How to Write a Shareholder Agreement – If you’re going into business with a co-founder, investor or silent partner and you’re using a company structure, then you need a Shareholder Agreement. A Shareholder Agreement sets out how the company is to be run; what the relationship between the shareholders is to be; and protects the investments made by those shareholders in the company.
This guide explains all the different elements of a Shareholder Agreement from an Australian startup’s perspective. So read on.
Legal issues covered in this guide
Click on any of the questions below to jump to that section of this legal guide.
- The Basics
- Alternative Forms of Agreement
- The Practicalities
- Can a Shareholder Agreement be verbal?
- Can a Shareholder Agreement be changed?
- What clauses should a Shareholder Agreement include?
- How do different share classes work (ordinary, non-voting, preference)?
- How can sweat equity be accounted for in a Shareholder Agreement?
- What if a shareholder is also an employee of the company or startup?
- Can a Shareholder Agreement be verbal?
- Adding or Removing Shareholders
- How can a new investor be added to an existing Shareholder Agreement?
- How can I avoid being diluted when a new investor joins?
- What share transfer restrictions should be included in a Shareholder Agreement?
- What are buy-sell provisions?
- What happens if a shareholder wants to retire from the business?
- What happens if a shareholder dies?
- How can a new investor be added to an existing Shareholder Agreement?
- Shareholder Disputes
If after reading this guide you still have a question, get in touch as we’d love to keep adding your questions to this comprehensive guide.
What is a Shareholder Agreement?
A Shareholder Agreement is a contract between the shareholder owners of a company. It sets out the various rights and responsibilities of the shareholders. Although Shareholder Agreements can vary substantially, they usually cover the following:
- The number of shares that each shareholder owns
- Whether there are different classes of shares, and if so, the different rights and rules for each share class
- Whether or not the company may issue additional shares in the future, and if so, whether existing shareholders will have their interest “diluted” or they will be able to acquire new shares
- Details of how new shareholders may join the company
- Details of how existing shareholders may leave the company (e.g. who they may sell shares to and whether they must first offer the shares to current shareholders)
- Reasons a shareholder may be forced out of the company (e.g. they commit a crime, declare bankruptcy or engage in behaviour detrimental to the company)
- Details of any procedures that may apply if a shareholder is forced out of the company or if they die
- “Drag along” and “tag along” rights (which protect the interests of minor shareholders) that may apply if a major shareholder intends to sell their shares
- Any procedure which may apply if the company requires a capital injection, and
- Details of any dividend policy
What are the advantages of a Shareholder Agreement?
A Shareholder Agreement provides a way to set out the various rights and obligations of shareholders. By doing so, it allows shareholders to understand the rights and obligations that apply to them, and to make sure that they are happy with the arrangement before they agree to it.
Many disputes that arise between business partners result from innocent communication failures. The parties might all have good intentions but might simply misunderstand the terms of the agreement. For example, there might be a misunderstanding about who is to perform a particular type of work for the company or how shareholders are going to be compensated for work that they perform.
These simple misunderstandings can develop into bitter disputes and can ruin a company.
In other cases, one or more shareholders might have somewhat more malicious intentions, and might deliberately set out to take advantage of other shareholders. By having a written an Agreement which clearly sets out the various rights and responsibilities, each shareholder is able to consider their role within the company and make sure that their rights are protected.
Is a Shareholder Agreement necessary?
A Shareholder Agreement is not required by law. However, nearly every company that we deal with (except for companies with only one shareholder) will benefit from having a Shareholder Agreement.
It is also worth considering that a Shareholder Agreement can be as simple or as complex as you want it to be. If you have reservations about the potential cost and hassle of preparing a very detailed Agreement, you may still benefit from preparing something more basic.
What are the risks of not having a Shareholder Agreement?
If you invest and buy shares in a company that does not have a Shareholder Agreement then you face a number of risks.
At some point during your involvement with the company, you are likely to encounter some kind of misunderstanding or disagreement. You might think that the company operates in one way, but discover several years later that it does not.
For example, you might perform work for the company on the understanding that you are going to be compensated in the form of additional company shares, only to discover several years later that this is not correct.
The majority shareholder might pass away, leaving his or her shares to their only child, who happens to have a gambling problem.
The company might issue new shares to all of the shareholders except you, meaning that your interest is drastically diluted and you no longer have the voting power, or even shareholding, that you used to have.
You might be the majority shareholder, wanting to sell your shares in the company, but might discover that the minority shareholders are able to vote against the sale, effectively holding you ransom.
Another shareholder might fail to perform the work that you thought they were going to do for the company, and you might have no way to ensure that they start doing what they are meant to do.
Lastly, the shareholders might be unable to agree about a particular company matter, and might have no way of settling the disagreement without incurring significant costs.
In all of these examples, having a written Shareholder Agreement, agreed ahead of time, would allow you to address and resolve these potential issues in a fair way, before they become an expensive (or insurmountable) problem.
Alternative Forms of Agreement
What is a Partnership Agreement?
A Partnership Agreement is a document that creates a partnership and sets out the rules between partners.
What is the difference between a Shareholder Agreement and a Partnership Agreement?
A Partnership Agreement applies to a partnership. A Shareholder Agreement applies to a company. A partnership and a company arrangement are very different, so the two documents serve different purposes. These business structures are very different and should be understood before deciding upon your ultimate business structure.
A Partnership Agreement can achieve a similar outcome for a partnership business structure as a Shareholder Agreement does for a company. But note, the business structure and liabilities are very different.
Shareholder Agreement vs Articles of Association vs Corporate Bylaws vs Company Constitution vs Replaceable Rules?
A Shareholder Agreement is often confused with a number of other similar documents. We have already described what a Shareholder Agreement is above; the other documents are described below.
Articles of Association – These were used by Australian companies prior to 1998. However, from 1 July 1998 Australian companies were required to use a Company Constitution instead, which complied with Australia’s updated company laws. Some older companies may still use Memorandum and Articles of Association. However, these are unlikely to be fully compliant and should be replaced with a Company Constitution and Shareholder Agreement.
Corporate Bylaws – This terminology is often associated with US companies. However, there is a particular type of Australian company – called a “Company Limited by Guarantee” – which may use Corporate Bylaws instead of a Shareholder Agreement. But these companies are usually not-for-profit and don’t have shareholders.
Company Constitution – Australian companies usually use a Company Constitution in conjunction with a Shareholder Agreement. In many ways, these two documents appear to do similar things, as they both deal with the operation of the company. A Company Constitution can only be created by special resolution (75% vote), may be a publicly available document and applies to all shareholders in the company. A Shareholder Agreement, on the other hand, is simply a contract between the shareholders (so it does not require the 75% vote). This means it may be cheaper to create, may be kept confidential and may be created between some (but not all) shareholders.
Replaceable Rules – Provided by the Australian Corporations Act of 2001, these are a set of general rules about the operation of companies, which apply automatically if the company does not have a Company Constitution. However, if the company chooses to create a Constitution then the Constitution overrides (or “replaces”) these rules.
Can a Shareholder Agreement be verbal?
Technically, yes. But in practice, no.
A Shareholder Agreement is a contract between the shareholders and, as with many other forms of contract, it may be created verbally. However, a verbal contract can be difficult to enforce because it can be very hard to prove what was actually agreed. In addition, Shareholder Agreements typically deal with some relatively complex terms, so if these are not written down then it is likely that different shareholders will have a different understanding of what was actually agreed. Then, over time, many key elements are likely to be forgotten.
If you are going to have a Shareholder Agreement, then you should do it properly, which means writing it down.
Can a Shareholder Agreement be changed?
Yes. If circumstances change, then it is possible to revoke or amend a Shareholder Agreement. However, it will need to be done by agreement between the relevant shareholders.
What clauses should a Shareholder Agreement include?
Shareholder Agreements are quite flexible, so they can often be adapted to suit the needs of your particular company. However, there are a number of common clauses that your Agreement should include:
- Company objectives (including any limitations on business activities)
- Share classes and voting rights
- Appointment of Directors (including their duties and maximum number)
- Shareholder loans, loan accounts and the right to payment of interest
- Dividend distribution policy
- Board meetings, decision making and reporting requirements
- Issuing new shares and capital calls
- Sale or transfer of shares and right of first refusal
- Company change of control and “drag along” provisions
- In case of divorce, incapacity or death
- Departing shareholders and business valuation
- Confidentiality and non-compete responsibilities
- Events of default
- Dispute resolution and arbitration
- Termination, and
- Governing law
How do different share classes work (ordinary, non-voting, preference)?
It is up to the shareholders to agree on the rights and obligations that attach to the different classes of shares. Shareholders can also agree on names for the share classes as they see fit. For example, they might name them “ordinary”, “non-voting” and “preference”. Alternatively, they might name them “first class”, “second class” and “third class”.
If there are multiple classes of shares, then the “ordinary” class might have normal voting rights (i.e. one vote per share) and the right to receive dividends. However, a different class of “non-voting” shares might have a right to dividends but no right to vote on company matters.
Another class of “preference” shares might have rights that go beyond the rights of “ordinary” shares, such as a priority in the payment of dividends. Any rights attaching to “preference” shares must be set out in the company constitution or approved by special resolution (75% vote). This protects the holders of other “non-preference” shares.
How can sweat equity be accounted for in a Shareholder Agreement?
“Sweat equity” refers to a situation where a shareholder performs work for the company and instead of being paid a fee or a wage for that work, they are given shares in the company.
It is possible to detail in a Shareholder Agreement the task or tasks that a shareholder is going to undertake for the company and the equity that they will receive in return. In addition, you can supplement the Shareholder Agreement with a Memorandum of Understanding (MOU) which explicitly states contributions of time versus financial contributions.
What if a shareholder is also an employee of the company or startup?
This occurs in many startup companies. The employee may be paid a wage, may work for “sweat equity” or some combination of the two.
If the shareholder is an employee, then various features of employment law may become relevant. A proper employment agreement must be signed and your State employment documents provided. In addition, the employee is entitled to Superannuation, annual leave, long service leave and workers compensation. The company may face penalties if it fails to meet these obligations as an employer.
Whichever structure you use, it is important that the parties all clearly understand the situation and the rights and obligations that arise from it. It is also important that the arrangement be documented in writing, to avoid any misunderstandings.
Adding or Removing Shareholders
How can a new investor be added to an existing Shareholder Agreement?
It is common for a Shareholder Agreement to explain the process for adding a new investor as a shareholder in the company.
Usually, a new shareholder will need to agree to the terms of the existing Shareholder Agreement. This can be done by providing a copy of the Agreement to the new shareholder and having them sign a “Deed of Accession” which says that they agree to the terms of that pre-existing Agreement.
The new shareholder will receive shares in return for their investment. If they are simply buying shares from a departing shareholder, then the shares may simply be transferred from one party to the other. If not, the company will need to issue new shares for the new shareholder to purchase. This can result in dilution of the interests of existing shareholders and this needs to be addressed in the Shareholder Agreement.
How can I avoid being diluted when a new investor joins?
You will need to ensure that your Shareholder Agreement deals with this possibility. In many Shareholder Agreements, a procedure is set out where existing shareholders have a right of first refusal to buy additional shares on issue, in proportion to their existing shareholding. Alternatively, any new shareholder will be issued shares of a different class with different rights attached.
This is an important clause to check and understand in any Agreement.
What share transfer restrictions should be included in a Shareholder Agreement?
Each company is different so it is not possible to provide a “one size fits all” solution regarding share transfer restrictions. However, in smaller companies where there are only a few shareholders, Agreements often contain detailed clauses restricting share transfers so the original shareholders have some control over whom they are in business with.
Generally, share transfers are restricted by first requiring Director approval or giving existing shareholders first rights to buy shares if another shareholder wants to sell them. You should seek legal advice in order to determine what sorts of restrictions are appropriate for your situation.
What are buy-sell provisions?
Buy-sell provisions set out how shares may be bought or sold in various situations, including if a shareholder encounters insolvency, disability, death or retirement. Generally, a price or valuation mechanism should be included in your Agreement.
What happens if a shareholder wants to retire from the business?
Again, this should be addressed in your Shareholder Agreement. It is common to require the departing shareholder to give the existing shareholders a right of first refusal to buy, before the departing shareholder is able to sell the shares to any outside party.
What happens if a shareholder dies?
If this is not addressed in the Shareholder Agreement, then it may be possible for the deceased shareholder’s shares to be transferred to the deceased shareholder’s beneficiaries. For example, to a spouse, children or even to a charity. This can be particularly problematic in some companies, especially if the company is small and the deceased shareholder owned a large proportion of the shares.
In order to avoid these problems, many Shareholder Agreements provide that the company will obtain an independent valuation of those shares and will buy the shares from the deceased shareholder’s estate, at the fair market value.
Is a Shareholder Agreement legally binding?
Yes. Provided the Shareholder Agreement is created in such a way that complies with legal requirements (e.g. it is validly signed by all parties) then it will be legally binding.
A Shareholder Agreement is a contract between shareholders and the Corporations Act of 2001 and ordinary principles of Australian contract law apply. If the Shareholder Agreement violates the Act in any way, then the Act is likely to prevail. Meaning that the part of the Agreement that does not comply will be overridden.
What happens if a Shareholder Agreement is breached?
Your Shareholder Agreement should describe what is to happen if it is breached. In many Shareholder Agreements, a shareholder who is in breach may be prevented from voting at any shareholder meetings, until the breach is rectified. If the breach is not rectified within a certain timeframe, then the company may buy the defaulting shareholder’s shares and the shareholder may be removed from the company.
What if the Shareholders have a disagreement or dispute?
Again, the Shareholder Agreement should explain the process that is to apply. It’s up to the shareholders to determine the most appropriate process for their circumstances.
Many Shareholder Agreements include a procedure, requiring parties that have a dispute to firstly set out their dispute out in writing then hold a meeting to discuss it. If the dispute cannot be resolved within a certain timeframe then they may have to attend mediation and/or arbitration.
Can a shareholder be forced out?
This is possible, however a Shareholder Agreement can protect against it.
For example, if new shares are issued which dilute the interest of an existing shareholder, then that shareholder may find that they no longer have the voting power they once had. The other shareholders could then pass resolutions to force that shareholder out of the company.
Can shareholders call a secret meeting, excluding some shareholders?
Shareholders are generally free to meet however they like. This includes meeting in secret and excluding some shareholders.
Under the Australian Corporations Act of 2001, a meeting between shareholders will not actually count as a “shareholders meeting” (or “members meeting” as it may also be called) unless all shareholders have been notified in accordance with the Act. This means they must be given a minimum amount of notice, in writing, to their nominated address.
However, certain matters that must be voted on by shareholders cannot be voted on at “secret” meetings where some shareholders have been excluded.
How can a Shareholder Agreement be terminated?
Your Shareholder Agreement should include a series of clauses explaining how it may be terminated. Agreements can usually be terminated in the following circumstances:
- By agreement between the shareholders
- If the company ceases to trade and is wound up
- If all of the shares are transferred to a single shareholder, and
- If the company undertakes an initial public offering (IPO)
In any event, even if the Shareholder Agreement does not specifically explain how and when it may be terminated, it may be terminated by agreement between the parties and in accordance with the usual principles of contract law.
We hope you found this guide on How to Write a Shareholder Agreement helpful.