One of the most important means to ensure sound and effective business operations, as well as to avoid unnecessary disputes in a private limited company, is the shareholders' agreement, which is also sometimes designated partnership agreement or consortium agreement. The shareholders' agreement is of particular importance in companies with a limited ownership base, as in such situations it is important to regulate the shareholders' actions in relation to each other and the company. In this article, we will describe the function of the shareholders' agreement and illustrate why shareholders, particularly in private limited companies with a limited ownership base, can derive major benefit from regulating their dealings through such an agreement.
GENERAL INFORMATION ABOUT SHAREHOLDERS' AGREEMENTS
A shareholders' agreement is concluded between at least two, but usually all (if there are more than two partners) shareholders in a company. The agreement regulates the shareholders' rights and obligations in relation to each other and the company. The agreement can also regulate the basis for the company's organisation, management and operations.
The Swedish Companies Act constitutes the principal regulation surrounding limited companies and share ownership, and there is no statutory requirement stipulating that shareholders must enter into a shareholders' agreement. The Swedish Companies Act is very generally formulated in view of the fact that it should constitute the fundamental regulation for all Swedish limited companies, regardless of business activity, ownership and so forth. As the law is so generally worded, in many cases there is a need for additional regulations, which becomes evident not least in private limited companies with a small number of owners. The principal reason to conclude a shareholders' agreement is consequently that in principle it is always beneficial for the owners in companies with a limited ownership base to regulate their internal relationships in a way that is adapted to the respective company and its ownership.
The fundamental purpose of the shareholders' agreement can be said to be, in part to control the ownership base and the owners' respective dealings, and in part to agree on deviations in relation to the Swedish Companies Act.
An important principle to bear in mind as you continue reading is the so called "legal separation principle for companies", which in this context means that the shareholders' agreement only takes effect between the parties in the shareholders' agreement. Actions that are permissible according to, for example, the Swedish Companies Act, but not permissible according to a shareholders' agreement, are thus not necessarily invalid per se from a company law perspective if they are implemented, but simply a breach of the shareholders' agreement.
BENEFITS OF SHAREHOLDERS' AGREEMENTS
Introduction
Below we will describe some of the – in our opinion – most important reasons to enter into shareholders' agreements. However, a general point is that it is naturally not actually entering into the agreement in itself that is the most significant, but rather that the agreement's content is well thought-out, clear and well-formulated. It is therefore important that the shareholders discuss what it is they want to achieve prior to drawing up and concluding a shareholders' agreement. For such discussions to be meaningful, it is advantageous to involve an actor at an early stage with suitable competence and solid experience of drawing up and negotiating shareholders' agreements.
Ensuring the shareholders' activity and engagement in the company
In completely or partially owner-managed companies, it is important that each shareholder's work input and engagement is regulated. This can be achieved by incorporating various agreements in the shareholders' agreement. The shareholder can thus safeguard the everyday running of the company and ensure that every shareholder contributes actively to the company's business. For example, the shareholders can insert requirements for work input, employment and responsibility in general in relation to the company's operation. Passivity among shareholders can thus be counteracted without needing to be the cause of uncomfortable discussions and feelings of injustice.
Each shareholder's private circumstances may change over time, which in turn can affect the running of the company. An operational shareholder can, for example, become long-term sick or injured, which can lead to the individual not being able or willing to work in an unchanged capacity in the company for a protracted period. It is therefore beneficial to agree in advance on how such a situation will be dealt with. A shareholders' agreement can regulate how different forms of incapacity to work on the part of shareholders are to be managed. For example, a shareholder can be forced to sell their shares in the company if he or she is no longer capable or willing to work in the company and this incapacity or unwillingness is of a permanent nature.
Further, the company's operations might need to be safeguarded financially. The shareholders might have different possibilities and attitudes to contributing to the company on a purely financial basis if such a need should arise. It is therefore important to regulate in advance which requirements are to be placed on the shareholders in the event that the company needs to bring in financing. A common condition in shareholders' agreements is therefore that shareholders are not forced to contribute financially, but that a shareholder who chooses not to contribute must accept that shareholders who do contribute will receive a larger holding through, for example, new share issues.
Controlling the ownership base
According to the Swedish Companies Act, the main rule is that shares are freely transferable, which means that each shareholder is able to freely transfer their shares to anybody they choose. This is not a desirable situation in companies with a limited ownership base, where it is important that the shareholders' agree and have the right conditions to be able to make joint decisions concerning the business. Control over and restrictions surrounding transfers of shares are therefore important aspects in a shareholders' agreement. The shareholders can agree in the shareholders' agreement on the conditions under which an external third party is entitled to acquire shares in the company and thereby become a shareholder.
The shareholders' agreement can also regulate different types of redemption rights, warrants and other regulations concerning when owners can be compelled to acquire or sell shares. A couple of central reasons for such regulations are, in part to control the ownership base (and thus ensure that the company's shares are not dispersed in an undesirable way), and in part to counteract inappropriate behaviour from the shareholders.
Further, a shareholder's shares can end up in outsiders' hands if the shareholder in question gets divorced and half of the shareholder's shares are apportioned to his or her ex- partner through division of property. Another important function of the shareholders' agreement is therefore to require all shareholders to ensure that their shares constitute private property. Shareholders who violate such an undertaking by not entering into a prenuptial agreement make themselves liable to breach of contract in relation to other shareholders.
If a shareholder acts inappropriately or commits breach of contract, the other shareholders may have an interest in excluding the shareholder who has committed breach of contract in order to avoid further harm to the company and the owners in general. Predetermining the conditions for redemption of shares in a shareholders' agreement means that the owners can regulate the circumstances under which a shareholder who has committed breach of contract can be compelled to sell their shares to other owners. Furthermore, the shareholders can regulate in advance how valuation and pricing will proceed in various redemption situations, thus facilitating how those situations are dealt with and reducing the risk of disagreements surrounding the purchase price.
As previously mentioned, it is important in companies with a limited ownership base that there is a functioning dynamic between the owners. If a majority shareholder chooses to sell his or her shares to an outsider, the new constellation of shareholders may upset the established balance in the ownership base. For that reason, the minority shareholders do not always want to remain in the company, which is why the minority might have an interest in being able to demand that their shares are sold to the outside party too. It is possible to regulate this issue in a shareholders' agreement. Such a clause is called a "tag along" and in principle means that a minority shareholder has the same rights as the majority shareholder to sell shares to a certain buyer.
In the same way that minority shareholders can have an interest in being able to "tag along" with a sale, majority shareholders can have an interest in forcing a sale of all shares in the company under certain conditions. It is also possible to regulate this in a shareholders' agreement. Such a clause is called a "drag along" and means that a selling majority shareholder can oblige the minority shareholders to also sell their shares to the same outside party. Such a clause usually makes it simpler for the majority shareholder to be able to transfer shares, as buyers are often more inclined to invest if they gain control over the entire company.
It can often be of interest to shareholders in a company to regulate different kinds of buying- and selling options in the shareholders' agreement. For example, this might be the case when an investor chooses to acquire a proportion of the shares in a company and one or all of the other shareholders want to have the option of demanding that further shares are acquired by the investor. Such options can be unilateral or reciprocal and they can be linked with various kinds of requirements and conditions, such as time limits, that certain performance targets need to be met by the company for the options to be triggered and so forth.
It should also be mentioned that it is to some extent possible to restrict the right to freely transfer shares by utilising the provisions that the Swedish Companies Act stipulates can be incorporated in the articles of association. The most common provisions are those concerning right of first refusal and post-sale purchase right respectively, which means that in connection with a sale of shares to a third party, the shares must first be offered to other shareholders (right of first refusal provision) and also that an external acquirer of a share is obliged to offer the share to existing shareholders or others (post-sale purchase right provision). However, the formulation of these provisions is limited by the Swedish Companies Act's prescriptions on what a company's articles of association may contain, and these regulations are therefore relatively undynamic and rigid in comparison with what can and may be regulated through a shareholders' agreement. Nevertheless, on many occasions it is important that one or both of these regulations is also included in the articles of association as, in distinction from the shareholders' agreement, the articles of association are effective in relation to third parties. The rules in the articles of association and the provisions in the shareholders' agreement then supplement each other.
We have written more about what should be considered in connection with changes of ownership in private companies in this article.
Avoiding deadlocks
There are specific challenges in cases where a limited company is owned equally by two shareholders or if the number of shares and votes distributed otherwise enables a so called "deadlock", which means that there is a real risk that the votes cast at a general meeting will be 50/50.
In the event that the shareholders do not agree, which can have the consequence that decisions cannot be made at, for example, general meetings, there can be a risk of the company's operations coming to a standstill. This is often designated a "deadlock" situation. When "deadlock" situations arise, the shareholders benefit from having agreed in advance on how the situation will be resolved. The shareholders' agreement therefore often contains specific procedures for decision-making, requirements for mediation in connection with conflicts, bidding procedures and other means to avoid the company getting stuck in a dead-end. In companies with an ownership structure that enables deadlocks, it is of the utmost importance to regulate these sorts of issues in a shareholders' agreement – not doing so can lead to major consequences for both the company and the shareholders.
Protecting minority shareholders
If the ownership base is divided into majority- and minority shareholders, there are certain important factors to take into consideration, which should be regulated in a shareholders' agreement.
It is frequently necessary for minority shareholders to ensure that they are not outvoted in crucial decisions. The point of departure in the Swedish Companies Act is namely that decisions are made with a simple majority, which means that a proposal that receives more than half the votes wins. In other words, a majority owner can single-handedly vote through the bulk of all decisions concerning the company and its operations. However, the requirement for a simple majority can be waived and the majority requirement can instead be tailored through insertion of specific rules on decision-making.
The shareholders' agreement can also contain regulations that require consensus between all shareholders or alternatively a set number of shareholders for certain types of decisions. On many occasions, this protection mechanism can be fundamental in ensuring that minority shareholders are able to protect their investments and interests.
Decisions on the composition of board members are generally made with a simple majority. Besides regulations surrounding majority requirements in connection with decisions, minority interests can be protected through regulations on the right to board representation and information sharing. This ensures that the minority have a voice and requisite insight into the company's operations. Such transparency can be decisive, particularly when there is a risk of majority shareholders taking actions that can adversely affect the minority interest.
Managing conflicts
Unfortunately, conflicts are unavoidable in the business world and disputes can be both time-consuming and costly. A shareholders' agreement is a cheap way to minimise the risk of disputes as it provides a framework for how certain decisions are to be made. The agreement usually also includes rules for how any disagreements and disputes are to be managed. It might concern conditions stipulating that shareholders who are in disagreement have to bring in a mediator before going to court, that disputes should not be resolved in court but rather through arbitration, and also where a dispute should be dealt with purely geographically.
Regulating non-competition, non-solicitation and confidentiality
A common element in shareholders' agreements is non-competition and non-solicitation, which, inter alia, prevent shareholders from conducting competing operations and recruiting personnel and/or collaborative partners from the company. The purpose of these clauses is to maintain integrity in the company's operations and they play a central roll in protecting the company's and other shareholders' interests. They can mean that potential conflicts of interest are avoided and can ensure that the company does not suffer adverse consequences due to unwanted competition or staff mobility.
It is possible to stipulate in the shareholders' agreement that non-competition and non-solicitation should also apply after the shareholders' agreement has ceased to apply. It should also be mentioned that protective labour law regulations give the owners more extensive possibilities to regulate competition issues in a shareholders' agreement compared with in an employment contract, which is why it is beneficial to regulate such restrictions directly in the shareholders' agreement.
Another question that has a bearing on protection of the company's interests and integrity concerns the handling of confidential information. In that the shareholders' agreement covers confidentiality surrounding, for example, the company's affairs and the content of the shareholders' agreement, it is incumbent on the shareholders to protect business strategies, product innovations and other sensitive business information from ending up in the wrong hands. The handling of confidential information serves not only to safeguard trust in the company, but also enables the company to retain a strong negotiating position and remain competitive in the market.
Sanctions in connection with breach of shareholders' agreement
Customary liability rules generally apply to breaches of a shareholders' agreement, which means that the breaching party is liable in relation to the injured part(ies) up to an amount equivalent to the damage the individual(s) have suffered.
As it is often difficult to show precisely what damage has been suffered by someone else's breach of contract, it is common in shareholders' agreements to include auxiliary regulations linked to certain types of breach of contract. We have described above the possibility of forcing redemption of a breaching party's shares. Such redemption is moreover often combined with a discount on the purchase price for the relevant shares, which constitutes a sanction in itself. Otherwise, various types of penalty provisions linked to specific breaches of contract are common. What is absolutely most common is, for example, to link penalty provisions to the competition-, solicitation- and confidentiality clauses, as it is often hard to show what damage has been suffered as contractual party to someone who has violated one of these regulations. A penalty clause can then, for example, be formulated in such a way that breaches of these measures will result in an obligation to pay a predetermined penalty (i.e. damages decided in advance) to other parties and that breaches of contract that are of an ongoing character entail a new penalty for each commenced month for which the breach persists.
CONCLUDING REFLECTIONS
As set out in this article, there are numerous reasons that shareholders in private companies with a limited ownership base should draw up shareholders' agreements. It is beneficial based on both cost- and effectiveness perspectives, and, moreover, a shareholders' agreement protects both the company itself and its shareholders in various respects.
Finally, it should be stated that the above is simply an overall summary of certain issues relating to shareholders' agreements This article does not therefore constitute legal advice in an individual case.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.