If you’re starting or running a business or buying a property with other co-founders, someone probably told you to get a shareholders’ agreement.
But why is this important? What does a shareholders’ agreement do? What can happen if you don’t get one? In this article, I’ll explain why you need to have some hard conversations with co-founders, and we’ll look at an interesting recent case with costly consequences.
What is a shareholders’ agreement?
A shareholders’ agreement is a contract where you agree on how you’re going to work together to run your business. Think of it like the ground rules for your business. Such an agreement can cover things such as:-
Ownership: What each person brings to the table and what portion of the business each person gets in return.
Shares: How each person can deal with their shares and how the company can issue more shares.
Decisions: How directors are appointed and whether any decisions require specific approvals.
Exit: What happens if someone leaves the business, and whether they get to keep their shares (e.g. vesting).
There is no one-size-fits-all solution to any of these points. Each business investment is different, and each founder is different. So it’s beneficial to agree on the rules that should apply early on and review them as your business grows and changes.
Why should you talk through the issues early on?
It’s kind of like a pre-nuptial agreement before you get married. If you can’t have a sensible discussion with your significant other about things like money and what happens if you break up, that might be a red flag.
I’ve seen businesses where the founders keep putting off a shareholders’ agreement, as it’s just “too hard” or “not a priority. If the company then fails, a messy end becomes even messier.
However, even if those businesses had survived, they may still have had problems. By not laying the groundwork for how the company will run right from the start, you may face high costs and lost opportunities down the line.
What if you don’t want a shareholder’s agreement?
Engaging with a commercial lawyer in the early days of your business or property purchase can be a bit daunting. There is also a cost to drafting a shareholders’ agreement. Depending on the lawyer, it is probably at least a few thousand dollars. So, what can you do if you just can’t afford the expense?
The minimum effort here is to talk through the issues with your co-founders. If problems arise, having nothing written down will make life more difficult.
But if you have talked through the key issues and documented them, this should hopefully help avoid problems or at least allow you to work through them before they become too big. If your business or property investment grows, the issues can become very big!
What can happen when things go wrong?
In one recent case, most business owners missed a crucial clause in their shareholders’ agreement. As a result, they had to pay an extra $2 million to the minority shareholder when they sold the business. How did this happen?
Most shareholders had agreed to sell the business for $A112 million. They then asked a minority shareholder to confirm his earlier approval of the sale, but he then demanded a higher share price for his shares.
This amounted to a $A2 million bonus for the deal to go ahead, even though he only held 6% of the company.
Unfortunately for the major shareholders, the opportunist minor shareholder was perfectly entitled to hold out for a better deal. So when the others paid him what was requested, the court ruled he could keep the extra money (even though some might think that sounds like extortion). A more appropriate shareholders’ agreement could have prevented the drama and loss of value to the principal shareholders.
What could they have done differently?
In principle, the shareholders could have agreed to include a “drag-along” provision in their shareholders’ agreement. A drag-along provision would have required the small shareholder to sell his shares (at the same price as the majority). The minor shareholder would still have received a substantial payout, but he would not have had the leverage to hold up the entire sale for an extra fee.
Minor Shareholders also need to beware.
Of course, this can happen in reverse, with several smaller, silent investors joining new farm syndicates without an adequately constructed shareholder agreement on how to exit or how they will be treated if the company requires additional capital.
We see this often in dairy and cattle farm syndicates, where unsuspecting foreigners buy into the hype without studying the underlying shareholders’ agreements, which are usually drafted to disadvantage smaller shareholders. Some of the worst examples we have seen were in Uruguay and in Chile involving foreign dairy syndicates.
The end result is that they have no exit except to take the value that the majority shareholders might decide to give them.
Another good test is to study the track record of the other founding shareholders. Have they invested successfully in the region before with similar investments?
The point I am trying to get across is to get legal advice from local lawyers who know the pitfalls before entering into these types of investments. The money would be well spent. There are many examples of shareholders who did not heed this advice and ended up in financial trouble.
Source: Geoffrey W McRae, Director GTSA
Contact the Gateway to South America team to learn about the best investment opportunities in the region. The company is a benchmark for foreign investors wishing to invest in Argentina, Brazil, Chile, Paraguay, Peru and Uruguay, providing expert advice on property acquisition.
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The New Zealander has a distinguished career of over 30 years in 7 countries, specializing in South American real estate, agriculture, and commercial matters. As the founder of Gateway to South America, he is known for his discretion, expertise, and experience in representing active clients in the region. His extensive knowledge of the market has positioned him as a leading authority and trusted advisor.
