Yes – it is recommended to sign a shareholders' agreement when launching a business together with another shareholder, founder, investor or business partner. The document is not normally a legal necessity for forming a UK private company, but it can become one of the most important pieces for protecting the founders and the business itself. When filing incorporation documents with Companies House, one should have articles of association and share allocation data, but such company formation documents will not address the whole of the commercial relationship between shareholders.
Key Takeaways
Shareholders' agreement is not required to incorporate a company in the UK, but it is recommended in most cases with multiple shareholders.
The difference between the company's articles of association and the private shareholders' agreement is often misunderstood by founders.
The shareholders' agreement can address such issues as decision making, shares transfer, founders' exits, deadlocks, further investment, confidentiality and dispute resolution.
The best time for signing such an agreement is early, before any pressure.
Relying solely on friendship and trust or using the standard company documentation can cause problems in the future.
Early professional guidance will allow founding shareholders to structure their company in the correct way and avoid conflicts.
What founders usually misunderstand
One of the most common misunderstandings is the fact that registration of the company automatically means the agreement on how to run the business.
Such conclusion is not correct.
When incorporating the company, it must have constitutional documents, including articles of association, which are described by GOV.UK as 'written rules on how to run your company, agreed between your shareholders or guarantors, directors and company secretary'. The company can adopt the standard articles or prepare its own ones during incorporation.
Those documents are important, but they do not provide everything.
It may be impossible to find answers to important practical questions in the standard articles, such as:
what happens in case a founder decides to leave after six months?
can a shareholder sell his shares to a third party?
how can founders solve possible disputes?
who will hold the intellectual property created either before or during the registration of the company?
can one shareholder block any kind of investment in or acquisition of the company?
what will happen if a founder decides to stop participating in the development of the company but retains his shares?
It is better to think about answering those questions beforehand.
What is a shareholders' agreement?
The shareholders' agreement is a private contract signed by some or all of the company's shareholders, and in some cases, the company is also one of the signatories.
Such an agreement covers the terms according to which shareholders deal with each other, how to make crucial decisions and what steps to take in case of certain changes.
Unlike the articles of association which belong to the company's constitutional documents, a shareholders' agreement remains private and thus can be used for regulation of such aspects as obligations of the founders, rights of the investors, exit terms, valuation formulae, restriction on competition etc.
Both the articles of association and the shareholders' agreement are supposed to complement each other. They should not contradict each other.
Why timing matters?
The ideal time to negotiate shareholders' agreement is normally early, before the company started actively operating, receiving investment or experiencing any stress.
The founders may be extremely optimistic when starting their business. This attitude is good, but optimism cannot replace organisation.
A properly structured agreement will make founders less likely to experience problems or disagreements later due to addressing the potential issues at an early stage. This approach is even more relevant if founding shareholders are friends, family members, former co-workers or foreign partners. People often rely on trust when working together, but absence of the detailed terms may cause additional stress if a business becomes profitable or fails.
Signing a shareholders' agreement does not mean that the founders do not trust each other. It is quite the contrary, it signals that they take their cooperation so seriously.
What should a shareholders' agreement usually cover?
The list of terms to be included in the shareholders' agreement will be determined by the business in question, but there are some common clauses that need to be addressed in the vast majority of cases.
Ownership and share rights
First of all, the agreement must specify the details regarding the ownership and share rights, if required, the different classes of shares. As confirmed by GOV.UK, companies are free to issue shares with different rights dependent on the class.
Different classes of shares become relevant when, for instance, a founder makes capital contribution, a second founder provides technical knowledge and skills while the third one introduces the company to clients.
Decision-making and reserved matters
Decisions are not made equally within a company. Routine decisions can be taken either by directors or management team while crucial decisions will require approval by shareholders.
Important matters, such as issuance of shares, that should be decided by shareholders are normally called "reserved matters".
They can include:
issuing new shares;
raising any debt financing;
selling of major business assets;
implementing of new business models;
appointing of new executive positions;
concluding large deals with clients;
sale of the company;
modifications of the articles of association.
In case there is no specific provision regulating decision-making, the founders of the company might come into disputes regarding their authority to take any actions.
Founder roles and contribution
In the course of negotiations regarding the agreement it is possible to specify the roles of the founding shareholders.
It might be defined if they need to contribute full-time or part-time, what salary arrangements apply, what to do if a founder stops participating in the company's operations and whether share rights are associated with continued contribution to the business.
This is especially important in the case of startups where the main asset of a company is not an initial idea, but efforts that require time.
Share transfer and exits
The agreement should define how and under what circumstances shares can be transferred.
The agreement will normally oblige to offer remaining shareholders the first right to purchase those shares before selling to any other party. Pre-emption rights can be applied under section 567 of the Companies Act 2006 in case of certain allotments, but in private companies additional provisions should be added regarding share transfers, founder exits and further investment.
Otherwise, the founders might find themselves forced to conduct business activities together with a stranger.
Good leaver / bad leaver provisions
These provisions are normally one of the key elements of a shareholders' agreement.
In case a founder leaves the business – should he/she remain a shareholder or is obliged to sell his/her shares in case of leaving? Will the price vary depending on the reasons of leaving?
A good leaver normally refers to resignation for valid reasons, such as illness or other circumstances approved by other shareholders. Bad leaver refers to a situation when a shareholder has committed misbehaviour, breached its obligations or left the company earlier than expected.
Lack of leaver provisions results in a shareholder's right to remain a shareholder in spite of leaving the company and thus stopping his/her contribution to the business.
Deadlock
Deadlocks are very common for 50/50 companies. This is where a shareholders' agreement with a solid Deadlock clause becomes something to seriously consider.
In case both founders participate equally in the management of the company, but do not reach an agreement, they will be unable to move forward until a solution will be found.
A shareholders' agreement should include the solutions that will allow the members to overcome deadlocks, including escalation to higher authorities, consultations of neutral experts, sale of shares, etc.
This provision will not solve any problems, but will make sure that in case of disagreement founders will not remain in deadlock situation.
Confidentiality, intellectual property and restrictions
Other aspects covered by the shareholders' agreement might include rules about confidentiality of information and intellectual property, protection of relations with clients and restrictions against conducting similar businesses.
This is especially important for technology, agency or consulting businesses.
When the core of the business depends on know-how, software, trademarks or client relations, this must be reflected in the agreement.
Articles of association vs shareholders' agreement
Articles of association and shareholders' agreement are related, but they are different documents.
Articles of association are constitutional documents that govern the activities of a company. According to the Companies Act 2006, constitution binds the company and members in accordance with the terms of covenants to observe the provisions thereof.
The shareholders' agreement remains private and will address the more detailed aspects of the business partnership between shareholders.
In practice, this means that:
articles determine how to govern the company;
shareholders' agreement regulates relationship between shareholders;
documents should complement each other.
Many founders have troubles when they use standard articles, but assume a totally different arrangement privately.
Is a shareholders' agreement always necessary?
Normally – yes. A shareholders' agreement should be prepared in case:
there are multiple founding shareholders;
shares are allocated for investors;
founders are family members or friends;
someone makes capital contribution and the other – works for the company;
company holds valuable intellectual property;
one shareholder is active while the other one is passive;
further investment in the company is planned;
there are special considerations concerning who can be a shareholder.
The more people are involved in the business, the more important the agreement becomes.
Practical Example: Two founders and No Agreement
Two founders start their business together, each of them holding 50% of shares. One founder works full-time in the company while the second one holds another job and makes smaller contribution to the business.
As long as the company is young, the situation works smoothly. After one year, the active founder considers such cooperation unfair and wishes to get rid of his/her inactive partner. Since he/she still holds 50% of shares, this will be hardly possible.
In absence of the shareholders' agreement, there are no provisions about selling of shares by a leaving founder. Thus, the passive founder refuses to sell shares and demands too high a price.
In this case, founders will incur additional costs for solving their dispute.
A shareholders' agreement won't guarantee a complete resolution of the dispute, but will at least provide some basic pre-determined rules.
Does a shareholders' agreement prevent disputes?
Absolutely not – the agreement will not prevent all the conflicts that may arise.
However, it can minimise the risks and provide a framework of how the decisions will be made, when founders need to sell their shares, what happens in case of deadlock and other issues. The parties will know the way in which to solve arising problems instead of resorting to statutory remedies or litigation.
Under section 994 of the Companies Act 2006, a shareholder has the right to file a petition to the court if the company's affairs are managed in a way which unfairly prejudices the member's interest.
Though the remedy can be applicable in some cases, it cannot replace the preparation of proper agreements in advance. Litigation procedures tend to be much more expensive and unpredictable.
Before you proceed, check...
Before starting your company with other persons as founders, check:
who will own the shares and in what percentages;
whether all the founders contribute equally;
will any of them receive shares gradually instead of at once;
what decisions require unanimous or majority approval by shareholders;
what will happen in case a founder leaves, gets ill, dies or stops participating;
whether founders are allowed to sell their shares to a third party;
how investment will affect the shareholders' situation;
who is the owner of intellectual property and brand assets;
whether founders can solve disputes amicably;
whether the shareholders' agreement complies with the articles of association;
whether other issues, such as tax, employment, accounting, are taken into account.
Common mistakes made by founders
Relying solely on trust
Trust is always appreciated, but this emotion cannot help in solving practical legal and commercial issues.
Using the standard articles without fully understanding them
Though model articles can fit a lot of cases, they do not reflect every possible situation. According to GOV.UK, companies can either adopt standard articles or develop bespoke ones.
Leaving a shareholders' agreement until after raising funds
After getting funds from investors and starting sales to clients, it will be more difficult to reach an agreement on certain rules.
Issuing shares without leaver provisions
It is a recipe for disaster. A founder who decides to quit earlier will stay a stakeholder.
Failing to address the issue of deadlocks
Even though a 50/50 company seems to be fair, a deadlock situation will occur easily without any mechanism to resolve it.
Failure to align the shareholders' agreement with the articles of association
It is not recommended to include conflicting provisions in those documents, thus making it more complicated to operate the company.
Forgetting about tax and accounting implications
Any structure, including founder arrangements, shareholder structure and transfer of shares may have tax consequences which should be reviewed in advance with professionals.
Frequently Asked Questions (FAQs)
Do you legally need a shareholders’ agreement to start a UK company?
Usually, no. A shareholders’ agreement is not normally required to incorporate a UK private company. Companies House requires incorporation documents such as the memorandum, articles of association and statement of capital. However, a shareholders’ agreement is often strongly recommended where there is more than one shareholder.
Is a shareholders’ agreement the same as articles of association?
No. Articles of association are the company’s constitutional rules. A shareholders’ agreement is a private contract between shareholders that deals with their commercial relationship. Both documents should work together.
Can we add a shareholders’ agreement after the company is formed?
Yes. A shareholders’ agreement can be entered into after incorporation. However, it is usually better to agree the main terms early, before the company becomes valuable, takes investment or faces disagreement.
Do equal shareholders need a shareholders’ agreement?
Yes, often more than most. Equal ownership can create deadlock if shareholders disagree. A shareholders’ agreement can include a process for resolving deadlock and managing exits.
What happens if a founder leaves and there is no shareholders’ agreement?
The outcome will depend on the company’s articles, any other agreements, employment arrangements and the facts. Without clear leaver provisions, a founder may be able to keep shares even if they are no longer contributing to the business.
Should investors ask for a shareholders’ agreement?
Usually, yes. Investors often want clear rights around information, consent matters, future share issues, transfers, exits and governance. A shareholders’ agreement can help make the investment structure clearer and more bankable.
When to seek professional assistance
Shareholders' agreement is not just a legal document. This is an important planning step.
Founders should consider professional assistance when deciding to form a startup, introduce investors to the project, establish a joint venture, give shares to family members or make any other informal arrangement.
At Sterling Legal Solutions, we assist individuals, entrepreneurs, SMEs, investors and cross-border businesses in Corporate Legal Advisory, which includes structuring founder arrangements, setting up shareholders, creating corporate governance and making preparations for attracting investment. We also prepare various types of Corporate and Commercial Contracts.
Disclaimer
This post provides general information only and cannot be considered a legal advice, tax or accounting consultancy. Requirements for concluding shareholders' agreement and the content of such agreement will differ depending on the particular company structure, shareholder arrangements, investment status and objectives.