Mitigating the risk of a deadlock: why you need a shareholder agreement

Shareholders’ agreements are not expensive to draft, and having one can bring significant certainty and protection from the scenarios which might arise from a deadlock (including costly litigation). The process of preparing a shareholders’ agreement also presents an opportunity to carefully consider many aspects of the impending relationship which you might not otherwise consider and as such is a good risk management strategy.

It all starts off with the best of intentions. Best mates, family or friends, forming a company for the purpose of running a business. It’s a familiar story and for all involved it’s the beginning of an adventure. The money is tight and you don’t want unnecessary expenditure on legal costs. But what about a shareholders’ agreement?  Many think of it as a sort of a “pre-nup” for such a venture, which is unnecessarily negative because everyone trusts each other.

Nothing could be further from the truth. Without a shareholders’ agreement, a deadlock in the management of the company could see a perfectly healthy business forced into liquidation, the loss of shareholder value and attraction of significant legal fees in the process.

A deadlock between the company’s directors and shareholders is a potential outcome for any company where two parties (or their aligned interests, such as spouses) each control 50% of the company. A deadlock can arise from any dispute over the company’s operations where the parties are unable to agree. As neither party has control, neither party can force the other to agree to any proposal or resolution at a directors’ or shareholders’ meeting. Those disputes can and do arise in many and varied circumstances, including:

  • The souring of the relationship between the parties, destroying the mutual trust and confidence enjoyed at the start
  • Differing views on the direction in which the company should be taken
  • The desire of one party to cease involvement with the company (for example, to take up some other opportunity or to move overseas)
  • Financial pressure requiring one of the parties to seek to realise their value in the company

A deadlock in the management of the company can be crippling and if the dispute escalates, may lead to court proceedings and ultimately, a winding up of the company. The goodwill of the company will be destroyed and the assets sold at fire-sale prices. Everything that you worked so hard to achieve will be lost.

How shareholders’ agreement may resolve a deadlock

A shareholders’ agreement can tailor a resolution mechanism, agreed to by both parties, ahead of time.  It is possible also to define in the shareholders’ agreement what might constitute a deadlock – for example, the failure of a particular resolution to be passed on, say, two or more occasions.

Common ways in which a shareholders’ agreement may resolve a deadlock could include:

  • Some form of alternative dispute resolution mechanism, such as compulsory informal meeting of shareholders or mediation with an independent third party
  • If that fails, there are a number of mechanisms which can be specified for the purchase by one side of the other side’s shares in the company – this can be by way of an open or closed process

The processes provided for in the shareholders’ agreement can be flexible (and can include a combination of different processes) and tailored to any particular circumstances if necessary.

Other advantages of having a shareholders agreement

In addition to dealing with the important aspect of deadlock situations, a shareholders’ agreement also represents a good opportunity for the parties to think about and determine many of the aspects of their future dealings with the company, including:

  • A dividend policy
  • Non-competition provisions if one party leaves the business
  • Procedures for the sale of shares, including first right of refusal provisions or the requirement of approval from other shareholders
  • Management issues, such as a division of responsibilities

Download the Hicksons App to read the commercial solution that covers even more on shareholders agreements.

Post by Chris Moore 

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