Starting a business with another person is often exciting.

At the beginning, shareholders may have the same objectives, trust one another and assume they will simply work things out as issues arise.

The difficulty is that circumstances change.

One shareholder may want to sell. Another may stop working in the business. The company may need additional funding. A shareholder may die or become incapacitated. A new investor may want to come in. A 50/50 company may reach a point where its owners simply cannot agree.

A well-drafted shareholders’ agreement establishes how those situations will be dealt with before they arise.

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

For privately owned companies, a shareholders’ agreement can therefore be one of the most important documents governing the relationship between the owners.

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 can establish rules dealing with matters such as:

• ownership and control;
• appointment of directors;
• decision-making;
• funding;
• shareholder loans;
• issuing new shares;
• dividends;
• transfer of shares;
• introducing new shareholders;
• sale of the company;
• death or incapacity;
• shareholder exits;
• valuation of shares;
• confidentiality;
• intellectual property;
• restraints; and
• deadlocks between shareholders.

The agreement can be tailored to the particular business and the relationship between its owners.

That is particularly valuable because two businesses with identical shareholdings may have completely different commercial requirements.

Isn't the Company Constitution Enough?

Not necessarily.

Every Australian company must have rules governing its internal management. Depending on the company, these can come from the replaceable rules in the Corporations Act, a company constitution, or a combination of the two.

A constitution deals with the company's internal governance. Under section 140 of the Corporations Act, a company's constitution and applicable replaceable rules have statutory contractual effect between the company and its members, directors and secretary, and between members themselves.

A shareholders’ agreement serves a different, complementary purpose.

It can address the particular commercial relationship between the shareholders in considerably greater detail.

For example, a constitution may establish how directors are appointed and meetings are conducted, while a shareholders’ agreement might establish that:

neither shareholder can sell their shares without first offering them to the other shareholder.

Or:

certain significant business decisions require unanimous shareholder approval even though one shareholder owns more than 50%.

The constitution and shareholders’ agreement should therefore be reviewed together to ensure they operate consistently.

Who Should Have a Shareholders’ Agreement?

A shareholders’ agreement should be considered whenever a private company has more than one shareholder.

This can include:

• two friends starting a business together;
• spouses or family members operating a company;
• professional practices;
• companies owned by several unrelated investors;
• family businesses involving different generations;
• joint ventures operated through a company; and
• established businesses bringing in a new shareholder.

The agreement becomes particularly important where ownership is 50/50, because neither shareholder necessarily has sufficient voting control to resolve a disagreement alone.

Define Ownership Clearly

The starting point is understanding who owns what.

ASIC confirms that a share represents part ownership of a company and that different classes of shares can carry different rights and obligations.

For example:

ShareholderOwnershipShareholder A50%Shareholder B30%Shareholder C20%

The percentages alone do not answer every governance question.

The agreement should also consider:

• what class of shares each person holds;
• voting rights;
• dividend rights;
• whether particular shareholders have director appointment rights; and
• whether different rights attach to particular shares.

This becomes especially important when investors or key employees are introduced later.

Who Makes the Decisions?

One of the most important functions of a shareholders’ agreement is establishing who has authority to make which decisions.

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

But shareholders may want particular significant decisions to require additional approval.

These are sometimes called reserved matters.

They might include:

• borrowing above a specified amount;
• purchasing or selling major assets;
• acquiring another business;
• selling the company's business;
• issuing new shares;
• changing the nature of the business;
• entering significant contracts;
• changing senior management remuneration;
• paying dividends;
• taking on significant debt;
• providing guarantees;
• commencing a major new venture; or
• winding up the company.

The appropriate approval threshold depends on the ownership structure.

Some matters might require a simple majority, others a special majority, and particularly significant matters might require unanimous approval.

Directors and Shareholders Are Different

It is also important to distinguish between shareholders and directors.

Shareholders own shares in the company.

Directors are responsible for managing or directing the company's business.

In many small businesses, the shareholders are also the directors, so the distinction can easily become blurred.

A shareholders’ agreement can establish:

• who may appoint a director;
• how many directors there will be;
• whether a shareholder must hold a minimum percentage to appoint a director;
• what happens when a shareholder sells their shares;
• who chairs meetings;
• whether the chair has a casting vote; and
• what constitutes a quorum.

These provisions can significantly affect control of the business.

What Happens When the Company Needs More Money?

Businesses often need additional capital.

The shareholders’ agreement should establish what happens if the company requires further funding.

Possible funding sources include:

• retained earnings;
• additional shareholder equity;
• shareholder loans;
• bank finance; or
• external investment.

Questions worth addressing include:

Are shareholders required to contribute additional capital?

Must they contribute in proportion to their ownership?

What happens if one shareholder cannot or will not contribute?

Can another shareholder provide the funding as a loan?

Can new shares be issued?

Could a shareholder's ownership percentage be diluted?

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

Shareholder Loans

It is common for owners of private companies to lend money to their company.

Those loans should be properly documented.

The shareholders’ agreement may address principles concerning shareholder funding, while separate loan agreements can record matters such as:

• amount advanced;
• interest;
• repayment;
• priority;
• security;
• further advances; and
• what happens to the loan if the shareholder exits.

Share ownership and shareholder debt are different things.

A shareholder selling their shares does not necessarily mean that a loan owed to them by the company automatically disappears.

The exit documentation needs to deal with both.

Issuing New Shares

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

For example, if two shareholders each hold 50 shares and the company issues another 50 shares to an investor, the original shareholders' percentages will change.

The Corporations Act contains a replaceable rule for proprietary companies requiring shares of a particular class generally to be offered first to existing holders of that class in proportion to their holdings, subject to the statutory rule and any applicable constitution.

A shareholders’ agreement can establish more detailed rules about:

• pre-emptive rights;
• valuation;
• approval for new issues;
• permitted employee equity;
• investor rounds; and
• dilution.

This allows shareholders to understand from the outset how future capital raising may affect their ownership.

What if a Shareholder Wants to Sell?

A shareholder should not necessarily be free to sell their interest to anyone they choose.

Imagine owning a business 50/50 with someone you have worked with for ten years.

Without appropriate transfer restrictions, you may face the prospect of their interest being transferred to someone you never intended to be in business with, subject to the company's governing documents and applicable law.

A shareholders’ agreement can establish a structured transfer process.

For example, it may require a selling shareholder to first offer their shares to the existing shareholders before selling them to an outsider.

This is commonly known as a pre-emptive right or right of first offer/refusal, depending on how the mechanism is drafted.

ASIC notes that share transfer rights can also be affected by the company's governing rules; for example, a replaceable rule gives directors of a proprietary company a general discretion to refuse registration of a share transfer.

The shareholders’ agreement and constitution therefore need to work together.

How Are Shares Valued When Someone Leaves?

This can become one of the most contentious issues if it has not been addressed beforehand.

The agreement can establish a valuation mechanism.

Options might include:

• an agreed formula;
• an independent business valuation;
• appointment of an accountant or valuer;
• market value;
• a valuation methodology based on maintainable earnings; or
• another mechanism appropriate to the business.

The agreement should also deal with who appoints the valuer and who pays the valuation costs.

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

For example, the parties may agree that a voluntary retirement is treated differently from serious misconduct.

What Are Good Leaver and Bad Leaver Provisions?

Some shareholders’ agreements contain good leaver/bad leaver provisions.

These are particularly common where shareholders are also employees or executives.

A “good leaver” might include someone who leaves because of:

• retirement;
• illness;
• incapacity;
• death; or
• another agreed circumstance.

A “bad leaver” provision may apply to circumstances such as serious misconduct or a material breach of the shareholders’ agreement.

The classification may affect matters such as:

• whether shares must be sold;
• how they are valued; and
• when payment occurs.

These clauses can have significant financial consequences and should be drafted carefully.

What Happens if a Shareholder Dies?

Death is an important issue that is often overlooked when the business is established.

ASIC confirms that under the relevant replaceable rule, where shares are not jointly held, the company recognises the deceased shareholder's personal representative as entitled to the deceased shareholder's interest.

But the shareholders may not want the deceased owner's beneficiaries to become long-term participants in the business.

A shareholders’ agreement can establish what happens on death, potentially including:

• an option or obligation to purchase the deceased shareholder's shares;
• valuation methodology;
• payment arrangements;
• insurance-funded buy-sell arrangements; and
• transitional management arrangements.

These provisions should be coordinated with estate planning and insurance advice.

What if a Shareholder Becomes Incapacitated?

Long-term incapacity can create similar difficulties.

If a shareholder is also a key director or employee, incapacity can affect both ownership and day-to-day management.

The agreement can address:

• how incapacity is determined;
• whether the shareholder must sell;
• who can exercise management functions;
• valuation;
• payment terms; and
• insurance arrangements.

Planning in advance avoids having to design a solution during an already difficult period.

What Happens in a 50/50 Deadlock?

A company owned equally by two shareholders requires particular attention.

If both shareholders must agree on significant decisions and they reach an impasse, neither has a majority capable of resolving it.

A shareholders’ agreement can establish a deadlock procedure.

Rather than immediately forcing an exit, the process might progress through stages such as:

1. referral to the shareholders;
2. a formal meeting;
3. negotiation between the principals;
4. mediation; and
5. an agreed buy-out or exit mechanism if the deadlock cannot be resolved.

The precise mechanism needs careful thought.

Some aggressive buy-sell mechanisms can disadvantage a shareholder with less access to capital, even where ownership is equal.

The goal should be to establish a commercially workable process appropriate to the owners and business.

Minority Shareholder Protections

A shareholder with 20% of a company does not ordinarily control decisions decided by simple majority.

But that shareholder may have made a substantial financial investment.

A shareholders’ agreement can give minority shareholders additional protections concerning specified fundamental decisions.

For example, their consent might be required before:

• issuing new shares;
• selling the business;
• changing the company's core activities;
• taking on substantial debt;
• entering related-party transactions; or
• changing particular shareholder rights.

The appropriate protections depend on the commercial bargain between the shareholders.

Majority Shareholder Protections

The agreement also needs to work for majority shareholders.

If a very small shareholder has veto rights over too many ordinary business decisions, the company may become difficult to operate.

The agreement should therefore strike an appropriate balance between:

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

That balance is one reason generic shareholders’ agreement templates can be problematic.

The right arrangement depends on the actual ownership structure.

What Is a Tag-Along Right?

A tag-along right generally protects minority shareholders where a majority shareholder proposes to sell their shares to a third party.

For example, if a shareholder holding 70% finds a purchaser for their shares, a tag-along clause may allow the 30% shareholder to require the purchaser to acquire their shares on the same or corresponding terms.

Without such a provision, the minority shareholder could potentially remain in the company with a completely new controlling shareholder.

What Is a Drag-Along Right?

A drag-along right works in the other direction.

It can allow shareholders holding an agreed threshold to require the remaining shareholders to participate in a sale of the company.

For example, a purchaser may offer to acquire 100% of a business but refuse to proceed unless every shareholder sells.

A properly drafted drag provision can prevent a small minority holding from frustrating a whole-of-company sale where the agreed threshold has been satisfied.

Because drag rights can compel a shareholder to sell, the triggering conditions and protections should be carefully drafted.

What Happens if the Whole Business Is Sold?

A shareholders’ agreement should contemplate an eventual sale.

The provisions may deal with:

• who can approve a sale;
• required shareholder thresholds;
• drag-along rights;
• tag-along rights;
• distribution of sale proceeds;
• repayment of shareholder loans;
• transaction costs;
• confidentiality;
• warranties given to the buyer;
• restraints; and
• completion mechanics.

A well-prepared ownership structure can make a future sale considerably easier.

Related article: Selling a Business in Queensland: How to Prepare for a Successful Sale.

Dividends and Profit Distribution

Shareholders may have different expectations about profits.

One shareholder may want profits distributed as dividends.

Another may want them reinvested to grow the business.

ASIC notes that directors determine whether dividends are payable and their amount, timing and method, subject to the Corporations Act and the company's governing arrangements.

A shareholders’ agreement can establish an agreed commercial approach to distributions, subject to the company's legal obligations and financial circumstances.

For example, it might establish principles concerning:

• maintaining minimum working capital;
• repaying external debt;
• funding future expansion; and
• considering dividends after those requirements have been met.

Salary and Dividends Are Different

Where shareholders also work in the business, the agreement should distinguish between returns received as an employee or director and returns received as a shareholder.

For example, a 50% shareholder working full-time in the business may receive a salary for their work.

Another 50% shareholder may not work in the business at all.

That does not necessarily mean they should receive the same salary.

Dividends, on the other hand, relate to share ownership and the rights attaching to the shares.

Separating these concepts helps avoid misunderstandings about how owners are being remunerated.

Confidentiality

Shareholders frequently have access to sensitive information including:

• financial records;
• pricing;
• customer information;
• supplier arrangements;
• intellectual property;
• business strategies; and
• employee information.

The agreement can impose continuing confidentiality obligations governing how that information may be used and disclosed.

Those obligations may continue after a shareholder leaves the company.

Intellectual Property

If intellectual property is important to the business, ownership should be clear.'

This might include:

• trade marks;
• software;
• copyright;
• business processes;
• websites;
• domain names;
• branding;
• databases; and
• proprietary materials.

Problems can arise where a founder personally owns intellectual property that everyone assumed belonged to the company.

The appropriate ownership and licensing arrangements should be documented.

Restraints

A shareholders’ agreement may contain restraints applying when a shareholder exits.

These might seek to restrict matters such as:

• competing with the business;
• soliciting customers;
• soliciting employees; or
• interfering with supplier relationships.

Restraints need to be considered carefully.

Their enforceability depends on their wording and circumstances, and an overly broad restraint is not automatically enforceable simply because the shareholder signed it.

Bringing in a New Shareholder

A shareholders’ agreement should also establish what happens when someone new acquires shares.

Commonly, the agreement will require the incoming shareholder to sign a deed of accession.

The deed allows the new shareholder to become bound by the existing shareholders’ agreement without requiring all parties to replace the original document.

This means the governance framework can continue as ownership changes.

Related article: What Is a Deed? When Should a Business Use a Deed Instead of an Agreement?

Shareholders’ Agreement vs Partnership Agreement

These documents should not be confused.

A shareholders’ agreement governs relationships between shareholders of a company.

A partnership agreement governs parties operating through a partnership.

The appropriate document therefore depends upon the underlying business structure.

If you are still determining how the business should be structured, see Business Structures in Australia: Company, Trust, Partnership or Sole Trader?

When Should a Shareholders’ Agreement Be Prepared?

Ideally, before or when the company is established.

That is generally when everyone is aligned and willing to discuss difficult future scenarios objectively.

However, it is not too late merely because a company has been operating for several years.

A shareholders’ agreement can also be prepared when:

• a new shareholder is joining;
• ownership percentages change;
• external investment is introduced;
• the business is growing;
• succession planning begins; or
• the existing owners recognise that their current arrangements are inadequate.

The company's constitution and existing corporate documents should be reviewed at the same time.

Should an Existing Shareholders’ Agreement Be Reviewed?

Yes.

Businesses change.

An agreement prepared for two founders operating a small business may no longer be appropriate once the company has:

• several shareholders;
• significant employees;
• external investors;
• substantial debt;
• valuable intellectual property;
• interstate operations; or
• plans for a future sale.

The agreement should also be reviewed when ownership or management changes materially.

Questions a Good Shareholders’ Agreement Should Answer

Before finalising the agreement, the owners should be able to answer:

Who controls day-to-day management?

Who can appoint directors?

Which decisions require shareholder approval?

Which decisions require unanimous approval?

What happens when the company needs more money?

Can new shares be issued?

Can ownership percentages be diluted?

Can a shareholder sell to an outsider?

How are shares valued?

What happens if a shareholder dies or becomes incapacitated?

What happens if a shareholder stops working in the business?

What happens if the owners cannot agree?

Can a majority owner sell the whole company?

Can a minority shareholder participate in a sale?

What happens to shareholder loans on exit?

If those questions do not have clear answers, the shareholders may be relying on assumptions rather than agreed rules.

Put the Rules in Place Before You Need Them

A shareholders’ agreement is not prepared because the shareholders expect their relationship to fail.

It is prepared because successful businesses change.

Owners come and go. Businesses need capital. Companies acquire assets. New investors arrive. People retire. Families change. Opportunities to sell arise.

Agreeing on the rules while everyone is aligned can make those transitions considerably easier to manage.