders to participate in the sale.

These provisions can be important when preparing a business for an eventual sale.

The thresholds, procedural requirements and protections applying to tag and drag rights should be clearly drafted.

16. What Happens in a 50/50 Company?

A 50/50 ownership structure deserves particular attention.

If the two owners disagree and neither has a casting vote or another mechanism for resolving the issue, the company can reach a deadlock.

The agreement can establish a process for dealing with deadlocks.

This might involve escalating the issue through:

• negotiation;
• mediation;
• another agreed dispute-resolution procedure; or
• ultimately, an agreed ownership-exit mechanism.

The appropriate solution depends on the business.

A mechanism that works for passive investors may be unsuitable for two founders who both work full-time in the company.

The best time to agree on a deadlock process is generally before there is a deadlock.

17. Confidentiality and Intellectual Property

Shareholders often have access to commercially sensitive information such as:

• customer information;
• pricing;
• financial information;
• trade secrets;
• business plans;
• supplier arrangements; and
• proprietary systems.

A shareholders’ agreement can contain confidentiality obligations governing how that information is used and disclosed.

It can also address intellectual property.

Where shareholders or founders create intellectual property used by the company, the parties should determine whether that intellectual property is owned by the company, licensed to it or held under another arrangement.

Ownership should not be left to assumption.

18. Restraint Provisions

The parties may also consider what should happen if a shareholder leaves the business.

For example, should a departing shareholder be restricted from immediately competing with the company, soliciting its customers or approaching its employees?

Restraint provisions require careful drafting.

Their enforceability depends on their terms and circumstances, and overly broad restraints may not operate as intended.

The commercial objective should therefore be identified first, with the provision drafted to address that objective appropriately.

19. Bringing a New Shareholder Into the Company

A shareholders’ agreement should contemplate future growth.

If a new investor or business partner acquires shares, the existing shareholders will generally want that person to become bound by the same agreed rules.

The agreement can therefore require a new shareholder to execute a deed of accession or similar document before their acquisition is registered.

The parties should also consider whether admitting a new shareholder requires a particular level of approval.

This prevents the agreement from becoming ineffective simply because the ownership group changes.

20. Selling the Entire Business or Company

A shareholders’ agreement should also contemplate the eventual exit.

For some businesses, that may involve selling the business assets.

For others, a purchaser may acquire the shares in the company itself.

The agreement can address how a proposed sale is approved and how shareholders participate in a transaction, including through tag-along and drag-along mechanisms where appropriate.

Planning for an eventual sale at the beginning of the shareholders' relationship can make the transaction considerably easier if that opportunity arises years later.

Related article: Buying or Selling a Business in Queensland: Key Legal Considerations.

When Should You Put a Shareholders’ Agreement in Place?

Ideally, the shareholders’ agreement should be prepared when the business relationship begins.

At that point, the parties are generally aligned and can discuss difficult hypothetical scenarios objectively.

It is also sensible to review an existing agreement when:

• a new shareholder joins;
• ownership percentages change;
• the company receives external investment;
• the business expands significantly;
• substantial new funding is introduced;
• the roles of the owners change; or
• the business begins preparing for sale.

An agreement prepared years earlier may no longer reflect how the business actually operates.

What if the Business Is Already Operating Without One?

It is not necessarily too late.

Shareholders can still negotiate an agreement after the company has commenced operating.

However, it is usually easier to agree on rules before a disagreement exists.

If the shareholders wait until a significant issue has arisen, each party may approach the proposed agreement from an established position rather than trying to create a framework for the future.

A Shareholders’ Agreement Should Fit the Business

A generic shareholders’ agreement downloaded from the internet may contain provisions that sound sophisticated but do not reflect how the particular business operates.

For example, a 50/50 business run by two founders has very different governance requirements from a company with:

• one 70% founder;
• two 10% working shareholders; and
• a 10% passive investor.

The agreement should reflect matters such as:

Who owns the company?
Who works in it?
Who invested the money?
Who makes which decisions?
What happens if more funding is needed?
How can someone leave?
How will their shares be valued?
What happens if the owners disagree?
What is the long-term exit plan?

Those are ultimately commercial questions as much as legal ones.

The legal documentation should record the answers clearly.