You have taken advice to carry on business in a limited company and you have some vague notion that you need a shareholders’ agreement-but why ?

Value of a shareholder agreement ?

The shareholders agreement is a form of insurance. It protects shareholders from the excesses of their fellows. It regulates the way in which the shareholders as a body will influence the manner in which the company will carry on business. It determines how shareholders may part with their shares and how to deal with approaches by potential buyers. It deals with issues which on their face ought not to be controversial but nevertheless can become fundamental.

In this first of a series of articles I will try to explain some of the typical and/or essential ingredients of this most important, and often underappreciated, business tool.

Deadlock and Exit

We believe that an important, perhaps most important, element of the shareholders agreement is to address the possibility of fundamental differences. The best shareholders’ agreements should provide for a means by which to resolve disputes between shareholders and, in particular, how to resolve disputes which cannot otherwise be resolved because there is no built-in majority to carry the day. In other words the shareholders are deadlocked.

We all know what a deadlock is. It’s a dispute, or argument, which no one is entitled, by reason only of a built-in majority shareholding, to win. So a 50:50 shareholding is a classic inbuilt deadlock.

If differences can’t be resolved by discussion the deadlock will not exist because there is a shareholder majority able to carry any resolution as of right. Either the minority shareholder(s) take it on the chin or they must extricate themselves from the company.

But does it end there? What if you wake up one morning with the realisation that you can no longer work with some of your fellow shareholders, or any of them. Supposing personal issues have invaded the boardroom. Supposing you have simply had enough and you want out. What if you just don’t agree with the way the company is going. Isn’t that just as bad as a technical deadlock? In truth, whatever the shareholding, a deadlock exists when one shareholder says so. Should that not also trigger the exit mechanism?

The longer deadlock exists, real or virtual, so the company has the greater potential to suffer as minds turn to the battle rather than the business.

If the company is to be protected from paralysis the deadlock, real or virtual, must be resolved. Usually this means that one party must go and it is essential that your shareholders’ agreement contains a mechanism for one party to exit the company. A company with a board that cannot pass resolutions is doomed unless that can be changed. A company whose shareholders can’t agree is on the slippery slope.

Management may be in the hands of a board which may not necessarily consist entirely of shareholders but the views of shareholders will ultimately prevail because a majority of the shareholders has the power to remove directors who, in their opinion, step out of line.

It is important to distinguish between the Board, which manages the business and the shareholders who may be on the board but may merely own shares. The ultimate power is theirs.

Exit strategy

Exit Strategy can take many forms but they all end up with one or more parties going and one or more staying. Shareholders embarking on a new venture (or waking up to the vulnerability to discord) are well advised to provide the exit strategy in advance so that the parties have the comfort of knowing that any deadlock will be resolved with the minimum disruption to the business. Do not assume the best. Always assume the worst, hope it doesn’t happen but be prepared if it does.

Whatever the exit strategy it would be foolish to rule out friendly discussion, by far the best, least painful and quickest means to resolve disputes. Who knows when your paths will cross again ?

A quick and friendly solution may yet have a sting in its tail. One wants to sell and the other will buy but do they have the money and how will the shares be valued? A formal share valuation process is often, if not always, slow, expensive and time consuming for the parties. The eyes can be off the ball whilst the process takes its course and suddenly a good business can become a bad business just because the parties did not have the foresight to legislate in advance for the worst.

A suggested exit strategy

Our favoured exit strategy is not the only good one but in over 40 years as a commercial lawyer I think it is the most effective. It is not possible to set out the whole process but here is a brief step by step illustration, which will give you an idea of how it works:

Step one – a dispute notice

Step two - consultation

Step three – a “buy/sell” notice served by the shareholder who served the dispute notice.

The buy sell notice is a notice served by one shareholder on all the others stating a price at which he or she will either buy the shares of the others or sell to them. Parties receiving the notice may agree either to buy or sell at the nominated price and the formula can be adapted to allow for multi-shareholders so that the body of shareholders will ultimately be divided into buyers and sellers. The Buy/Sell agreement will allow the parties time to put their funding in place and for shareholders to be obliged to sell if they fail to respond to a notice. You may have noticed the absence of any valuation. The Buy/Sell avoids the cost and inconvenience of independent valuation. It is a self regulating mechanism. The party serving the notice will not put too high a price on his shares for fear that he may have to pay it nor too low a price lest he be required to sell.

In order to concentrate the minds a Buy/Sell agreement is sometimes produced separately from the shareholders agreement but it occupies the same locked safe until the parties may feel the need to implement it. The great thing about Buy/Sell is that the process is so stark and finite that the vast majority of deadlock disputes are resolved by negotiation at the consultation stage with all parties aware that there is an infallible solution locked away in the safe should negotiations fail.

It may seem strange when starting a new company to contemplate its failure but our advice is to promote pragmatism over sentiment and make exit terms a priority.

David Swede is a Consultant in commercial law and offers experienced and cost effective advice on shareholder agreements at Darlingtons Solicitors in London.

Despite the somewhat strange latin name, ultra vires is a legal concept and not in fact a disease. It prevents companies carrying out actions which are beyond their scope of power.

Origin & Development

The doctrine of ultra vires has been developed in the interest of the investors and creditors of a company. The concept dates back over 140 years to case in which a railway company was incorporated as a company under the Companies Act 1862. The object clause in the Memorandum of Association stated that the company was to make, sell, lend, or hire railway carriages and wagons and all kind of railway machinery, plant, fittings and rolling stock; to carry on the business of general contractors and mechanical engineers; to purchase, sell, and lease minerals, mines, buildings.

The directors of the company agreed to purchase a concession for making a railway in a foreign country. The object clause in the Memorandum of Association was to supply and sell materials required to construct railways and not to undertake the construction. This was contrary to the company’s Memorandum of Association and the court held that the construction contract entered by Ashbury Ltd was ultra vires not only to the directors but to the whole company.

Meaning & Definition

Ultra vires means “beyond the powers”. It is a concept relating mainly to corporate law. In corporate law, the act is ultra vires, when the company perform acts which are beyond it’s powers. Such actions may include acts which are specifically prohibited by the company’s articles or memorandum or excessive use of the corporate power that has not been granted to the company.

Important points to note

• Acts performed by the company that are beyond the scope of its charter are void or voidable.
• The shareholders can ratify an ultra vires act if they wish it to be ratified.
• If the company’s agent commits a tort within the course of its employment then the company cannot exclude liability on the basis that the act is ultra vires.

Exceptions to the doctrine of Ultra vires

• An act that is within the ambit of the company but beyond the authority of the directors can be ratified by the shareholders in proper form.
• If the company has purchased a property by an ultra vires act, the company’s right over such property shall still be secured.
• The company can alter its articles in order to validate an otherwise ultra vires act.

Ultra vires is a complicated subject but has less significance since the Companies Act 2006 has simplified many issues including the need for a memorandum of association.

This post provided courtesy of Darlingtons Solicitors. If you have any additional questions about company law or the concept of ultra vires, please contact darlingtons.