Erika Moralez-Perez’s Guide to Shareholder Agreements: Control, Protection, and Smooth Exits

Welcome to the podcast that’s dedicated to helping business owners to prepare for an exit so you can maximise value and exit on your terms. This is the Exit Insights podcast presented by Succession Plus. I’m Darryl Bates-Brownsword, and today I’ve got Erika back with me. Erika is a commercial lawyer, and she had such an impact last time I asked her back to talk to us about shareholder agreements. Welcome, Erika, and thanks for joining me today.

Thank you so much for inviting me back, Darryl. It’s lovely to be here.

Yeah, brilliant. Erika, last time we spoke, we touched on the topic and we said one of the things that often, I guess, gets slipped or business owners aren’t aware of in terms of the protecting their business, and especially in the unplanned exit circumstances, or even when it comes to a planned exit, is that we need to consider something that is known as a shareholders agreement. Can you start by just giving us a bit of a heads up of what a shareholders agreement is?

Absolutely. So you know how I love a legal document, and you know how I love business owners to start as they mean to go on. If you own a company, the reason you want a shareholders agreement is to essentially set out the rules under which your shareholders will operate. So whether they own very few or very many shares in your business, you want to set out some rules around that. So the shareholders agreement is a private document, i.e., it’s not something that comes automatically in law to protect your company. It’s a private document between you and your fellow shareholders that sets down those rules. And between you, you can agree on what those rules look like. So that might be restrictions around spending and all sorts of things.

Okay, so it’s not required by law. It’s just if I have a business and I’m in with a number of other business partners or shareholders, it’s kind of a rules of engagement for shareholders.

Yeah, absolutely. That’s a really nice way to put it rules of engagement. What happens if we fall out? How do we deal with that? What happens if you want to leave and I don’t want you to leave? What happens if the reverse is true? What happens if you suffer a tragic accident and you no longer have mental capacity to deal with business things? How does that work? Where does that leave me? As the shareholder and director of this company, do I have the authority to act without you being there? So it’s all manner of things that may happen engagement is a lovely way to put it.

So you’re touching on, I think, a few points that business owners may have been making assumptions about. So I guess we should start at the top. If I’m a major shareholder of the business, I started the business and I started as a sole owner. And over the years I’ve gradually allowed or invited or in whatever structure had other shareholders join the business. But I’m still a majority shareholder.

I own, I don’t know, let’s start with 95% of the business. Is there any threshold point where I can just make assumptions and go, look, I’m the boss, I call the shots, you’ve got to do what I want? Or is there any shareholder level where we have to start considering these agreements? I get it’s good practice, but from a legal perspective.

Yeah. So you’re absolutely right. It’s good practice. It makes life easier in day to day management of your business. And indeed, if you want to sell it, the bottom line is this. If you have other shareholders, whether they are minority shareholders or major shareholders in your business, you have to have them on board if you want to sell. So you cannot force anybody in law to sell their shares.

You can say I might own 95% of the business and you might own 5%, Darryl. But if I say I want to sell my 95% and you say, well, I’m sorry, Erika, I don’t want to sell my 5%, then I can’t physically make you sell those shares unless we’ve got a document in place that enables me to do that.

Okay, so it’s a bit like a prenup then as well. We got rules of engagement and we’re agreeing while we’re still friends for planned reasons or not, or health or any other reasons. If one of us chooses or one of the shareholders chooses that they want to move on and they no longer want to be part of it, we need to agree how we’re going to do that.

I guess we also need to agree how we’re going to value your shareholding, especially in a private SME company. We’re not listed. The equity in our business is not liquid. There’s no market as such for our equity. And if it’s a minor shareholder or the major shareholder, I guess they want some sort of sense of control of who their new shareholder is.

Absolutely. So the shareholder agreement would deal with all of those things that you’ve suggested. You’re absolutely right. Valuation, as you say, really important. There’s no market drivers in the kind of businesses that we deal with the SMEs to say, well, this is how much these shares would be worth because they’re not listed.

So it’s really important that we have an understanding on how that takes place. And we often use fair value, which is somebody independent, usually an accountant or an auditor, saying, well, look, based on your turnover, this is what we think your shares will be worth. And that’s really important because we might not just want to sell our business. In many cases, that’s exactly what motivates us to do these things. But I’ve had situations where shareholders pass away unexpectedly.

And the last thing that you want is for one of my sons coming in as your 95% fellow shareholder when they know nothing about our business and nothing about the relationship that we have and how we do things. So it regulates that as well. So, as well as if you want to sell, it gives you those rules of engagement. Now, you touched upon a point which is really important. You called it a prenup, and it’s very similar.

We all go into business with the very best intentions, but things happen. Life happens. I gave the example of lack of mental capacity. I’ve had clients who were running a very successful events business, and one party was significantly older than the other. She was diagnosed with early onset Alzheimer’s and was very ill, and that happened over a series of years.

The other shareholder, they were 50-50 shareholders. The other shareholder was hamstrung because she wasn’t able to do anything in the absence of a shareholders agreement. So she couldn’t sell, she couldn’t bring on other investors. She couldn’t actually do anything because she was in a very difficult situation. So, like I say, we go in with the best of intentions, as indeed we do into our marriages, but things happen.

So it’s really about identifying as many of those potential pitfalls as early on as you can, documenting them, and saying, well, in this situation, this is how we’ll deal with that.

Okay, so why don’t we dig into some of those and just explore what they mean? And before we do that, let’s put some structure. Beat myself up here. So what are some of the major headings that we want to make sure that we address in the shareholders agreement, given that we’ve said, and I’m thinking a lot of business owners out there assume that these sort of issues are covered by their articles or the company, the compliance documentation. So what are some of the headlines that we want to make sure that we address in the shareholders agreement? And I’ll get us started, because we’ve already discussed it, is how we can sell our equity, I think, but over to you to guide us through this.

Yeah, absolutely. And it’s a great question. So we know, Darryl, dealing with companies that if you have a limited company in the UK specifically, because that’s what we’re talking about here. We have articles association, which is largely similar across the globe, but the articles of association is the legal document set out in law that says, this is what you can and can’t do with companies. That doesn’t help us.

So we then have this shareholders agreement. One of the things that we would absolutely want in that shareholders agreement is drag and tag along rights. You and I both know what they are because of what we do. But essentially what they are is that if you’re a majority shareholder and therefore you have minority shareholders in your business, so in the example that you gave, you’ve got 5% shares in my business and I want to sell. I want to be able to drag you along to sell with me because you’re a minority shareholder.

So, so long as you own below a certain percentage, which we can set in that shareholders agreement, I can drag you into the sale. But the tag also means that if I want to sell my share, you can join me and say, well, hang on a second, Erika, I might only have 5%, but I want to join you. So I’m going to tag along with your sale as well, so I can get my equity out too.

So push and pull. And I guess you’ve explained the concept really well, and here’s where it gets specific to each business. If a business has 10 shareholders, or 20 shareholders, or just two shareholders, and depending on where they see their business going from a shareholding, over time, they can figure out how tight or loose they want to be. I guess they can say, well, we need 50% of equity holders to agree to a sale before we go ahead, or they can put some, whatever rules you like in. Am I understanding correctly?

Correct? Yeah, absolutely. So the nice thing about the shareholders agreement, that so long as you’re not breaking the law, being acting fraudulently or something like that, then essentially you can pretty much say whatever you like in there are the companies act sets out very clearly some things that you can and can’t do with shares, and there are certain procedures that have to be followed. So, for example, you have to report changes to company’s house, our UK registrar of companies. That’s set in law. You can’t change that, for example. But what you can say in this agreement is the shareholders agree that we won’t spend without unanimous consent, for example, or at least 75% agreement of all of the existing shareholders.

We won’t incur an expenditure of over 75,000 pounds in the business or something like that. So you can set those parameters really clearly. I’ve had situations where shareholders have said if one party, a significant party in the business, unfortunately dies, then the wife of that individual wouldn’t inherit the business, but she would get a payoff of a percentage or of an equivalent value of X. And then we can determine a formula to make sure that that person is then, in that awful situation, financially comfortable.So there are lots of creative things you can do in that agreement.

So this is the planning for the unplanned exit now. So if one of the shareholders passes away whilst in active engagement in the business, we want to make sure. They want to make sure that their family is looked after in a way that’s expected. And there they get reimbursed, shall we say, for the value of their shareholding.

Where does that money come from? Let’s assume the business doesn’t have millions or whatever the valuation is in cash sitting in the bank accounts. How do they fund that? I guess, again, it’s up to each business to get creative around that. Is that what you’re suggesting?

Yeah, absolutely. So we don’t normally put how it’s funded in the shareholders agreement, because obviously that is subjective, depending on what’s happening at the time in that business. There are lots of ways to do it. Sometimes other shareholders take on some of those shares and therefore they put some cash into the business to purchase those shares, which would then be paid out to that exiting shareholder, whatever that exit looks like. They can take a loan, they might have cash in the business, they might agree to pay it by installments.

There are lots of different ways to cut it, basically.

And I guess the business can even take out some sort of insurance as well.

Yes. So you do have key man insurances, whether that’s a right or wrong terminology, that’s what it’s known at. So key person insurance is really important and can be valuable. It doesn’t always cover everything you might hope for. So we have to be quite careful with those insurances. We can’t 100% rely on those to necessarily pay out values of shares, but that can certainly cover some gaps.

Okay, so we’re starting to unpick it now. We’ve got some scenarios where there’s an unplanned exit due to death or disability or something unfortunate.

We’ve got the scenario where if one person just wants to change their career or move on or feel they no longer fit to the strategy of the business, we’ve got some tag long clauses there. What other scenarios do you need to make sure that are included in the shareholders agreement, Erika?

So there are probably a couple of other really important ones. The next most important, I would say, after drag and tag, would be good and bad lever provisions so frequently omitted from company regulation documents not set out in law. So what I mean by good and bad lever provisions are that if you and I, we go into business with the best intentions, we fall out.

I want you to leave. You say, over my dead body. Not going to happen. And I say, well, I’ll pay you off. And you say, well, that’s not enough. You’re never going to be able to afford to pay me off, Erika, so I’m just going to stay here and I’m going to be a thorn in your side, which means I can never take the business forward. And again, I’m hamstrung. I’m stuck. So good and bad leaver provisions set out some processes and some parameters whereby you can leave either on good terms, so we can agree that you leave and we value, in a certain way, we value those shares following a certain process, or we’ve fallen out irreparably, we can’t repair our relationship. And under the terms, if that is the case, you then have to leave and you have to give your shares back, because that’s what the contract, the shareholders agreement says, so that you can’t continue in the business and be a thorn in my side. And the same would work in reverse.

And I guess we would also want to address some issues in scenarios like that about who gets to use the IP or if you’ve built up some IP or methodology, I guess even key suppliers, vendors, et cetera, who can access what.

Absolutely, and the dog right? The third thing I was going to say would be really important would be restrictive covenants around who gets what, who can you deal with, what will we agree to in terms of anti-competitiveness? I would always have some restrictive covenants in shareholders agreements to say that any exiting shareholder, unless they are a good lever, for example, cannot compete with the business and they cannot compete in a certain area, because a restrictive covenant should always be restricted either geographically or by time, if not both, because otherwise it might be unenforceable, but restrictions around what you can and can’t do. And again, you have to talk about this early on in the business, because what do we agree might prevent either one of us from moving on? Clearly, we both have to make a living, but how do we do that without hampering the other party, and that’s what you put in the shareholder agreement.

Okay, and what about valuations? I know valuations, it’s only worth what someone’s willing to pay for it. But do you put a methodology or a formula in the agreement as to how the business will be valued at the time?

Yeah, always include a formula. So what we usually say is fair value or market value, and fair value is essentially nominal value of the shares. You look at the turnover, identify what an accountant might deem to be a fair value price for those shares, and then that’s what’s paid. And you might say fair value plus a percentage. But typically it’s fair value. And that’s quite a sensible formula upon which to base it, because it usually means that it gives you a bit of a swing either way to say, okay, well, if fair value is ten pounds a share, I’ll pay you twelve, because we’re leaving under the terms of the good lever provisions, and then you can come to an agreement that way. But it gives you what you need to have is a mechanism to say if you can’t agree what the value is. We agree now that in the future, where we can’t agree, this is the formula which will be agreed upon in the absence of any other agreement.

Yeah, and I guess that’s really important in the scenario where someone doesn’t choose to leave, it’s an unplanned exit due to death or disability or something like that. If it’s fair to one side, it’s also fair to the other side.

Absolutely.

Okay, so, Erika, is this a document that we really need to get legal advice on, or is it something know, people are downloading templates from the internet somewhere. What’s best practice here?

You always ask me that question, Darryl, don’t you? So, I never recommend downloading templates from the internet, largely because you just don’t know what’s in them. And quite often they can be more complicated than they appear. On the face of it, shareholders agreements. I would recommend you take legal advice. It is a worthwhile investment because it will save you many, many headaches in the future. But essentially for not too much money as a business, you can have a document that you can continue to use throughout the lifetime of your business, and then any new shareholders that you bring in, they agree to that same agreement, so you don’t have to rewrite it every time you have a new shareholder. And if it’s done properly with legal advice, it should cater for almost all eventualities we could possibly think of. So yes, definitely take legal advice, especially when it comes to drag along, tag along, good bad lever provisions. They can become a little bit complicated in terms of when transfers happen, because those specific provisions give you some triggers.

So, for example, a good lever might be when somebody dies. So you’ve got a trigger across a couple of clauses or a number of clauses that all has to kind of flow nicely. It all has to make sense together. So, yeah, take legal advice.

And getting a lawyer involved. They’re dealing with this sort of thing all the time. So they know what current best practices, they know what I won’t say getting away with, but they know what you can include and what you can’t include and what is considered a reasonable request or demand. And even if it’s budding against legally, they’ll know that, well, you can’t put in that in there. It’s just not legal. And if that clause is useless, does it void the whole agreement? And they can give you all that sort of advice and include specifics relevant to the legal structures of your business.

Absolutely. And I think that’s the key where templates don’t work. Unfortunately, what you’re getting with the legal advisor is a tailored document to suit your business.

I like what you said. Once you’ve got it, you just get new shareholders to agree, because it’s not stating how much shareholding they have that’s held on companies house info. This is just the rules of engagement. By you signing this document, you’re agreeing to play by these rules or participate by these rules. And it’s a document where we’ve had the conversation up front and we’ve considered all possible scenarios.

Murphy’s law is that we won’t capture everything. So is there some sort of best practice of how often we should review these things, knowing that most businesses don’t have one at all? But if we did have one, and we’re trying to keep things operating, best practice, how often should we review it?

I’ve been a lawyer for a decade now, as you know, and I’ve only had really one scenario where we’ve had to review shareholders agreements because they are quite generic. And that’s where a business is moving from a private, limited company to either listed in some way.

So whether that’s going to PLC or aim stock market, something like that, or indeed bringing on investors in a way that is not ordinarily contemplated under the standard articles of association. So, for example, crowdfunding, you might then want to make some changes, because you have to also make changes to the articles of association. So really, I would say the main reason you revisit this document is if you’ve grown exponentially and you’re bringing in many, many investors or changing the way that your investment is coming in.

Okay, that’s a great tip there, Erika. Okay, so we’ve built our business, we’ve got our shareholders agreement. We’ve been running along. We’ve just been your average business that we’ve grown steadily over 10,20, 30 years. Maybe not exponentially, but we’ve had nice, linear, straight line growth, and we’ve grown the business significantly over our lifetime. Our founders are now getting to the stage where they’re going, hey, look, I want to start looking at my exit options, and so they’ll get their shareholders involved. But how does this help in the exit planning or the exit execution stage? How do buyers perceive shareholders agreements? Are they go no go gauges? What’s your experience around that?

Yeah, well, I would say, obviously, depending on the structure of a business, they might very well be a no go gauge if you don’t have one, because the seller might then be hampered by other minority shareholders. So it might be that the buyer might be able to come in and just take over the shareholding from the major shareholder.

So I would say, as a buyer, if I were buying, I would be comforted by the fact there was a shareholders agreement rather than the opposite, essentially more concerned if there wasn’t one and there were multiple shareholders.

Yeah, it’s just mitigating another risk, isn’t it? If someone’s looking to buy your business and they’re just only having the conversation with the main shareholder, who’s, as I think we started, they’re the boss. They’re calling the shots. The buyers want to know that that conversation includes all of the other shareholders and that there’s not going to be any gotchas at the last minute that someone may say, well, actually, I don’t want to sell.

We can explore rollovers and incentives, but we just don’t want any gotchas, do we? We want to know exactly what it is we’re buying, what the risks are, and have a good clean slate to start something new on.

Definitely. And if I were a buyer and there were minority shareholders, I would be asking if we didn’t have those drag and tag clauses, I would be asking all minority shareholders to sign the share purchase agreement, or certainly a connotation of that, even if it were a reduced one with less warranties, for example. So if you’ve got 25 shareholders and each of them owns 0.0 25% of your company, they’re all going to have to sign your spa.

So that’s a lot of people to kind of round up and say, oh, by the way, and then they read the document and it’s 127 pages long, and they’re going, well, hang on a second. You’re getting all this money? I’m not getting that much. Why am I not getting that much? Maybe I don’t want to sell. I want to stick it out for a little bit longer. Having your shareholders agreement drag tag and that they give you a power of attorney to sign on their behalf, that’s a buyer’s dream. That’s what you want.

Nice and clean, Erika. Look, this has been great advice. Apart from get yourself a shareholders agreement, because while we’re all still friends, let’s get clear on the rules of engagement. It’s a really powerful document. What’s the key message? What’s the number one thing that you really want business owners and listeners to take away from your message today?

So I think that the one message I want to get across today is that you think you’re the boss, and you probably are because you founded the business. In most probability, you’re running it on a day to day basis. But if you’ve got any other shareholders, you need to make sure that you are in control of that business in every way. So my message today is make sure you understand the setup and the structure of your business so that you have the control that you want. And it might not be that you want to have all of the control, but understand what level of control you have and what limitations you are restricted by. Because only then can you make really sound decisions, not just for your business, but for yourself.

Because we all do what we do because we love it, but we’re usually also in it for some financial gain, whatever that looks like for everybody. And actually having the power to control what that looks like for you is really important.

Erika, thanks. That’s brilliant. We’ll put all your contact details in the show notes. As always, thanks for sharing your exit insights with us today.

Thank you so much.

About Erika Moralez Perez