Shareholders' Agreement: Definition, Purpose & Key Provisions

A shareholders’ agreement is an arrangement among the shareholders of a company. It contains provisions regarding the operation of the company and the relationship between its shareholders. A shareholders’ agreement is also known as a stockholders’ agreement. It protects both the corporate entity and the shareholders’ investment in that entity.

Summary

• A shareholders’ agreement is an arrangement among the shareholders of a company. It protects both the business and its shareholders.
• A shareholders’ agreement describes the rights and obligations of shareholders, issuance of shares, the operation of the business, and the decision-making process.
• The unanimous approval requirement and the tag-along provision protect the interests of minority shareholders.

Understanding a Shareholders’ Agreement

A shareholders’ agreement is created with the purpose of protecting both the business and its shareholders. It ensures the shareholders are treated fairly. It can also be beneficial to minority shareholders, who usually have limited control over the business operation.

For the shareholders, it outlines what their rights and obligations are and how the shares can be distributed or sold. For the business, it describes how the company will be operated and how significant decisions will be made.

It is optimal to draft a shareholders’ agreement while starting up the company or issuing the first shares. It helps the entrepreneursEntrepreneurAn entrepreneur is a person who starts, designs, launches, and runs a new business. Instead of being an employee and reporting to a supervisor or investors to reach a common understanding of what they expect to provide to the business and receive from the business. If investors find it difficult to settle the major conflicts and reach a consensus on a shareholders’ agreement, they may need to reconsider their collaboration relationship.

Investors can also draw up a shareholders’ agreement on a later date; however, their expectations may further diverge as the business operates. It may make it more difficult to reach a consensus.

Characteristics of a Shareholders’ Agreement

A shareholders’ agreement is optional. The contents and provisions vary in different cases. The details depend on the nature of the entity, the class of shares, and many other factors. There are basic components that every shareholder’s agreement contains. Examples include the number of shares issued, the issuance date, and the percentage of ownership of shareholders.

Shareholders’ agreements often determine the selling and transferring of shares to third parties. They also illustrate the treatment of shares if a shareholder dies. A pre-emption provision ensures the current shareholders have access to new shares before they can be issued to other potential shareholders.

A shareholders’ agreement also covers details about dividend payments and the distribution of earnings. Regarding the business operation, it contains provisions about the frequency of board meetings and the appointment or resignation of directorsBoard of DirectorsA board of directors is a panel of people elected to represent shareholders. Every public company is required to install a board of directors.. It also outlines how the processes will be for different levels of decision-making.

Many shareholders’ agreements also include competition restrictions and a deed of adherence. The competition and restrictive covenants prevent a shareholder from competing with the company.

For example, they are not allowed to work with a competitor firm in the same geographical area. It is important, as it protects the company and the interests of other shareholders. A deed of adherence ensures new shareholders adhere to the pre-existing shareholders’ agreement.

Shareholders’ Agreement and Minority Shareholders

Minority shareholders are those who own less than 50% of the shares of a company. Since the business operation of most companies follows the majority decision, minority shareholders usually have little control over the business. Laws have been set to protect the interests of the minority shareholders; however, the protection is limited, as it may be costly or practically difficult to enforce.

A shareholders’ agreement can protect minority shareholders. One way is through the provisions that need unanimous approval for certain decisions. As long as one shareholder disagrees, the decision will not be approved, regardless of how much that shareholder owns in the company.

The decisions that are bound by the unanimous approval requirement usually include the issuance of new shares or bonds, change in capital structureCapital StructureCapital structure refers to the amount of debt and/or equity employed by a firm to fund its operations and finance its assets. A firm's capital structure, appointment or removal of directors, and changes in major business operations. Despite benefiting the minority shareholders, the unanimous approval requirement also comes with drawbacks. It may slow down the decision-making process and diminish efficiency.

Another provision that can protect minority shareholders is known as the “tag-along” provision. The provision applies when someone offers to purchase shares from a majority shareholder. The shareholder is not allowed to sell unless the same offer is made to all the other shareholders as well, including the minority ones. It ensures the minority shareholders are treated fairly. They should be able to receive the same returns as the majority ones.

More Resources

CFI offers the Commercial Banking & Credit Analyst (CBCA)™Program Page - CBCAGet CFI's CBCA™ certification and become a Commercial Banking & Credit Analyst. Enroll and advance your career with our certification programs and courses. certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:

• Non-Compete AgreementNon-Compete AgreementA non-compete agreement is a covenant between an employer and employee that prevents the employee from using information learned during employment
• Extraordinary General Meeting (EGM)Extraordinary General Meeting (EGM)An Extraordinary General Meeting (EGM) is a meeting held by a company or an organization to deliberate upon matters which require the urgent
• Minority InterestMinority InterestMinority interest refers to having a stake in a company that is less than 50% of the total shares in terms of voting rights.
• Drag Along RightsDrag Along RightsDrag Along Rights (also referred to as "drags" or drag-along provisions) are rights that give the majority owners the right to force minority owners to join in the sale of a company. The rights give the majority owners the ability to sell the entire company based on the terms and conditions they desire.