Founder disputes: what your shareholders’ agreement should cover

Most co-founders get on well when they start a company together. The problems come later. One wants to sell and another wants to keep building, one stops pulling their weight but keeps their shares, or two equal shareholders simply can't agree on anything. A shareholders' agreement is where you decide in advance how those situations will be handled.

Without one, you fall back on the company's articles of association and the Companies Act 2006. Many small companies use the Model Articles, which say very little about what happens when founders fall out, and the statutory remedies that are left are slow, expensive and uncertain.

What is a shareholders' agreement?

A shareholders' agreement is a private contract between the shareholders, and often the company too. It sits alongside the articles, which are a public document filed at Companies House. Some provisions, such as the rules on transferring shares, usually need to be in the articles as well so that they bind future shareholders and the company, so the two documents should be drafted together and shouldn't contradict each other.

It typically covers who can sell shares and to whom, which decisions need everyone's agreement or a set majority, what happens when a founder leaves, dies or becomes permanently incapacitated, how shares are valued when they change hands, and how disputes are resolved. Investors will usually expect one to be in place, or will bring their own as part of a funding round, but it is worth having long before that stage.

Where you stand without one

Shareholders with more than 50% of the votes can pass ordinary resolutions, and that includes removing a director under section 168 of the Companies Act 2006 (special notice is needed). So a founder with a minority stake can be voted off the board while remaining a shareholder. Shareholders with 75% can pass special resolutions, which include changing the articles. A founder with more than 25% can block special resolutions but not ordinary ones.

A shareholder who believes the company's affairs are being conducted in a way that is unfairly prejudicial to their interests as a member can petition the court under section 994 of the Companies Act 2006. Typical complaints include being excluded from management of a company that was set up on the understanding that all the founders would be involved, diversion of business or assets, and the majority paying themselves excessively instead of declaring dividends. The court can make any order it thinks fit, and the most common is an order that the other shareholders buy the petitioner's shares at a price the court decides. These cases are expensive and slow, and the outcome depends heavily on the facts. A petition to wind the company up on the just and equitable ground under the Insolvency Act 1986 is also possible, but it is a last resort.

Much of a good shareholders' agreement is about giving founders a quicker and more predictable route than either of those.

Key provisions for founder protection

Vesting through leaver provisions. The idea is that a founder who leaves after six months shouldn't keep the same stake as one who stays for years. In UK companies this is usually done through leaver provisions rather than shares literally vesting: if a founder leaves within a set period, some or all of their shares must be transferred, with the proportion falling over time. The length of the period and how quickly it runs down are for negotiation.

Pre-emption on new shares. If the company issues new shares, existing shareholders usually have the right to be offered them first in proportion to their holdings, so their percentage can't be diluted without their say. The Companies Act 2006 gives a statutory pre-emption right on issues of shares for cash, but private companies can exclude or disapply it, and many articles do. Check whether your documents keep it and what majority can override it.

Anti-dilution clauses are something else: usually investor protections that compensate an investor if shares are later issued at a lower price, which can dilute founders further.

Reserved matters. A list of decisions that need the consent of every founder, or of a set majority, protects minority founders from being outvoted on the things that matter most, such as issuing shares, borrowing above a limit, selling the business, changing the articles, appointing or removing directors, and setting founders' pay. Make the list specific. If it covers too much, the company can't run day to day; if it covers too little, it gives a minority founder no real protection.

Information rights. A shareholder who isn't a director has limited statutory rights to information, mostly the annual accounts and the minutes of shareholder meetings. If you might step back from the board, agree a right to regular management accounts and board papers now.

Drag-along and tag-along rights

A drag-along right lets shareholders holding a specified majority, who have agreed to sell all their shares to a buyer, require the others to sell on the same terms. Buyers generally want 100% of a company, so this stops a small holder blocking a sale. A tag-along right works the other way: if a majority sells, the minority can require the buyer to purchase their shares on the same terms.

Check the percentage that triggers the drag, whether “same terms” means the same price per share, and what a dragged shareholder can be required to give in the way of warranties and indemnities. A minority founder shouldn't be dragged into giving the same warranties as the people who ran the business, or into liability beyond what they receive.

Deadlock resolution mechanisms

Deadlock is most likely in a company owned 50:50, or where the reserved matters give each founder a veto. The agreement should set out what happens when the shareholders or the board can't agree on something important.

The usual first step is escalation, often a meeting between the founders followed by mediation. Some agreements give the chair a casting vote, which in practice hands control to whoever holds that role. If that fails, a common mechanism is the shotgun or “Russian roulette” clause. One shareholder serves notice naming a price per share, and the other must either sell their shares at that price or buy the first shareholder's shares at it. It encourages a fair offer, because you might end up on either side of it. But it favours whoever finds it easier to raise the money, which matters if one founder has much deeper pockets than the other. Variants include sealed bids, and a requirement to put the whole company up for sale. Winding the company up is the final fallback.

Expert determination is useful for disputes about a specific question, most often the value of shares, but it isn't a way of resolving a disagreement about how the business should be run.

Managing departures

Good leaver and bad leaver. Where founders work in the business, the agreement usually says that a founder who leaves must transfer their shares, with the price depending on why they left. A good leaver often receives fair value. A bad leaver often receives the lower of fair value and what they paid for the shares. The definitions matter more than the prices. Some catch only dismissal for serious misconduct or breach of restrictive covenants; others treat anyone who resigns within a set period as a bad leaver, whatever the reason.

Who buys the shares. If the company is to buy them back, it must follow the procedure in the Companies Act 2006, and in most cases it needs enough distributable profits to fund the purchase. The agreement should provide for the other shareholders, or an employee benefit trust, to buy if the company can't.

Restrictions after leaving. Many agreements restrict a departing founder from competing with the business, poaching clients or poaching staff for a period. These restrictions will only be enforced if they protect a legitimate interest and go no further than is reasonably necessary, so keep them proportionate in length and scope.

Death and incapacity. On death, shares pass to the founder's estate. Agreements often give the remaining shareholders an option to buy them at fair value, sometimes backed by life insurance and cross-option arrangements so that the family receives value and the remaining founders keep control.

Valuation methods for share buyback

The agreement should say how the price is worked out when shares change hands, whether by formula, independent valuation or both. The key point to settle is whether the price is a pro rata share of the whole company or the market value of the particular holding, which for a minority stake usually means a discount. Leave that open and it can cause a dispute on its own.

What to include in your shareholders' agreement

At a minimum, a founder shareholders' agreement should deal with share classes and voting, leaver provisions, pre-emption on new shares and on transfers, drag-along and tag-along rights, reserved matters, board appointments, deadlock, valuation, restrictions on departing founders, confidentiality and how the agreement can be amended. It should be tailored to your company: how many founders there are, how the shares are split, whether founders work in the business full time, and whether you expect to raise investment.

Getting it reviewed

A shareholders' agreement is hard to change once it has been signed, because changes usually need everyone's agreement. Before you sign, you can use QuickLegalCheck to review the draft and see where the protections and risks lie, or upload your agreement now.