Shareholders’ Agreement (SHA): What It is And Why You Need It.

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We often have clients knocking on our door seeking our advice on how to resolve a dispute that has arisen between the shareholders of a company. Our first question to the client will always be:

“Is there an SHA between the shareholders?”

What is an SHA?

An SHA is a document that governs the way in which businesses are conducted between the shareholders of a company.

SHA regulates decision-making process, right of appointment of directors, right to sell shares etc. It also provides for means of dispute resolution when a conflict arises between the shareholders; without the shareholders having to resort to formal legal action.

Protection of the shareholders’ interest

When negotiating an SHA, one must always bear in mind that different considerations would apply. This often depends on the percentages of shares held by the shareholders in a company.

Minority shareholder

A minority shareholder (i.e. a shareholder who owns less than 50% of shares in a company) should endeavour to negotiate for the following terms in the SHA:

  • Quorum
    A minority shareholder with a large minority stake or a strong bargaining power may negotiate for a right to appoint a director. The minority shareholder may further require his representative to be present at the board of directors’ meeting in order to form a quorum. This ensures that the minority shareholder’s appointed director gets to be involved in every decision making of the board.
  • Tag-along right
    A tag-along provision grants the minority shareholder a right to exit from the company. This is when a majority shareholder sells his shares to a third party. The provision allows the minority shareholder to “tag-along” with the majority shareholder’s right to exit. How this done, is by compelling the majority shareholder to procure that the third-party purchaser must also make an offer to purchase the minority shareholders’ shares. Note that, it will be on the same terms that are being offered to the majority shareholder.
  • Reserved Matters
    A minority shareholder will normally have a minority representation (or sometimes no representation) on the board. Therefore, it is pertinent for the minority shareholder to ensure that certain key matters of the company are reserved for the unanimous approval of the shareholders. This gives the minority shareholder a right to veto over certain significant matters in the company.
  • Pre-emption rights
    The majority shareholder will have the right to allot new shares without the approval of the minority shareholders. A minority shareholder would, therefore, want to ensure that it has the right to purchase any new shares allotted by the company before the new shares can be allotted to third parties. This provision seeks to avoid further dilution of the minority shareholder’s shareholding in the company.
On the other hand…

Majority shareholder

A majority shareholder (i.e. a shareholder who owns more than 50% of shares in a company) should endeavour to negotiate for the following terms in the SHA:

  • Board representation and control
    A majority shareholder typically has the right to control the board. This can be achieved by having the right to appoint the majority of the directors to the board and having a majority representation on the board. The majority shareholder should also negotiate for the chairman of the board to be either one of his directors and to ensure that the SHA clearly provides that his appointed chairman has a second or casting vote. In the event of an equality of votes at the board meeting, the chairman of the board will, therefore, have the right to vote and decide on the matter.
  • Drag-along right
    A drag-along provision is an important exit clause in the SHA to protect the interest of the majority shareholder. This provision enables the majority shareholder to compel the minority shareholder(s) to sell their shares to a third-party purchaser who offers to purchase all (and not part only of) the shares of the company.
  • Reserved Matters
    Minority shareholders will seek to ensure that significant matters of the company are reserved for their approval. However, this can be destructive to the business of the company. Especially when matters reserved for the approval of the minority shareholders failed to be approved after several attempts. A majority shareholder would, therefore, want to ensure that the scope and the number of reserved matters are restricted under the SHA.
  • Right of first refusal
    Right of first refusal provision restricts shareholders of a company from transferring their shares to outsiders. Any shareholder seeking to transfer his shares must first offer his shares to the existing shareholders of the company. This provision provides the majority shareholder with an opportunity to purchase the shares of the departing shareholder and restricts outsiders who may be complete strangers from purchasing the shares of the company.

Other important provisions under the SHA

  • Resolution of Deadlock

Deadlock refers to a situation where there is a fundamental disagreement between the shareholders of a company. A deadlock situation is most common where there are two shareholders with equal shareholdings (i.e. 50:50 shareholding) in the company and one of the shareholders refuse to vote or attend a meeting.

Deadlock provisions in the SHA set out the process, manner and time period within which the deadlock is to be resolved. In the absence of a deadlock provision in the SHA or the lack of an SHA, the disputed issues may end up unresolved, causing disruption to business or in a worst case, resulting in the company’s total failure to function.

  • Valuation of shares

An SHA – that is well-drafted – should consist of provisions on how the shares of the company are valued. These provisions help to avoid potential disputes during the valuation process when one shareholder seeks to trigger a buy-sell provision under the SHA. In the absence of such provisions, different parties may have different views as to how the shares are to be valued. For instance, one party may argue that the shares should be valued based on the fair market value. On the other hand, a party may argue that the shares should be valued based on the book valuations.

Summary

While it is important to have an SHA, it is also important to ensure that the rights of the shareholders are clearly spelt out in the SHA. The lack of an SHA or the existence of a badly drafted SHA can often lead to disputes which can be disastrous and costly to the shareholders.

Before you enter into an SHA, make sure to get proper legal advice and ensure that your interests are well protected!

*****

About the Author:
This article was written by Zuan Yin, Poh (Spring),  Partner of this firm.
The view expressed in this article is intended to provide a general guide to the subject matter and does not constitute professional legal advice. You are advised to seek proper legal advice for your specific situation.

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