Prevention Is Better Than Division: The Role of the Shareholders’ Agreement in Family-Run SMEs

Family businesses are often underpinned by trust, shared values and a common history. That foundation of trust is a major strength, but at the same time it may also harbour the greatest risk. Important arrangements are sometimes left unspoken because everyone assumes that the other family members share the same expectations. However, in the event of a family transfer, differing ambitions or unexpected events, this lack of clarity can lead to tensions or conflicts.

In the article published to mark the International Day of Reconciliation, we have already discussed how family dialogue, a family charter and opportunities for discussion can help to ensure that values, expectations and responsibilities are addressed in good time. In this article, we take the next step: we look at how this family vision can be translated into a shareholders’ agreement in legal terms.

A child who has been actively involved in the business for years may expect to take over the day-to-day management one day. A brother or sister who does not work in the business, on the other hand, tends to view matters primarily from their position as a shareholder and expects to be consulted and to receive a financial return. These expectations are not necessarily contradictory, but they do need to be expressed in good time.

This is precisely why it is important to discuss difficult scenarios while the cooperation is still going well. A shareholders’ agreement helps to set out expectations clearly and to determine arrangements before a potential problem escalates into a conflict. It is not a sign of mistrust, but a tool for defusing difficult situations before they arise.

More than just a legal document

The articles of association constitute the formal and legal basis of the company. Among other things, they govern the structure of the company, the functioning of its bodies and certain rights attached to shares. The articles of association are binding on the company, its governing bodies and all shareholders, including those who join the company at a later date.

A shareholders’ agreement, on the other hand, is a confidential contract in which shareholders make arrangements regarding their mutual cooperation, the exercising of their shareholder rights and how to deal with certain key moments or tensions. In principle, the agreement is binding only on the shareholders who are parties to it.

A shareholders’ agreement may, for example, contain provisions regarding:

• the company’s long-term vision and the role of active and non-active shareholders
• decision-making, voting arrangements, dividends and reinvestment
• transfer of shares and the admission of new shareholders
• exit and valuation
• death, divorce or incapacity
• confidentiality, competition and dispute resolution.

So the shareholders’ agreement does not replace the articles of association – it supplements them. Provisions that govern solely the rights and obligations of the contracting shareholders may be included in the shareholders’ agreement. Where a provision relates directly to the functioning or powers of a corporate body or is intended to be binding on the company itself, it must be properly enshrined in company law, for example in the articles of association.

The added value of a shareholders’ agreement lies not only in the arrangements themselves, but also in the discussions that lead up to it. Who’s going to take charge? How much scope will the head of the family have after the handover? What happens to the profits? Can people exit? How is the value of the shares determined?

These discussions are best held before a specific event forces the parties to negotiate.

The challenges that no one likes to talk about

We see, for example, that the following situations regularly give rise to discussions among those involved:

When shareholders take on different roles

When it comes to the handover of a family business, it is often the case that one child takes on an active role in the business, whilst another child remains primarily a shareholder. The active child is responsible for day-to-day operations, whilst the non-active child mainly keeps an eye on the figures and the strategy.

The active child may feel that their efforts are not being sufficiently recognised. The non-active child, on the other hand, may feel that an equal shareholding entitles them to an equivalent say in important decisions. However, an equal shareholding does not necessarily entail equal responsibilities, the same role or even the same remuneration.

A shareholders’ agreement can help to define the various roles more clearly. For example, it may contain provisions regarding the operational involvement of shareholders, the nomination of directors, the provision of information and the remuneration of shareholders who work for the company. Remuneration for labour or management must be distinguished from the return on shares, for example in the form of dividends.

Succession: who takes on which responsibilities?

Family succession is not just about the transfer of shares. The transfer of responsibility and decision-making powers must also be discussed. What happens when the head of the family business formally steps back, but in practice continues to manage staff and suppliers?

A shareholders’ agreement can set out arrangements regarding the future role of the head of the family, any advisory or chairing role, the duration of the transition period, the transfer of operational powers, and communication with staff, customers and suppliers.

Dividends or investment? Who decides?

When shareholders share the same vision for the future, discussions regarding the authority to take specific decisions may be necessary. Is opening a new branch an operational decision or a strategic choice? Can the manager make a major investment on their own? Is the consent of all shareholders required for an additional loan?

The allocation of profits can also give rise to differing expectations. Suppose two children are shareholders in a family business. One of them is actively involved in the business on a daily basis and wishes to use the available funds to purchase a new machine, take on extra staff or open a second branch. The other child is not actively involved and is primarily looking for a return on the shares, for example in the form of dividends. Both points of view are understandable. The active shareholder is primarily concerned with the continuity and further development of the business. The non-active shareholder tends to view matters from the perspective of an investor. However, without a pre-agreed framework, a difference in outlook can quickly escalate into a recurring source of personal tension.

A shareholders’ agreement can help to establish a clear decision-making structure. Shareholders may, for example, agree as follows:

• which decisions fall within the scope of day-to-day management
• which decisions fall within the scope of the governing body
• which matters must be put to the shareholders
• which decisions require a special majority or consensus.

In addition, the agreement may set out guiding principles for:

• the dividend policy
• the priority given to reinvestment
• growth financing
• shareholder loans
• additional funding rounds
• the consequences if not every shareholder participates in a funding round.

In this context, shareholders may undertake to exercise their voting rights in accordance with certain arrangements. Therefore, the agreement does not automatically oblige the company to make a specific payment or investment, but it can help to structure expectations and mutual voting arrangements.

What if someone wants to sell their shares? How is the value of the shares determined?

Not every shareholder remains actively involved in the company for life. Someone may decide to pursue a different career path, no longer wish to be involved, or receive an offer from an external buyer.

At that point, questions often arise that are best answered in advance:

• Can a shareholder freely sell his or her shares to a third party?
• Do the other shareholders have a right of first refusal?
• Can an external party simply join the company?
• Can the other shareholders block a sale?
• What happens when one shareholder receives a bid?

It is therefore advisable to agree in advance on matters such as pre-emption and approval rights, transfers within the family or to third parties, tag-along (resale) rights and drag-along rights, any call and put options, a period of non-transferability and mediation or other dispute resolution mechanisms.

The aim is not to deprive a shareholder of the opportunity to exit, but to clearly define in advance who may exit, to whom the shares may be sold, under what conditions and in accordance with what procedure.

The valuation of the shares also merits special attention. Suppose one of the children no longer wishes to remain involved in the family business. The outgoing shareholder is considering the company’s strong results, reputation and growth potential. The other shareholders may point to necessary investments, debts or the risks associated with further growth. Without a valuation method agreed in advance, an exit can quickly lead to a fresh family dispute in situations like this.

A shareholders’ agreement may therefore specify which valuation method and parameters are to be used, at what point in time the valuation is to take place, and whether an independent expert is to be appointed. The payment arrangements can also be agreed in advance, for example, payment in instalments. In addition, the conditions and procedure for an exit can be set out, so that it is clear in advance who may acquire the shares and within what timeframe.

When life gets in the way

Some events are not the result of a conflict, but can nevertheless have a significant impact on the shareholder structure. What happens when a shareholder dies? Do the shares pass to heirs who are not involved in the business? What if a shareholder gets divorced or becomes incapacitated (for work) on a long-term basis?

A shareholders’ agreement may contain provisions regarding the transfer of shares in the event of death, purchase options for the other shareholders, succession arrangements, the position of the heirs and the entry of the next generation into the company.

A new purchaser of shares does not automatically become a party to the shareholders’ agreement signed by the previous shareholder. It is therefore important to carefully examine accession mechanisms – such as an accession deed or a contractual condition of accession in the event of a transfer – and ensure that they are consistent with the articles of association. Furthermore, these arrangements must be consistent with the law of succession, matrimonial property law, and inheritance and estate planning.

A shareholders’ agreement as a governance tool

A shareholders’ agreement is therefore not only a legal safety net, but also a governance tool. It helps to clarify expectations, define roles and take an objective view of important decisions. This in turn helps to ensure that family tensions are less likely to escalate into a crisis within the company.

The shareholders’ agreement serves both a preventative and a remedial purpose in this regard.

• It is a preventative measure, because shareholders discuss difficult issues while the cooperation is still going well.
• It serves a remedial purpose, because the agreement provides a pre-arranged framework in the event that interests do diverge at a later date.

So the shareholders’ agreement is not a stand-alone document. It forms part of a broader governance framework in which family dialogue, the family charter, the articles of association and other agreements can complement one another.

Clarity for tomorrow

A family business is built on trust, but trust alone is not always enough to reconcile ownership, family and the business in the long term.

A shareholders’ agreement does not prevent every difference of opinion. It does, however, help to defuse difficult situations in good time and to safeguard the continuity of the business and family relationships. The best arrangements are made while the cooperation is still going well.

Do you have any questions about a shareholders’ agreement or a family business succession? Grant Thornton’s Legal Team can help you identify relevant issues, draw up clear agreements or review existing ones. In doing so, we ensure that the shareholders’ agreement is consistent with the articles of association, other governance documents and your wider succession and wealth planning