© Winston & Strawn London 2008. These notes are provided free of charge as a convenience to attendees of the Bootlaw series of seminars. They relate to the laws of England and Wales only. They do not purport to offer advice, or to be fit for any particular purpose. For this reason, they are supplied with no warranty, express or implied, of any type. We accept no liability for their use and you should obtain independent legal advice in connection with the issues discussed. We hope you understand why we cannot accept liability for the use of these notes when we are not aware of the circumstances of their use. Please contact Barry Vitou if you have any questions about their use and application. You are granted a limited licence to copy the documents for internal use in your organisation only, and you undertake to keep the copyright notice and disclaimer portions of the document intact (if applicable).
Shareholders Agreements and Articles of Association Love and Marriage?
Barry Vitou Speaking Notes 15 October 2008 Shareholders Agreements Consider, Analyse and Think. Before blindly going down the path of signing up to a Shareholders Agreement it is worth Considering what they are, Analysing what's in them and Thinking about whether you want one. Basics Before we start I’m going to whizz through some real basics very quickly about companies shares etc. what they are etc. so that everyone understands the context for Shareholders Agreements and Articles of Association in the first place. What does it mean to own shares. For example, you decide that you want a company and there are two of you. Each of you buys 1 share each. It means that together you own the company and in essence in turn its underlying business 100%. Which means that if you create the next google you’ll each have a half share. What does it mean to own those shares. Owning shares is not the same as loaning the company money. Obtaining the return of money invested in shares from a company is potentially more complicated than simply having a loan repaid. As a result generally speaking if you want your money back, instead of the company itself buying back those shares, shares tend to be sold to someone else. Broadly speaking, in the meantime as an owner of shares you get to vote those shares on certain key strategic decisions set out in Company law. Meanwhile, day to day issues are in effect delegated by the shareholders to the directors.
Finally, if the company becomes insolvent shareholders will typically be the last people to be paid out after all other creditors. This overview of Shareholders Agreements is going to look at 3 key areas: 1. What is a Shareholders Agreement 2. What's in it? 3. Do you want one? What is a Shareholders Agreement? A Shareholders Agreement is an agreement between the shareholders which governs the relationship between the shareholders and how the company is run. Three other points to set the scene for Shareholders Agreements. 1. They are "secret". In other words there is no legal requirement to file a Shareholders Agreement on the public record. This is in contrast to Articles Of Association of a UK company which must be filed at Companies House. 2. Generally speaking a Shareholders Agreement can contain whatever the Shareholders wish to agree (in contrast there are restrictions on what you can put in the Articles of Association). 3. Generally speaking if a Shareholders Agreement is breached the award from a court is likely to be damages. What is in a Shareholders Agreement? In many cases there is a large amount of overlap between what is in a Company's Articles of Association and its Shareholders Agreement. Focussing on the extra provisions that you might find in a Shareholders Agreement, broadly these can be distilled into seven key areas: 1. 2. 3. 4. 5. 6. 7. Business of the Company (what is it and dealing with the business plan etc.) Minority Protections (things the Company can't do without shareholder consent) Restrictive Covenants (non competes; stronger than those available from employees) Money (agreement about how the company finances itself) Directors for the company and management (number, chairman, nominated directors) Dividends (policy) Deadlock (perhaps it should say divorce)
Deadlock warrants a little further explanation and is potentially the most important, though in many cases is simply left out. What is deadlock. A situation where it becomes difficult to run the business because key decisions are blocked by one of the parties. Its important to remember that if shareholders cannot agree then, just like in a divorce, no contractual agreement is going to get you back together again.
So deadlock procedures in a shareholders agreement are not the magic cure all. Instead the Deadlock procedures are normally just a process for working out the divorce settlement. Various names can be given to them, for example, Russian Roulette, Texas Shoot Out. However, its not important for the purposes of a general overview to know what each of these means. But it is important to understand that because there is no way the agreement can force people to put aside their differences or even to agree to sell their shares, the procedures bring in an arbitrary process to sell the shares with a large element of luck thrown in. Its also worth mentioning that if you have to divorce your fellow shareholders there are other methods of doing so without deadlock written in a Shareholders Agreement. Do you want a Shareholders Agreement? Bootstrapping start ups need to assess their individual circumstances. Ideally shareholders probably would have one. But we don't live in an ideal world. The answer is probably forthcoming when shareholders consider the following: 1. If you are a company which is all about looking for VC funding you have to question the wisdom of spending money on something they will tear up; because they will impose their own shareholder agreement with protections in their favour. Alternatively if you do not raise VC funding and your company fails, will several thousand pounds invested in a Shareholder Agreement to divide up the Shares in an insolvent company really have been money well spent? 2. If you have to litigate a Shareholder Agreement, its going to take a long time and cost a lot of money. If you're lucky you’ll probably only get a damages award. And the damages may be very hard to quantify. For example: What are the damages for failing to adopt your business plan or appoint X as a director? 3. As a practical matter what is your attitude to risk?
Danvers Baillieu Speaking notes 15 October 2008 ARTICLES OF ASSOCIATION As Barry has said, I am going to tell you about Articles of Association this evening, which I might simply refer to as “articles”. The point of this session is to boost your awareness of your articles, both as to their existence but also to their importance and therefore the possibilities that they open up for you. WHAT ARE THEY? If your shareholders’ agreement is the equivalent of the pre-nuptial agreement, then the articles are like your wedding vows. For several reasons - articles are a legal requirement needed to form a new company and secondly, there is lots of standard wording that goes into every set of articles - and although you can write your own - a bit like with wedding vows - in this country at least - most people go initially with the standard version prepared by their company formation agents. Articles are also public documents, so they are made in public – like wedding vows – and unlike shareholders or prenup agreements. Finally, and here the analogy probably falls apart, the articles are the governing document of your company. The shareholders agreement might deal with nitty gritty details such as who puts out the bins, but the contents of the articles deal with fundamental things such as how resolutions are passed or how new shares are issued. The articles bind every single shareholder, whether they have explicitly agreed or not, every shareholder has the protection of the articles and more importantly, they bind the company so much so that if someone tries to take a corporate action - such as passing a resolution WITHOUT abiding by the articles - it is not a question of having a claim for breach of contract, the resolution can simply be declared invalid and any actions taken on the back of it, can be unwound. Remember, changing your articles requires a special resolution of the company - that is 75% of the shareholders in favour - so if you have a minority shareholder with more than the magic 25%, he can prevent you from amending the articles. Also, note that Articles are not the same as Memorandum of Association, although they are often referred together as “mem ‘n’ arts”. The Memorandum of Association simply set out what a company is allowed to do and so they are usually drafted to permit just about anything imaginable – as well as set out the authorised share capital of the company – however, this concept is going to be abolished shortly. WHAT’S IN THEM? As I just said, most company articles are still the same basic set prepared by the incorporation agents. These will vary slightly from agent to agent, but they all have a common theme, in that they are printed in very small text and their effect is to adopt and then amend the default set, known as Table A.
Table A is an annex to the Companies Act - there has just been a new Companies Act which has a new Table A. A company can simply adopt Table A wholesale but there are some quite irritating and cumbersome things in there, hence the “standard amendments”. The Companies Act itself has default provisions which basically say that a company must do something a certain way, unless the shareholders have resolved differently – and properly drafted articles will state that certain provisions of the Companies Act do not apply. You can find a copy of the Companies Act and Table A on the internet My copy is somewhere in this thick book (Companies Legislation). You will not be surprised to hear that the Companies Act is the longest single piece of legislation ever passed by Parliament. Rather than run through every provision which comes into the standard, or which could be adopted, I am just going to take you through a few which are commonly found in more advanced versions and which we think are sensible to have. PREEMPTION RIGHTS Very simple concept, often misunderstood. First, on a transfer: say you three are equal shareholders in company and you want to sell to Bob. Well, your fellow shareholders might not want to have Bob in the company or they simply might want the shares themselves. With pre-emption rights, you will have to offer your shares to these two first, probably at the price you’ve agreed with bob. Generally, they can either challenge the price if it is too high and get a 3rd party to value the shares, or they can accept or they can decline. If they decline, you are free to sell to Bob at the stated price. These rights can apply on the issuance of new shares as well. So to continue the example, if your company needs to raise £100,000 at say £10 per share, you each have the opportunity to buy a third of these new shares before they are offered to another investor. On new issues, this right is automatic – its in the Companies Act - so you might use your articles to disapply this right, to give the directors complete discretion as to who gets new shares. COMPULSORY TRANSFERS The articles can also force a shareholder to sell his shares to the other shareholders. So say for example not only are you all shareholders but you all work together. Before the business really takes off, one of you then decides to leave to work for Microsoft. It would be unfair that you get to keep a third of the company going forward, but equally, you deserve some reward for the effort you’ve put in to date. The solution is that you are obliged to offer up a proportion of your shares to your co-founders – the precise amount will depend on how the articles have been drafted which should factor in how long you have been with the company and can also depend on the manner of your departure. We call this a “Good Leaver/Bad Leaver” clause. A bad leaver is someone who leaves for a pretty bad reason – for example gross misconduct. A good leaver is anyone else.
The compulsory transfer can also kick-in in other situations for example, when a shareholder dies or goes bankrupt, which means you don’t end up with a random co-shareholder, such as the beneficiaries of your co-founders or even worse, his creditors. I would emphasise that although you could agree otherwise, on a compulsory transfer, you still pay market value for the shares, and if you decline to do so, they either stay with the errant shareholder or can be sold by him to the highest bidder. Market price is generally determined by agreement or negotiation but the backstop arrangement is to have the right for any party to have an independent expert determine the market value. However, the cost of this exercise alone usually encourages the parties to work together. DRAG AND TAG RIGHTS Drag and tag rights kick in when the majority want to sell, i.e. 2 out of 3 want to sell the whole company to Google, but the third partner who has left the company and now only owns 10% doesn’t want to sell. With drag along rights, the majority can do the deal with Google and deliver the missing 10% - i.e. force the last shareholder into line. This is crucial to prevent a spanner in the works from stopping an important deal going ahead. Tag along is the opposite: if the majority decide to sell their shares, the minority have the right to sell at the same price to the purchaser – and if the purchaser does not want to buy 100% of the shares, he will buy from all the shareholders in the same proportion, so that everyone gets the chance to cash out at the same rate. ELECTRONIC NOTICE One of the biggest bug-bears for company administration – and a costly exercise if you are using lawyers – is corralling all your shareholders to pass resolutions, quite regardless of whether you need them to vote in favour or not, all shareholders have to be given the chance to participate. Under the new Companies Act it is now possible to have everyone agree to receive electronic communication from companies, which includes not just email, but also via a website, which, if via a secure site could include voting buttons and so on. There is a great business opportunity for someone to develop a portal for businesses to run their company administration online. You heard it here first. I just mention this, as now articles can be adapted to permit electronic communication, although it is also necessary to get shareholder consent – which can be done in the shareholders’ agreement or just by a letter which they counter-sign. SUMMARY Your articles of association are important.
Embrace them and understand what they do at the moment. Consider if you need changes: they can be your friend as with a few tweaks they can make dealing with your shareholders much easier. They can do away with the need for a shareholders agreement.
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