28 May 2024

Early stage companies are normally set up by the person that is the driving force behind the new enterprise. There will come a time when shares are issued in return for new investment, to secure specialist expertise or to incentivise employees to stay with the company and together develop the enterprise.

This is an important juncture for the company.  The company’s constitution, which is known as the Articles of Association, should be reviewed to ensure that it can deal with the new issues that have been created.

Outlining the rights of the shareholders

With no alteration to the rights that apply to shares, then all shareholders will be entitled to their proportional entitlement to vote, participate in dividends and to participate in the capital rights of the shares if the company is sold or liquidated. As new parties are introduced to the company, the starting point is to consider these key rights and whether the commercial reality of the relationship means that these standard rights should be altered. For example, if friends and family are being introduced as shareholders to fund the company in its early stages, then perhaps they should not benefit from voting rights. Alternatively, if an investor is introduced, they may insist that on a company sale their investment is repaid before the other shareholders are entitled to participate in a capital distribution.

This process helps define the shareholders roles and rights from the outset. You should also consider how these roles may develop over time.

Exiting the Company

If shares are provided to incentivise employees or harness their expertise, then there may come a point when the employee leaves the company. It’s essential for the Articles of Association to consider this scenario and the classic position is that the shares will be bought back either for a nominal sum (if the employee has held the shares for a short period) or for market value (if the shares have been held for a longer period). This mechanism is often further developed to categorise the leaver as either a “Good Leaver” or “Bad Leaver” depending on the reason or timing of the departure, with Bad Leavers usually receiving nothing or a nominal sum and Good Leavers receiving market value for the shares or being entitled to retain the shares for a future exit.

If the Articles of Association do not provide a smooth and well understood buyback process then it can lead to various issues like having unruly ex-employees as shareholders that may not vote in the best interests of the company,  or it may simply lead to a dispute about the terms of an exit.

Separately, the majority shareholders may wish to create a mechanism to deal with a scenario where there is an offer to buy the company then all shareholders are bound to accept the offer if the majority of shareholders wish to proceed.  This is known as a drag-along right. Conversely, a tag-along right can be created to benefit the minority of shareholders. This deals with the scenario that if the majority of shareholders sell their shares, they can only do so if the buyer offers to also acquire the minority shareholders’ shares on the same terms.

Conflicts of interest or conflicts between shareholders

Shareholders’ interests can become entangled with the Company’s interests. For example, a director / shareholder may lend the company funds and require repayment when that is suitable for the director / shareholder as opposed to the Company. These can be complicated issues and the Articles of Association should lay down a template of how these decisions are taken fairly so the Company’s best interests are preserved.

Shareholder disputes can also arise for a variety of reasons and the Articles of Association are the first opportunity to regulate how a dispute would be resolved, principally through the Company’s decision making process.

Public document

It should be borne in mind that the Articles of Association are a public document recorded at Companies House and available for any interested person to view.  As such, the more sensitive issues that are created by this new relationship in the company may best be documented in a private Shareholders’ Agreement. For example, some Shareholders’ Agreements will have a defined dispute resolution process, particularly if voting rights in the company are proportioned so that they may create deadlocked or tied decisions. There are different mechanisms to resolve such conflicts, but they are usually a private consideration so not usually found in the Articles of Association.

Likewise, the shareholders may decide that dividends should be distributed in a predetermined proportion annually by creating a dividend policy. Again, this is usually a private consideration perhaps best dealt with in a Shareholders’ Agreement as opposed to the Articles of Association.

Conclusion

The changing composition of a company’s shareholding can create numerous issues. The Articles of Association can be used to define roles and rights, allow shareholders to understand their rights when leaving the company and to smooth areas of potential conflict. These issues should be considered when the shareholding position within a company changes. If you would like to discuss any issues raised in this note, please contact a member of the BTO Corporate team.

Michael Cox, Senior Associate: mxc@bto.co.uk / 0131 222 2939