Drafting a Shareholders Agreement: The fundamentals (part 1)

18 Jan 2024

Previously Derick dived head-first into the complex world of drafting a Memorandum of Incorporation for a Company, where he learned how to draft an MOI with different share structures and how to draft MOI provisions relating to directors and shareholders.

Derick is now faced with a new challenge – the Shareholders Agreement.

In the ever-evolving landscape of corporate governance, the task of drafting a Shareholders Agreement presents both a challenge and an opportunity to define the foundational aspects of the governance of the shareholders and the Company.

Derick again turns to Kevin for assistance.

The purpose of the Shareholders Agreement

Kevin, drawing upon his wealth of experience in corporate governance, begins by outlining the dual purpose of the Shareholders Agreement.

Firstly, he explains how the Shareholders Agreement provides a framework for how the interests of different shareholders are balanced, especially in scenarios involving minority and majority stakeholders.

Secondly, Kevin emphasises that the Shareholders Agreement also governs the relationship between the shareholders and the company itself.

To start things off, Kevin decides to first focus on the provisions which deal with the relationship between the Shareholders on the one hand and the Company on the other.

Funding provisions

Kevin explains there is a fundamental question to be addressed in all Shareholders Agreements – how the Company will be capitalised.

When drafting the Shareholders Agreement, especially regarding the provision of loans by shareholders to fund the company’s operations, several key considerations must be meticulously outlined to ensure clarity and fairness among all parties involved.

Shareholder loans

The agreement should specify whether the loans provided by shareholders will bear interest. If interest is to be charged, the fixed or variable rate and the frequency of interest calculation and payments must be clearly defined.

In situations where a shareholder contributes more than their pro rata share, the agreement must address how this excess will be treated. One approach could be to allow additional interest on this excess amount. Another aspect to consider is the repayment hierarchy – whether these excess loans will be repaid before other loans.

Another important aspect of these provisions is the consequence if a shareholder refuses to provide a loan, especially if there is an agreed obligation to do so. The provisions should clearly state whether such refusal constitutes a breach of the agreement. If it is a breach, the agreement must also detail the repercussions for the non-compliant shareholder. This could range from diluting their equity stake, or other legal remedies.

Third-party funding

When delving into the provisions regarding third-party funding in Vector AI’s Shareholders Agreement, a critical aspect to address is the obligation of shareholders to provide security, such as personal guarantees, if required by a third-party funder. This aspect is fundamental as it directly impacts the shareholders’ individual risk and liability in relation to the company’s financial obligations.

The provisions should state whether shareholders are required to provide security for third-party loans. This could include personal guarantees, pledges of shares, or other forms of security. The nature and extent of such security must be clearly defined to avoid any ambiguity.

The provisions should consider how the burden of providing security is distributed among shareholders. It should address whether all shareholders are equally obliged to provide security or if the obligation varies based on their shareholding percentage or other factors.

Additionally, the provisions must specify the consequences if a shareholder cannot provide the required security.

By addressing the above points, Vector AI’s Shareholders Agreement can provide a clear framework for third-party funding, ensuring that both the company’s financing needs and the shareholders’ risk tolerances are adequately considered and balanced.

Dividend provisions

When drafting the Shareholders Agreement and, more specifically, the provisions relating to dividends, it is important to consider the requirements under section 46 of the Companies Act, 2008, which relates to distributions made by the Company.

Subject to the Companies Act, 2008, the Shareholders Agreement can specify how often dividends will be declared – whether annually, semi-annually, quarterly, or at a different frequency.

The provisions dealing with dividends can also place certain restrictions on declaring dividends. For example, no dividends may be declared before certain specified debts (for example, excess shareholder loans) are paid in full.

The provisions should also address the percentage of the company’s profits that may be distributed as dividends. This decision impacts the company’s reinvestment strategy and the shareholders’ return on investment. It should balance the need for rewarding shareholders with the necessity of retaining enough earnings for future growth and stability.

Provision can also be made for special dividends or other distributions in specific circumstances, such as in the event of exceptional profits or upon achieving certain milestones.

Lastly, these provisions should outline the process for modifying the dividend policy in the future. This allows flexibility to adapt to changing financial conditions or the company’s strategic directions.

By carefully crafting these provisions, Vector AI’s Shareholders Agreement can ensure that dividend distributions are handled fairly to shareholders, compliant with legal requirements, and supportive of the company’s long-term financial goals.

Annual business plan provisions

Unlike the typical scenario where the board of directors approves the business plan and budget, an alternative approach may be considered where the shareholders are required to approve the Company’s business plan and yearly budget.

Once the business plan and budget are approved, the company is required to operate within these parameters. This ensures that the company’s activities are aligned with the shareholders’ agreed-upon vision and financial strategy.

The provisions should address what happens if the shareholders do not approve the proposed business plan and budget. One common approach is to carry over the previous year’s budget, adjusted for inflation (e.g. Consumer Price Index – CPI). This provides a default guideline for the company’s operations while new approval is sought.

The provisions must further specify what the business plan should include. Typically, this encompasses financial projections, marketing strategies, operational goals, capital expenditure, revenue targets, and other relevant metrics that guide the company’s operations for the year.

It is also crucial to stipulate how and under what circumstances the company can deviate from the approved business plan. This includes who has the authority to approve deviations (e.g., the board of directors or a specific committee) and the process for such approvals. The provisions should detail the extent to which deviations are permissible and the reporting or notification requirements when deviations occur.

Remuneration Committee

Incorporating provisions for establishing a remuneration committee in Vector AI’s Shareholders Agreement is a strategic move to ensure a balanced and effective approach to employee compensation, which is one of the largest expenses for most companies.

This committee plays a crucial role in balancing the need for competitive remuneration to retain talent and the imperative to maintain fiscal responsibility for the benefit of the shareholders.

These provisions should clearly define the role and responsibilities of the remuneration committee. This typically includes setting and reviewing compensation packages for senior executives, developing remuneration policies for the company, and ensuring that these policies are aligned with the company’s strategic goals and financial capacity.

These provisions should detail the composition of the remuneration committee. It often includes a mix of directors and potentially independent members to ensure a balanced perspective. The criteria for selecting committee members should aim for expertise in finance, human resources, and corporate governance.

Right to information and confidentiality

The provisions in Vector AI’s Shareholders Agreement regarding shareholders’ rights to company information are critical for maintaining transparency, trust, and engagement between the company and its shareholders.

While the Companies Act, 2008, sets a baseline for these rights, the Shareholders Agreement can further amplify and specify them.

The Companies Act, 2008, provides certain basic rights to shareholders regarding access to company information. However, the Shareholders Agreement can extend these rights, offering shareholders more comprehensive insight into the company’s operations, financial health, and strategic plans. This could include more frequent or detailed financial reports, access to meeting minutes, or insights into business strategies and risk assessments.

While extending these rights, it’s important to balance them with the company’s need to protect sensitive information and operate without undue interference. The provisions should clearly define what information is accessible, how often, and under what conditions.

Integral to these information rights are robust confidentiality provisions. These ensure that while shareholders have access to more detailed information, they are also bound to protect this information from disclosure to third parties.

By thoughtfully crafting these provisions, Vector AI’s Shareholders Agreement can ensure that the shareholders are well-informed and engaged while protecting the company’s sensitive information and maintaining operational efficiency. This balance is key to fostering a healthy, transparent relationship between the company and its shareholders.

Restraints

Incorporating restraint provisions in Vector AI’s Shareholders Agreement is crucial in safeguarding the company’s interests and maintaining a fair competitive landscape.

These restraints, such as prohibiting a shareholder from starting or being involved in a competing business, are designed to prevent conflicts of interest and protect the company’s proprietary information, customer base, and market position.

A common form of restraint is the non-competition clause. This provision prohibits shareholders from starting, investing in, or being employed by a competing business. The scope of such a clause should be carefully defined, including what constitutes competition, the geographical scope of the restriction, and its duration.

It’s crucial to balance the need for these restraints with legal and ethical considerations. Restraint clauses must be reasonable in scope, duration, and geographic coverage to be enforceable. Overly restrictive clauses might be deemed unenforceable in court.

Conclusion

In conclusion, the provisions detailed in this article form the backbone of a robust and dynamic relationship between the shareholders and the Company.

From funding operations and determining dividend policies to setting out guidelines for annual business plans, remuneration committees, access to information, and ensuring confidentiality and appropriate restraints, these elements collectively establish a comprehensive framework.

This framework aligns shareholder interests with the company’s strategic goals and ensures operational efficiency and transparency, which are crucial for long-term success.

As we continue to navigate the nuances of corporate governance in our forthcoming articles, our focus will shift to delve deeper into the relationships between the different shareholders of a Company.

We will explore vital aspects such as pre-emptive rights, drag and tag-along provisions, buy and sell arrangements, and forced sale provisions. These topics are essential in understanding how shareholders interact with each other within the company’s ecosystem.

Stay tuned as we continue to unfold the layers of shareholder relationships and their pivotal role in shaping a company’s future.

See also:

• A guide to drafting provisions relating to shareholders in your MOI
• What is a contract playbook and why do you need one?
• Recent lessons in determining fair value – Share valuation can be a contentious issue, especially if the valuation is left to the courts
• Are you sure that you are a shareholder?

(This article is provided for informational purposes only and not for the purpose of providing legal advice. For more information on the topic, please contact the author/s or the relevant provider.)