Two former classmates each own half of a renovation company. After five years, one wants to expand and the other wants to scale back, and from then on no decision can be passed and the bank account, which needs both signatures, is frozen. This kind of 50:50 deadlock is common in companies owned by friends, relatives and couples. The answer is to sign a shareholders' agreement while relationships are good, setting out in advance what happens if you disagree, someone wants out, a marriage breaks down or a shareholder dies. Without one, the dispute often ends up in court, which is expensive and slow.
At a glance
- The constitution governs how the company runs internally; a shareholders' agreement is a more detailed private contract between shareholders, and the two should be consistent.
- Deadlock can be resolved through escalation, mediation, an independent director, expert determination or a buy-sell mechanism.
- The agreement should cover pre-emptive rights on share transfers, the valuation method and payment terms.
- Death, incapacity, leaving the business and divorce each need specific provisions.
- With overseas shareholders, agree the governing law, dispute resolution method and which language version prevails.
1. Constitution versus shareholders' agreement
An Australian company can operate under the replaceable rules in the Corporations Act 2001 or adopt its own constitution. These mainly deal with procedural matters such as appointing directors, general meetings and issuing shares. A shareholders' agreement is a contract among all shareholders and can deal in more detail with funding obligations, dividend policy, who runs the day-to-day business, which major matters need unanimous approval, and exit arrangements. The agreement should state which document prevails if they conflict, and require shareholders to cooperate in amending the constitution.
2. Breaking a deadlock
Common deadlock mechanisms can be used in combination:
- Escalation: first a directors' discussion, then the shareholders themselves meet within a set time.
- Mediation: a neutral third party helps the parties reach a solution, confidentially and at lower cost.
- An independent director, or a casting vote held by a rotating chair.
- Expert determination: an independent accountant decides valuation or accounting questions.
- A buy-sell (“shotgun”) clause: one party names a price, and the other must choose either to buy or to sell at that price, which encourages a fair offer.
Without any mechanism, a shareholder may have to apply to court under the Corporations Act for relief from oppressive conduct, or seek a winding up on the “just and equitable” ground. Courts have wide powers, but the process is expensive and, for a small company, often not worth the cost.
3. Exits and share transfers
The agreement should provide that when a shareholder sells, the others have pre-emptive rights; how the price is set, for example by an independent valuer using an agreed method, and whether a minority holding is discounted; and whether payment can be made in instalments. It can also include drag-along rights, so a majority selling all its shares can require the minority to sell too, and tag-along rights, so the minority can sell on the same terms. For shareholders who work in the business, the agreement can distinguish a “good leaver” from a “bad leaver”, with the latter's shares bought back at a lower price, together with a reasonable restraint.
Death and incapacity are the situations most often overlooked. If a shareholder dies, their shares form part of their estate and the executor or beneficiaries exercise the rights, and they may not know the business or want to be involved. Many companies use life insurance to fund a buy-sell arrangement, so the surviving shareholders buy the shares at an agreed price and the family receives cash.
Fourth, special issues regarding joint ventures by couples and overseas shareholders
In a company where both spouses own shares, once they separate, the deadlock is often immediate. In Australia, when dividing marital property, the Federal Circuit and Family Court of Australia can treat company shares as marital property; the shareholders’ agreement cannot exclude the court’s authority, but it can stipulate transfer restrictions and repurchase procedures to reduce the impact on the business; spouses can also consider signing a financial agreement. When there are overseas shareholders, it is necessary to agree on whether to apply the Victorian law or other laws, to resolve disputes through mediation or arbitration, and to determine which of the English and Chinese versions is valid.
If it is a family business in which two generations share ownership, you will also need to address issues such as how to distribute dividends to the next generation of family members who have joined the business or whose relatives hold shares but do not participate in the management of the business. Please refer to Family Business Shareholder Agreement: Why Australian Family Businesses Need Shareholder Agreements and Key Terms and Family Business Shareholder Disputes: Company Stalemate, Mediation, and Relief from Acts of Oppression under Article 232 of the Company Law.
5. Checklist of common clauses
- Capital contributions, shareholder loans and calls for further funding.
- Rights to appoint directors and matters requiring unanimous approval.
- Dividend policy and rights to information.
- Deadlock and dispute resolution mechanisms, including mediation.
- Pre-emptive rights, valuation method, and tag-along and drag-along rights.
- Treatment of shares on death, incapacity, leaving or divorce, and insurance funding.
- Confidentiality and restraints, plus governing law and language version.
Frequently asked questions
We only have two shareholders. Do we still need an agreement?
Two equal shareholders are the most exposed to deadlock, so an agreement is even more important. Its cost is far lower than litigation later.
Does a shareholders' agreement need to be lodged with ASIC?
No. It is a private contract between shareholders and is not lodged with ASIC. However, share issues and transfers must still be notified to ASIC as required.
Can we sign an agreement years after setting up the company?
Yes, it can be signed at any time with all shareholders' agreement. It is best done before any dispute arises, because agreement becomes much harder once you disagree.
Can a shareholders' agreement keep shares out of a divorce property settlement?
Not entirely. The court can still take the shares into account, but the agreement can restrict transfers to a spouse and set buy-back procedures to protect the company and other shareholders.
Chua Tan Associates has practised in Melbourne since 1990, advising businesses and investors in Mandarin, Cantonese and English on company set-up, buying and selling businesses, commercial leases, contracts and commercial disputes. For help, call 03 9602 3988 or contact us online. We can meet at our Melbourne CBD office or by video.
This page provides general information only and is not legal advice.
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