On set up, or shortly thereafter, the shareholders of a new company will have various issues to think about for the short and longer term. Agreeing your approach to dealing with various situations and milestones in advance, can ensure a smooth running operation and prevent confusion, ill-feeling or disputes which might otherwise arise during your business relationship.
In most straightforward limited companies, shares held by individual shareholders are generally of the same type with equal rights attaching to each share. In more complex situations with differing share classes, preferences and voting rights, there will inevitably be more complex scenarios to consider. However, the fundamental concerns discussed here, remain the same.
We have set out below the main areas that we recommend be discussed and agreed at an early stage. Such agreements can be reflected in a company’s Articles of Association or a Shareholders Agreement or in a combination of both. Traditionally Shareholders Agreements have been favoured because, in most circumstances, they do not have to be registered at Companies House and are therefore private documents.
Control of the Company – How Decisions are Made
Often, decision making power is devolved to the directors, which allows them to deal with the day to day running of the company. Directors may be independent appointees or the shareholders themselves. (See ‘The Role of Directors’ below) Shareholders however, have ultimate power, as they can determine who the directors of the company are and often what they do. Shareholders are able to do this based on voting rights.
Usually, each share issued in a company will have one vote. So the number of shares/percentage of ownership that you have also reflects your voting rights. The following percentages of voting rights are of significance:-
· 51% - a mere majority of the votes is sufficient to carry most decisions for a company;
· 75% - a three quarters majority is the statutory minimum required to make constitutional changes or wind up a company.
How you use your voting rights as a shareholder will determine the destiny of the company. You may therefore decide to agree on enhanced voting requirements, beyond the statutory minimum, for important decisions to protect minority shareholders (eg. 100% unanimity to change the company’s name rather than the statutory 75%).
How Can Voting Rights be Varied or Protected?
There are two main ways to alter voting rights. The first is a numbers game – the issue of further shares. In order to protect the status-quo for shareholders, the statutory default position on issue of shares is that no new shares in a company can be issued unless they are first offered to all existing shareholders in proportion to their existing shareholdings. Every shareholder gets the right to take up their proportion and any shares not taken up can then be offered round again to those shareholders who did take up shares. This is commonly referred to as a rights issue. The result is that no shareholder can be forced to take up more shares (i.e. make a further investment in the company) but a shareholder who does not wish to take up any further shares will find that their proportion of ownership and, consequently, their voting power have been diluted. The questions which therefore have to be addressed are:-
· is unanimity to be pre-requisite of any share issue?
· if not, will a lower level of consent be required?
· if the answer is still no, is this issue simply to be within the control of the company’s directors?
The second way to vary voting rights is to re-classify shares into differing categories. ‘A’ and ‘B’ shares might be created for example, with full voting rights attaching to the ‘A’ shares and no voting rights attaching to the ‘B’ Shares. This is often an approach taken where employees are rewarded with small shareholdings.
Share Transfers
This is a more flexible area and whatever you agree can be provided for. The two extremes are i) complete freedom on transfer (both in relation to price and the person to whom the shares can be transferred) and ii) a complete prohibition on transfer without the consent of the company’s directors. The norm (if there is one) is somewhere in between. The main issues which have to be addressed are:-
a) what happens if a shareholder dies?
b) what happens if a shareholder leaves voluntarily?
c) what happens if a shareholder who is a director/employee leaves on ‘good’ terms? or on ‘bad’ terms?
d) are shareholders to be free to transfer shares to other shareholders of their family and to family trusts?
e) at what price are transfers to be carried out?
There may be many solutions for such scenarios however the following suggestions are based on common practices and may form the basis for a discussion:-
A. In the event of the death of a shareholder, and their shares passing to other members of their family, then the directors might be given the right, within six months of the date of death, to require those family members, or the estate if no transfer is effected, to offer the shares for sale to the remaining shareholders or the company.
B. In the event of a shareholder leaving and proposing to transfer shares, then they may be required to first offer them to other shareholders. In the event of any share not being purchased after the first offer round then, there would be a second offering to those shareholders who purchased on the first round. If after the second offering any shares remain un-purchased, the directors would have the ability to find a purchaser acceptable to them or the company could purchase the shares. As a last resort the shareholder wishing to sell would have freedom to sell the shares to whoever they can find as a purchaser.
C. In the event of a shareholder who is a director/employee of the company ceasing to be the director/employee then the directors might be given the right within six months of the date of cessation to require a transfer notice to be served, which would trigger the procedure set out in B above. If the existing shareholder is a ‘good’ leaver, they may be paid fair market value for their shares, whereas, if they are a ‘bad’ leaver they might only receive a price equal to what they paid for their shares.
D. Each shareholder could be allowed to transfer shares to their spouse or children or trusts for the benefit of spouse or children. The spouse or children or trust to whom the shares would be transferred would then be bound by the transfer provisions and would have no greater freedom of transfer than the original shareholder.
E. The price at which shares can be transferred is the price suggested by the person wishing to transfer assuming that price is acceptable to the directors. If that price is not acceptable then the transferring shareholder and the directors should attempt to agree the price. If they cannot agree the price then the matter could be remitted to an independent chartered accountant to fix the price usually on the basis of the fair value.
The Role of Directors
It is up to you as shareholders to decide whether any of you should be appointed as directors of the company. If this is to be the case then an individual service contract detailing a shareholder’s appointment as a director and, if appropriate, employment status should be put in place.
As a protection for any minority or non-director shareholders, it is usual to have a list of reserved matters, which will require the consent of a percentage of shareholders, over and above the statutory minimum, before the directors are entitled to proceed. You should discuss this with a view to agreeing any enhanced voting requirements, for important decisions, which the directors will have to abide by. The voting requirement for consent need not necessarily be the same in each case. There may be specific matters related to the company’s business which should also be considered. However, the following list will give some idea of the commonly ‘reserved’ matters:-
1. the incurring of any capital expenditure by the company out with the ordinary course of the business and in any event in excess of £XXXX in aggregate;
2. the entry by the company into any contract, liability or commitment out with the ordinary course of the business and in any event a contract, liability or commitment which:-
a. is incapable of being terminated within 12 months; or
b. could involve expenditure or the incurring of any other obligation by the company which in any case exceeds £XXXX in any one year;
3. the creation or giving of any guarantee, indemnity, surety, mortgage, lien, charge, encumbrance or other security interest of any nature whatsoever in respect of all or any part of the undertaking, property or assets of the company or the acceptance by the company of any such arrangement for its benefit;
4. the creation by the company of any borrowings or other indebtedness or obligation in the nature of borrowings except by way of normal trade credit;
5. any sale or proposed sale of any assets of the company or any acquisition or proposed acquisition of any assets by the company; (See also ‘Exit Strategy’ below)
6. any letting or proposed letting of any property held or which may be acquired by the company;
7. the creation or acquisition of any subsidiary or associated company;
8. the entry by the company into any partnership, joint venture or other profit sharing agreement;
9. any material change in the organisation of the company or the manner in which it carries on the business;
10. the cessation by the company of the business or the carrying on of the business on any materially reduced scale;
11. any revisions to the budget of the company;
12. any advance, loan or deposit of money by the company;
13. the initiation, conduct, settlement or abandoning of any litigation involving the company or any admission of liability by or on behalf of the company except in any case in relation to debt collection in the ordinary course of the business;
14. any change in the level of remuneration paid to any of the directors or the terms or conditions of employment of any of the directors;
15. the appointment of any agents or sub-contractors or employees with a remuneration exceeding £XXXXX per annum;
16. the variation of any terms of any of the company’s policies of insurance or the taking out of any additional or replacement policies of insurance;
17. any transaction with any person otherwise than at arms length and for full value or any transaction with a connected person of any shareholder (as that term is defined in section 839 of the Income and Corporation Taxes Act 1988); or
18. any proposal for the winding – up or liquidation of the company;
19. the changing of the accounting reference date of the company;
20. the approval of the statutory accounts of the company;
21. the appointment or removal of auditors, or the appointment as auditors or joint auditors of the company of any firm except the auditors;
22. the issue of any shares in the company (by way of bonus, rights or otherwise) and/or the grant of any option or right to acquire or call for the issue of the same whether by conversion, subscription or otherwise;
23. the redemption or purchase by the company of any share or the reduction in the share capital, or any uncalled or unpaid liability in respect thereof;
24. the recommendation of or proposals for any payment of any dividend or any other distribution of the company;
25. the pre-payment of any amount due under loans to the company; and
26. any matter in relation to the running of the company which is out with the ordinary course of business.
Dealing with Deadlocks
Deadlocks occur in relation to decisions where i) an enhanced voting requirement of unanimity cannot be met or ii) there are joint equal shareholders in the company. There are differing ways to deal with deadlocks for differing circumstances. Provisions can be made for arbitration, a casting vote of a chairman or a third director (whose casting vote is based on the best commercial interests of the company). Ultimately a minority who felt that a deadlock was harming the company could seek some redress in court, but at a practical level, this too can be bad for business and may result in the company being wound up. Another last resort is to provide for the ability of one or other shareholder to buy out the other entirely on at a price pre-agreed or calculated in accordance with a pre-agreed method. If the potential for deadlock is high (say in a 50/50 company) then parties may re-weigh the voting power with the issue of additional shares.
Exit Strategy
Planning at an early stage for longer term goals for the company and its shareholders can be helpful. Inevitably there may be differing interests in deciding whether or not to trade the company for the long term or perhaps sell within a few years. Various mechanisms can be put in place to make sure that a minority of shareholders cannot block the sale of the company provided that they get the same minimum price for their shares as the majority shareholders. It can also be made compulsory that, if a majority shareholder receives an attractive offer for their shares, they cannot sell them unless the buyer buys all of the shares in the company at the same price. That way none of the shareholders are left with a stranger co-owning the company or missing out on a deal.
Conclusion
The nature of company law dictates that it would be impossible to cover every eventuality here. However, we hope that this provides some stimulus for thought and discussion among a team of new shareholders.
For more information please contact April Bingham, Head of Corporate
T: 0141 218 4902 E: april.bingham@bellwethergreen.com