For many owner-managed and family run businesses, the relationship between shareholders is fundamental to the success of the company. While much attention is often given to strategy and growth, it is equally important to consider what will happen when circumstances change.
A shareholders’ agreement is one of the most effective tools available to business owners when it comes to managing risk, protecting value and ensuring continuity. When properly drafted, it provides a clear framework for dealing with a range of scenarios, including death, incapacity, exit and, in some cases, relationship breakdown.
When entering into a shareholders’ agreement, it is essential to ensure that both the company’s articles of association and the individual’s personal estate planning are reviewed (and amended if necessary) to ensure they all work together.
What is a shareholders’ agreement?
A shareholders’ agreement is a private contract between some or all of the shareholders in a company. It sits alongside the Articles of Association, but unlike the Articles, it is not publicly available.
Broadly speaking, the Articles of Association set out the rights attaching to shares and the framework for running the Company and the Shareholders’ Agreement sets out how those rights will be exercised and any restrictions on them.
For many businesses, the shareholders’ agreement provides both a degree of flexibility and certainty that cannot be achieved through the Articles alone.
Why it matters for business owners
In the absence of a shareholders’ agreement, the default position is governed by company law and the Articles of Association. While these provide a basic framework, they rarely address the practical realities faced by family businesses and owner-managed companies. For example, the default rules allow shareholders to transfer their shares to anyone they choose, which may not be appropriate in a family-owned business. Equally, they do not set out situations where shares must be transferred (e.g. following death or incapacity).
Without clear provisions, issues can arise such as:
shares passing to individuals who are not involved in the business;
disputes between shareholders over control or decision-making;
uncertainty as to how shares should be valued on transfer; and
difficulty in facilitating an orderly exit.
A well-structured shareholders’ agreement can help anticipate these issues and provide a mechanism for dealing with them.
Good leavers, bad leavers and exit planning
Shareholders’ agreements also commonly distinguish between different types of exit. For example, a “good leaver” (such as a retiring shareholder) may be entitled to receive full market value for their shares, whereas a “bad leaver” (for example, someone leaving in breach of their obligations) may receive a reduced value.
These provisions can incentivise appropriate behaviour, provide clarity on exit terms, and reduce the scope for disputes.
In the context of business continuity planning, having clear exit provisions can be just as important as planning for unexpected events such as death or incapacity.
Protecting the business from external influences
For family businesses in particular, ownership can be affected by personal circumstances, including divorce or financial difficulties. A shareholders’ agreement can include provisions designed to limit the risk of shares passing outside the intended ownership group. For example:
restrictions on transferring shares to third parties;
provisions triggered by insolvency or bankruptcy;
mechanisms requiring shares to be offered to existing shareholders in certain circumstances.
While these provisions cannot prevent a court from taking shares into account in divorce proceedings from a financial perspective, they can help ensure that the company retains a degree of control over who ultimately holds them. This is an area where coordination with family law advice may be beneficial, particularly where shareholders wish to consider additional protections such as pre-nuptial agreements.
Valuation and funding considerations
A recurring issue in shareholder exits is how shares should be valued and how any purchase will be funded.
A shareholders’ agreement can address both points by:
specifying a valuation methodology (for example, by reference to an independent expert); and
aligning with funding arrangements, such as insurance-backed cross-option agreements.
Without this clarity, disagreements over value can delay transactions and create tension between shareholders and the departing shareholder or their estate.
Dealing with death and incapacity
Another key function of a shareholders’ agreement is to address what happens if a shareholder dies or becomes unable to act.
Typical provisions may include:
compulsory transfer clauses, requiring the transfer of shares in defined circumstances;
pre-emption rights, giving existing shareholders priority to acquire shares;
a valuation mechanism, setting out how the price for the shares will be determined;
a clear process and timetable for completing the transfer.
These provisions are often designed to work alongside cross-option agreements and a shareholder’s Will, ensuring that the transfer of shares can take place in an orderly and predictable manner.
Without such provisions, surviving shareholders may find themselves in business with a beneficiary who has no prior involvement in the company, while the beneficiary may hold shares that are difficult to realise. Equally, without ensuring that appropriate valuation and funding arrangements are put in place, the remaining shareholders could find themselves in a situation where they are required to purchase the outgoing shareholders’ shares but cannot afford to.
Interaction with Wills and personal planning
A shareholders’ agreement does not operate in isolation. Its provisions must be consistent with the shareholders’ Wills and wider estate planning arrangements.
For example, if a Will leaves shares to a particular beneficiary, but the shareholders’ agreement requires those shares to be offered to other shareholders, the beneficiary may ultimately receive cash rather than shares. This is not necessarily problematic, provided the overall structure has been designed with that outcome in mind.
Difficulties tend to arise where documents have been prepared separately and do not align. A coordinated approach involving both corporate and private wealth advisers can help ensure that the intended outcome is achieved.
It is also sensible planning to ensure that Lasting Powers of Attorney are prepared so that business owners can appoint Attorneys who would act in their place in respect of their shareholdings in the event that they lost capacity, either permanently or temporarily. In the absence of a Lasting Power of Attorney, the continuity of the running of the business could be impacted.
Common pitfalls
In practice, a number of issues frequently arise where shareholders’ agreements are outdated or incomplete:
the agreement does not reflect the current ownership structure;
death or incapacity provisions are unclear or absent;
valuation mechanisms are impractical or lead to dispute;
the agreement is inconsistent with the shareholders’ Wills;
no funding mechanism is in place for share purchases.
Regular review is therefore essential, particularly following significant events such as investment, restructuring or changes in personal circumstances.
Keeping arrangements under review
A shareholders’ agreement should not be seen as a one-off exercise. As the business evolves, so should the arrangements between its owners.
Periodic review can help ensure that the agreement continues to reflect:
the current shareholder base;
the strategic direction of the business;
the personal circumstances of the shareholders; and
the Wills of the shareholders,
For business owners, this forms a key part of effective business succession planning.
A practical safeguard
While no agreement can anticipate every eventuality, a well-drafted shareholders’ agreement provides a practical framework for dealing with change.
By setting out clear rules on ownership, control and transfer of shares, it can reduce uncertainty, minimise disputes and help ensure that the business continues to operate smoothly. When combined with appropriate Wills, Lasting Powers of Attorney, cross-option arrangements and family law planning, it becomes a central component of a broader strategy to protect both the business and the individuals behind it.
If you would like to review your Will or shareholders’ agreement or discuss how it fits within your wider business succession planning, please contact Laurence Twiselton in BPE’s Corporate team or Philip Allen in the Private Wealth team.
