In the absence of an agreement to the contrary, shareholders are free to transfer their shares to whom ever they choose.
This situation is usually unacceptable for companies with more than one shareholder. Shareholders carefully weigh up the positive and negative factors before deciding to go into business with each other. It is not a decision which is made lightly. However, if the shareholders can transfer their shares to whomever they choose after the company is formed then this selection process is undermined. What happens if the remaining shareholders don’t approve of the new shareholder? What if the shares are sold to a competitor?
A shareholders agreement can resolve this issue by giving the remaining shareholders a right of first refusal (also known as pre-emption rights) to purchase any shares being sold. If the remaining shareholders do not want to purchase the shares then the selling shareholder may then offer them to a third party. There can be exceptions to this rule. For example shareholders may want the ability to transfer their shares to a family member (for tax reasons, for example) without first offering them to the other shareholders.
A shareholders agreement can also set-out the price at which shares are sold between shareholders. For example, shareholders may not be able to sell their shares for a price lower than the price at which they were offered to the other shareholders. In certain circumstances the shareholders may want the price of the shares being sold to be determined by an independent valuer.
Another common restriction imposed by shareholders agreements on the sale of shares is an initial ‘lock-in’ period. A lock-in period is a period of time in which no shareholder can sell their shares. If the company’s business plan requires a commitment of three years from each of the shareholders then a lock-in period for three years may be appropriate.
Where there is a change in the personal circumstances of a shareholder (for example if they are declared bankrupt or become mentally ill) which affects their ability to be actively involved in running the company, or which makes them unsuitable to be involved with the company, then there should be a plan of action.
The same applies to a transfer of shares on the death of a shareholder. Should the shares pass in accordance with the deceased shareholder’s wishes, or should the shares be sold to the other shareholders with the proceeds paid in accordance with the deceased shareholders’ wishes?
A shareholders agreement can set-out an agreed procedure, which may include a sale of the shares. It is particularly important for small and medium sized businesses to anticipate and deal with changes to the personal circumstances of the shareholders.
Where there is a sale of shares, it is more likely that all the shares in the company will be sold, rather than just the shares of one shareholder.
Shareholders should consider the following common scenario. At some point in the future a buyer may wish to purchase the whole company. What should happen if most of the shareholders want to sell, but one or more would rather keep their shares? In the likely event that the buyer is only interested in buying 100% of the shares, should a shareholder who only holds 10% or even just 5% be able to prevent the sale?
A shareholders agreement can contain ‘drag along’ provisions so that if shareholders holding a set percentage of shares want to sell, then the other shareholders will also be obliged to sell. They will be ‘dragged along’ with the sale. This percentage is decided by the shareholders and recorded in the agreement. This prevents a minority of shareholders disrupting a sale of the company which has overwhelming support.
The opposite of a ‘drag along’ is known as a ‘tag along’. This is where a buyer is found for some but not all of the shares in the company. In this scenario the shareholders agreement can state that the sale cannot go ahead unless the buyer is willing to offer to buy all of the shares in the company on the same terms. This is also know as a ‘me too’ provision.
Shareholders agreements should be applied to current and future shareholders. In order to achieve this the agreement should state that no shares can be transferred to a new shareholder unless they have first agreed to adhere to the agreement. This is done via a document know as a deed of adherence.
