Practical Law Australia Advisory Board Member, Rachel Launders, shares some lessons she’s learnt over the years, sometimes the hard way, from transactions she has worked on involving shareholders’ agreements. For simplicity, this article only refers to shareholders’ agreements, but the issues described apply to any sort of joint business activity, including joint ventures or partnerships. These issues are worth considering before you next start drafting a shareholders’ agreement or similar document.
Drafting a successful shareholders’ agreement
A shareholders’ agreement is essentially a corporate pre-nuptial agreement. The key purpose of a shareholders’ agreement is to govern the relationship of the parties and how they behave towards each other while they are in the relationship, and when they end the relationship.
As with a pre-nuptial agreement, the shareholder agreement is prepared at a time when hopes are high and everyone is on their best behaviour. The new deal is exciting with limitless upside. The commercial team won’t necessarily want to think about what might go wrong and how they might need or want to extract themselves from the relationship. Part of the lawyer’s role on these transactions is to be the pessimist (or maybe the realist) and focus on these issues, so that, if things don’t go to plan, there are clear rules to play by.
This is a fascinating type of transaction for a lawyer to be involved in, as you may be helping to create a brand new business or breathing new life into an existing one. There are many issues to consider, in addition to the ones I have addressed, and many variations on the solution to the issues I have addressed. This is an area of legal practice where creativity is demanded.
Understand your client’s business
You need to understand upfront what your client is seeking to get out of the venture they are going into, as that will inform other decisions such as the ownership structure, decision making and exit strategy.
What other business does your client do or want to do?
Understanding how the new business fits into your client’s overall strategy is important. Shareholders’ agreements will often have restraints on the shareholders participating in competing businesses. The scope of the restraint which will be acceptable to your client will be affected by:
- any existing businesses they have which may overlap with the new business; and
- the client’s strategy for growth of its own business – are they totally committed to growth through the new venture or are there related activities they may want to participate in, outside the new venture?
How will your client contribute capital to the business?
Some understanding of the client’s financial and tax position is imperative. That may affect the way in which your client will provide funding to the business and the type of return which it seeks. Options to consider are:
- Contributing funds as a loan, to receive a return initially in the form of interest payments (which, unlike dividends, cannot be franked) and ultimately a return of the principal. There may be less benefit to shareholders from putting in funds as a loan if the business will also have third party debt, as any non-shareholder lender will insist on having a preferred position in terms of security and repayment, over the shareholder debt.. Another issue to consider is what happens to the loan if the lender ceases to be a shareholder. Does the loan just stay in place and get repaid according to its terms? Do terms change to more arm’s length terms (which might include more detailed access to information and restrictions on conduct by the business without the lender’s consent)?
- Contributing equity capital, to receive dividends which may be franked, and a capital return. A return, through dividends or capital returns, may occur from the start of the investment, if the client is buying into an existing business which is operating profitably. It may be at a point in the far distant future, if it is a brand new venture which may generate losses for some time. If the client is looking for a more immediate return, debt may be preferable to equity for the capital contribution, if the business will have the cash flow to pay interest.
There is also the option of a convertible instrument. This is essentially debt, so is repayable and may provide for a fixed return, payable when the company has profits or cash flow to service the repayments. However, it can be converted to equity in some circumstances, usually if there is a favourable exit opportunity from the business available to shareholders. This allows the investor to participate in upside on an exit, while retaining the ability of a debt holder to have capital repaid more easily than shareholders can have capital returned.
How does your client account for its investment?
You need to understand the likely financial performance of the business. If your client controls the entity, it will need to consolidate the results of the business into its own financial statements. If the new business is going to be loss making for some time, it may be preferable to defer the point at which control is achieved, so that your client doesn’t need to consolidate the losses. This can be done through the way in which the shareholding structure, voting rights and rights to appoint directors are effected but this needs to be considered early as it will have an impact on the overall deal structure.
Are there any collateral benefits sought from the business?
Your client might be seeking benefits from being a part of the jointly owned business, other than a direct financial return. These other benefits could include:
- access to a share of production of the business (for example, in a mining joint venture);
- ability to provide goods or services to the business (which may be as simple as back office services as a way of sharing costs, or could be something fundamental to the operation of the business such as intellectual property) as a way of receiving fee income from the business; or
- getting the benefit of an experienced partner’s expertise in a new geographic area or type of business, if the shareholder is keeping an option open to go it alone in the future.
Any other goals or aspirations need to be well understood from the start of the venture, to ensure that the terms on which your client can obtain those benefits or the process for making decisions about related party transactions are clear to all involved.
Don’t overcomplicate decision making
A key issue in any shareholding relationship is how decisions are made about the business. Some issues to consider are:
- What issues will be decided by the shareholders and what issues will be decided by the board? This needs an assessment of what issues are so important that shareholders want to be able to act in their own interests, without the obligation on directors to act in the best interests of the company. Material changes in the nature of the business, major transactions, further contributions of capital or transactions which will dilute shareholders’ interests would typically be reserved to shareholders rather than to the board. If there are many shareholders, it will be easier to leave all decisions with the board rather than calling shareholder meetings regularly to make decisions, given the time and cost involved in calling shareholder meetings.
- Which issues will be decided by a simple majority of the board and which issues will have a higher voting threshold? Are there matters which require a unanimous decision? I usually recommend restraint in specifying unanimous decisions, particularly where there are many shareholders or directors. Just one of them can block a proposed action if the relationship sours which can be very bad for the business. Of course, if you are acting for a minority shareholder, you may well want to such a veto power but this should be limited to very important decisions.
- Is there a difference between the short term and long term decision making structure? If the shareholders’ agreement includes an opportunity for a major shareholder to buy out minorities at a future time, those minorities will be concerned about anything which will decrease value over the buy-out period. They may be looking for more influence, in the form of veto rights or higher voting thresholds, while the buy-out right is on foot, but a different structure may be appropriate, when the buy-out period has finished.
- If there are only 2 equal shareholders, in practice everything will need to be decided unanimously. In that situation, the deadlock provisions assume much greater importance (see Decide how to deal with stalemates, below).
Some of the problems I’ve seen in this area come from an overly complex decision making structure, such as requiring multiple layers of decision making. An example of this is requiring a 75 per cent board approval on a decision whether to call a shareholders meeting, for the shareholders to vote on an issue that also require a 75 per cent vote in favour. This level of complexity is unnecessary and can lead to frustration for all participants when actions can’t be taken promptly.
Difficulty can also arise if the shareholders’ agreement contains a very long list of issues which require special board or shareholder approval or if it specifies dollar thresholds which are acceptable at the start of the business’ operations but which become too low to be workable over time. It is likely that the mandated processes will be overlooked in practice, or the business will be stuck with a cumbersome decision making process. Neither of those outcomes will contribute to good governance or a productive business relationship.
Decide how to deal with stalemates
There are a range of options for dealing with stalemates – an inability of the board, or shareholders, to agree on an issue. If there are only two shareholders, the strategy for dealing with stalemates needs to be determined. If there are more than two shareholders, depending on the allocation of decisions between board and shareholders and the number of directors or shareholders, it may still be worthwhile considering where a stalemate can occur and how it should be resolved.
The simplest approach is not to deal with it – if a matter cannot be agreed, it cannot be acted upon by the company. However, neither shareholder is likely to be well served where that approach is taken. For example, if one shareholder wants to invest and grow the business and the other doesn’t want to, the likely result will be frustration for both shareholders, and a business that then dwindles. If you combine this with an inadequate exit strategy (see You need an exit, below), it is set up to disappoint or, worse, to fail.
One approach I have used was to set out how different types of stalemates would be resolved, rather than taking a single approach to all types of deadlock. This approach used a table of alternatives, that covered most of the issues likely to be the subject of a deadlock and the alternatives for dealing with them. Some of the issues addressed are set out below:
Setting a new budget before the end of a financial year
The previous year’s budget plus CPI applied.
Another option is to just keep the previous budget for operating expenses and no permitted capital expenditure (as an incentive to agreeing a new budget).
A CPI escalator can be challenging for high growth businesses – I have had a counterparty argue for a 30 per cent increase in operating expenses if the budget isn’t agreed on the basis that that reflected their recent trading history. Locking in numbers based on recent history, rather than considering the likely future growth profile, could quickly become a problem. We compromised with a multiplier that reflected actual growth in the two years before the deadlock, rather than a multiplier that was fixed for all time.
Proposed capital expenditure or operating expenditure above a specified value
Escalate to shareholders for negotiation over a short period of time. If they cannot agree, the expenditure doesn’t proceed.
A methodology was specified to calculate surplus cash, which is then the default amount for payment of a dividend.
Directors need to consider more than just the current cash position when declaring a dividend. To ensure solvency requirements are also met, a stable and predictable cash flow and little capital expenditure is needed for this approach to be appropriate. It may be more prudent to say that no dividends will be paid, if no agreement can be reached on the amount.
Change of auditors
No escalation process applied – if there was no agreement, the auditor would not be changed.
Appointment of key employees
One shareholder had the ultimate right to appoint one key employee, and the other shareholder had the ultimate right to appoint the other key employee.
Serious deadlocks might also be a trigger for termination of the joint venture. This could be through:
- a “shotgun” arrangement – where one shareholder specifies a price at which they will buy out the other, or be bought out at that price, and the other shareholder gets to decide whether to sell or buy at the nominated price. This puts an incentive on the party seeking to terminate to be reasonable. If they offer a derisory amount, they could be bought out at that price. If they offer a ridiculously high price, they may have to buy at that price; or
- a sale at a pre-agreed valuation such as a multiple of earnings.
The criteria for a shareholder to cause a termination for deadlock needs to be serious and clearly defined, so that neither party can hold this threat over the other party. Your client needs to consider which issues are so fundamental to the business and your client’s reasons for being in the business that they would want to be able to walk away from the business if there was no agreement reached on the issue. It should be a very short list.
You need an exit
One key purpose of a shareholders’ agreement is to specify what can lead to a termination and the consequences of the parties going their separate ways. Careful thinking is needed at the start of the deal, about the circumstances which may lead to one party needing or wanting to exit and the way in which that should be effected.
It can be difficult to sell a partial interest in a business, particularly if there will be few potential buyers and the stake may not be of any interest to a purely financial buyer. Because of this, it should be rare for a shareholders’ agreement to have no obvious exit mechanism. I have seen agreements which do not have any exit mechanism. Lawyers usually see these agreements when one party is frustrated because they are stuck in the business and looking for a way out. While the Corporations Act has the oppression remedy as an option, the process of seeking a court order to unwind a venture is not a great outcome for anyone involved.
Some issues relating to exit arrangements to consider are:
- Should there be a right for a party to simply terminate at will? That creates an easy exit, but can be used by a shareholder as a constant threat. That may be too easy an alternative.
- Should there be a period of time that the parties have to stay together before any termination is permitted, so that there’s a forced period of time to make things work? If two existing businesses are being merged, this might be a worthwhile approach to ensure that the value of the combination can be realised, before anyone is able to exit. I used this approach on a transaction in 2003 and am happy to say the business still exists, so the forced togetherness appeared to have some benefits for the parties.
- What happens to the assets of the business on termination? If each party has contributed defined assets, can those assets be separated so each shareholder goes back to where it was before the venture commenced? That might be possible in the early days but after a while, that will either not be possible or will be value destructive.
- Are there assets which one party contributed and will insist on retaining after termination? An example of this could be trade marks or other core intellectual property which the shareholder uses outside the joint business, and so will want to retain ownership of globally. This might affect how an exit can be structured – the other party can’t buy out the business if the business loses all value without that key intellectual property. Consider whether this can be addressed by allowing the buyer a period of time to rebrand the business and how the costs of doing so and effect on value should be accommodated in the buy-out price.
- How should value be determined if one party is buying out the other? It is easy to say that fair market value will apply, but parties and experts will differ about the basis for determining fair market value. It can be useful to specify some principles for determining fair market value. This might include the valuation methodology to be used, whether earnings should be normalised in any way (particularly if the business model will not be sustainable after the buyout, such as where one party has been providing services which will cease to be supplied after termination), and whether there should be a premium for control.
Think through all the possible outcomes for your exit mechanism – it needs to work
I have seen some shareholder agreements with very complex exit provisions. In some cases, those complex provisions cannot actually achieve their goal. One example I have puzzled over is an exit clause that required an independent valuer to choose which of the parties’ submissions on valuation to accept, and then, depending on how the termination process had commenced, one shareholder could elect whether to buy the other out, or be bought out, at that price. So far, so good. However, some commercial arrangements between each shareholder and the company continued for a period of time or would be immediately terminated, depending on why the venture was being terminated and who was buying the shares. Those commercial relationships had a significant effect on the value of the shares being bought or sold. It was never clear how the valuation methodology was meant to operate with any certainty or fairness to the parties, when the key issue – what would the business look like after termination of the shareholders’ agreement – was unknown.
Perhaps this was a cunning plan to keep the parties together in the business as the option of getting out was too difficult to contemplate. I suspect it was more likely that insufficient time had been given to plotting out the exit scenarios, to find where the exit mechanism failed to work. That venture ended through a negotiated outcome, so fortunately we never had to try to implement the exit mechanism established by the founders of that business.
I find it useful to step through each possible exit scenario (such as breach by a party, insolvency, deadlock, termination at will, termination of a related arrangement), and work out who should be entitled to terminate and what should happen to all of the relationships between the parties. A flow chart can be helpful for this purpose. You will need to consider:
- The shareholding – which party gets to buy or sell? Is there a pre-determined price or formula? A premium paid by a defaulter or a discount to value for the non-defaulter? If an expert needs to decide the price, what guidance do you give the expert about how to approach this task? Is there a scenario in which the company is wound up rather than one party buying the other out?
- Any shareholder loans – are they repayable immediately? Do the terms become arm’s length commercial terms?
- Any related commercial agreements which support the business – is there a transitional period during which those agreements continue, or do they end immediately? Do the terms become more arm’s length or continue on terms which are favourable to the business?
If the parties to a shareholders’ agreement succeed in having a long and harmonious relationship, it may well be attributable to spending time at the outset considering how they want to work together and thinking through the possible pitfalls, as I have outlined. If they can do that co-operatively, my experience is that the parties will have a strong foundation for a profitable, long term relationship. Your carefully drafted shareholders’ agreement may rarely, if ever, be looked at. I see that as a measure of success.