Before the Argument: A Director’s Health Check for the Shareholders’ Agreement

Most owner-managed companies start with a set of articles of association and a shared understanding of how the business will be run. A shareholders’ agreement is often added later, perhaps when a new investor joins or when a solicitor recommends one. It is then signed, filed and rarely opened again. That is understandable. The document deals with uncomfortable subjects: deadlock, exit, death, divorce and disagreement. Directors prefer to focus on trading.

The difficulty is that a shareholders’ agreement is not a compliance formality. It is the framework that determines what happens when the owners no longer agree. Reviewing it before a dispute is cheaper, calmer and more effective than negotiating it during one.

Why the agreement matters more as the company matures

The articles of association are a public document. They set out the basic constitution of the company, including share classes, voting rights and director appointment procedures. A shareholders’ agreement is private. It can sit alongside the articles and deal with matters that the articles do not address in detail: reserved matters, transfer restrictions, valuation and dispute resolution.

As a company grows, the gap between the original understanding and the written agreement tends to widen. A 50/50 company formed by two founders may later have three shareholders, a family member on the payroll and an investor with a preference share. The original agreement may not reflect any of that. A health check is about closing that gap before it becomes a legal problem.

Deadlock provisions: what happens when nobody can move

Deadlock is most obvious in a company with two equal shareholders. It can also arise where a minority shareholder has a blocking right over reserved matters. The agreement should set out how a deadlock is identified, who must be involved in discussions and what happens if those discussions fail.

Useful provisions include a defined escalation process, a requirement for mediation before litigation, a casting vote in limited circumstances, and a buy-sell mechanism often called a shotgun clause. A shotgun clause allows one shareholder to offer to buy the other’s shares at a stated price, with the recipient choosing either to accept the offer or to buy the offeror’s shares on the same terms. It is a blunt instrument, but it can break a genuine impasse.

The health check question is not simply whether a deadlock clause exists. It is whether the clause is workable. A provision that requires unanimous agreement to appoint a mediator, for example, may fail at the very moment it is needed.

Drag-along and tag-along rights: protecting the exit

Drag-along rights allow a majority shareholder to require minority shareholders to sell their shares as part of a sale of the whole company. Tag-along rights allow minority shareholders to join a sale if the majority sells its shares. Both are common in companies with external investors, but they are equally relevant in family or founder-owned businesses.

A drag-along right should be checked carefully. What percentage of shareholders must approve the sale? Must the minority receive the same price and terms as the majority? Are there exceptions for a sale to a connected party? A poorly drafted drag-along can be difficult to enforce or can create unfair outcomes that the minority will challenge.

Tag-along rights protect the minority from being left behind in a sale. They should specify the circumstances in which the right arises, the notice required and the terms on which the minority can participate. For directors, the practical point is that exit negotiations are much easier when the rules were agreed before a buyer appeared.

Valuation: the clause that decides the argument

Share valuation is often the most contentious part of a shareholders’ agreement. A clause that says the shares will be valued at market value sounds reasonable until the parties disagree about what market value means. Does it assume a sale of the whole company or a minority stake? Is a discount for lack of control applied? What is the valuation date? Who appoints the valuer, and who pays?

A workable valuation clause should specify the method, the assumptions and the process. Common approaches include a formula based on earnings, an independent expert determination, or a price agreed annually by the board. Where the company has different share classes, the clause should explain how value is attributed between them.

Directors should also consider how a buyout would be funded. Life insurance or a cross-option arrangement can provide cash on death or critical illness. Without a funding mechanism, a valuation right may be sound in principle but impossible to exercise in practice.

Dividend policy: expectations versus rules

Dividend policy is often left informal. The company pays dividends when there is cash and the shareholders agree. That can work for a time, but it becomes problematic when shareholders have different needs or when a new investor expects a return.

The agreement can set out the intention to distribute a proportion of profits, the frequency of dividend reviews, the retained cash the company needs for working capital, and how different share classes participate. It cannot override company law: dividends still require distributable reserves and proper documentation. But it can reduce the scope for disagreement about what the company should do with surplus cash.

When family members or new investors join

Family ownership brings particular issues. Employment terms, succession, death, divorce and incapacity can all affect share ownership. A shareholders’ agreement should address what happens if a shareholder dies, becomes incapacitated or divorces. It should also distinguish between family members who work in the business and those who hold shares as an investment.

New investors bring a different set of expectations. They may require information rights, consent rights over certain decisions, anti-dilution protection and a clear exit route. The existing shareholders’ agreement will usually need to be amended, and the articles may need to be updated at the same time. A health check should confirm that the agreement and the articles remain consistent. Where they conflict, the articles usually prevail at law, which can defeat the intention of the private agreement.

A practical health-check list for directors

Use the following questions as a starting point for a board discussion. They are not a substitute for legal advice, but they help identify where the agreement needs attention.

• Are all current shareholders parties to the agreement, and are the share classes correctly described?
• Do the articles of association and the shareholders’ agreement conflict on any material point?
• Is there a clear deadlock process, including escalation and mediation?
• Do the drag-along and tag-along rights work for the current shareholding structure?
• Is the share valuation method specific enough to be applied without dispute?
• Is there a funding mechanism for a buyout on death or incapacity?
• Does the dividend policy reflect the company’s cash needs and the shareholders’ expectations?
• Are death, divorce, incapacity and succession addressed?
• Are reserved matters and investor consent rights still appropriate?
• Is there a diary date for periodic review?

Review before the need arises

A shareholders’ agreement is easiest to improve when everyone is still on speaking terms. The review need not be adversarial. It can be framed as routine governance: confirming that the document still reflects the company as it is today, not as it was when it was signed. For directors of owner-managed companies, that is time well spent. The alternative is to discover the gaps in the agreement at the point when the business can least afford uncertainty.