It is often the case that when close friends decide to start a joint business, the only thing they lack is capital to bring a good idea to life. Before starting the business development process or involving investors (funds or independent investors – business angels) in a business, certain steps need to be taken to protect against potential future disputes. The most common way to start a business is to form a private limited liability company. Such form of a legal person provides the assurance that subsequently it will be easier to sell it or attract investors by offering shares in exchange for the invested funds.

One first step in setting up a private limited liability company is to enter into a shareholders’ agreement. A shareholders’ agreement is a legal instrument that enables company shareholders to regulate their mutual relations, especially those that do not fall under mandatory legal regulation. The following are some of the key terms (provisions) you should consider before signing a shareholders’ agreement.

Investments, business financing

In order for a shareholders’ agreement to be useful to the company and the shareholders, it is reasonable to include provisions on investing in the business developed by the company, i.e. how and in what proportions the shareholders will invest in the business, whether or not investments by the shareholders will be mandatory, etc. It is especially advisable to include such provisions when an investment fund (angel investor) acquires the shares in the company in exchange for its investment. In such cases, there is a need to include provisions on the size of investments the fund is required to make, the procedure for transfer of investments to the company, and provisions on how the existing proportion of the shares will be changed in certain scenarios, etc. It is also handy to include in a shareholders’ agreement provisions that enable to deal with situations when in the course of its business the company may reasonably lack funds to attain certain business goals. It can be provided in such cases that the company has a right to attract additional investors, for instance, by increasing the share capital. It should be noted that a fund that is already a shareholder and investor of the company may establish safeguards that additional investors may be attracted only with the written approval of the fund, etc.

Corporate governance, the competence of the management bodies

Shareholders are required to agree on the company’s management bodies and the scope of their competence. Any company is required to have the general manager and the general meeting of shareholders; however, when one of the shareholders is an investor (fund or angel investor), there can be proposals to form collegial management bodies – the management board and the supervisory board. These are non-obligatory company bodies in which the statutory supervisory functions are vested. For example, the management board oversees the activities of the key executive and may decide whether investments are used for the agreed purposes. Often professional investors seek to protect themselves, particularly in situations when the fund becomes a minority shareholder. In such cases specific guarantees in favor of the investor are included in a shareholders’ agreement, e.g. should the investor request to form the management board, the other shareholders undertake to vote for such resolution; one of the persons nominated by the fund is appointed to serve on the management board, or the general manager must be dismissed if the fund so requests. Thus, in the case of a professional investor joining a company, specific issues related to corporate governance are often covered in a shareholders’ agreement.

Transfer of shares

It is advisable to discuss the peculiarities of transfer (sale) of the shares in the shareholders’ agreement in case one or more shareholders decide to exit the business. Shareholders’ agreements often include provisions by means of which professional investors seek to gain certain control in the company in which they invest, e.g. it can be provided that throughout the term of the shareholders’ agreement the other shareholders will not be entitled to transfer (sell, exchange, gift) their shares to third parties. Also, shareholders’ agreements often contain provisions on the redemption of the shares which provide for precise time limits, prices, etc. It should be noted that specific provisions on the transfer of the shares may not be contrary to the mandatory (binding) statutory provisions and the articles of association of the company.

Distribution of profit and losses

In order to avoid disputes as the business is off and running, it is recommended to set in a shareholders’ agreement clear and precise guidelines along which the shareholders will distribute profit and losses. Most companies distribute a portion of their annual profit to the shareholders as dividends. However, in deciding on the distribution of dividends, companies may deviate from the standard model, because some companies tend to be more generous to their shareholders, while others choose not to pay dividends so that they can invest in business development, and in practice such cases are most common when the company has entered the stage of rapid business growth.

Venue and procedure of dispute resolution

Shareholders’ agreements frequently provide that in situations where shareholders fail to resolve disputes amicably, disputes are resolved by arbitration rather than litigation. Arbitration is considered to be a more attractive dispute resolution mechanism for elementary reasons: companies running a large and well-known business seek to retain their reputation and avoid publicity, so for the sake of confidentiality they select arbitration; besides, arbitration is preferred over litigation in order to avoid a dispute resolution process that may last for years. Also, there are other advantages to dispute resolution by arbitration: flexibility of the process because the parties may select arbitrators/mediators and the venue of dispute resolution; the binding nature of arbitral awards, etc. In any event, be it a court or an arbitral tribunal, it is a must to include dispute resolution provisions in a shareholders’ agreement.

To sum up, a shareholders’ agreement is a legal instrument which facilitates mutual relations between the shareholders and possibilities of attracting new investments. It also defines specific obligations of the shareholders towards each other and the company to help avoid or at least reduce the chance of disputes while growing the business.

The article is written by Giedrė Cesiulytė, Associate at COBALT.