Shareholders' agreement mistakes: no drag-along, no deed of adherence, wrong document

If you do not include drag-along provisions in your shareholders' agreement, you might not be able to sell your business. As the saying goes, the threat is from within. In my experience business owners make three main mistakes with their shareholders' agreements: leaving out drag-along provisions, leaving out a deed of adherence, and using the agreement for things that belong in the articles of association. Here is what each mistake looks like and how to avoid it.

What is a shareholders' agreement?

Very quickly, a shareholders' agreement is a contract between the shareholders, also known as the members, of a company. It details a number of things, including:

• How decisions are to be made, and which decisions are reserved for the directors.
• Non-compete clauses, to stop existing shareholders setting up a separate business that competes with the current one.
• The duties of the shareholders towards the company.

It is the document that governs the relationship between the owners. That makes it important, and it also makes the gaps in it expensive. For more on the basics see what is a shareholders' agreement?.

Mistake 1: not including drag-along provisions

Drag-along provisions enable a shareholder, or a few shareholders, to drag along everyone else and sell their shares to a third party.

This matters enormously when it comes to selling the entire business, exiting and cashing in. Business acquirers usually want to acquire the entire business, and they want to do it quickly. A buyer is not interested in ending up with 90% of a company and a reluctant minority shareholder they have never met. So if one small shareholder refuses to sell, and there is no drag-along provision, the buyer may walk away and you may not be able to sell your business at all. That is the threat from within.

Here is how drag-along provisions usually work. You set a threshold, for example 51% of the shares. As long as that threshold is met, in other words as long as holders of at least 51% want to sell, they can drag along everyone else to sell their shares to the third party on the same terms.

Including the provision costs nothing at the start of a company's life. Trying to add it later, once there are shareholders who might prefer to hold out, is far harder. For the detail see drag-along rights explained.

Mistake 2: not including a deed of adherence

The second mistake is not including a deed of adherence in the shareholders' agreement itself.

A deed of adherence enables you to get new shareholders to sign up to the existing shareholders' agreement without having to draft a new one. It is usually found in a schedule to the shareholders' agreement, towards the end of the document, and it is usually a one-page document that the new shareholder can easily sign, stating that they agree to be bound by the existing agreement.

Without it, every time someone new comes in, whether an investor, an employee receiving shares or a buyer of an existing holding, you face a choice between redrafting and re-signing the whole agreement with everyone, or having a new shareholder who is not bound by it at all. Neither is good. Redrafting reopens every negotiated point, and an unbound shareholder undermines the protections the agreement was meant to give. A deed of adherence turns that into a one-page signature, and it should be part of the agreement from the day it is first drafted.

Mistake 3: using the agreement when you should amend the articles

The third mistake is trying to use a shareholders' agreement when you should probably be using, and amending, the articles of association.

For example, if you are taking on investors and want to issue different kinds of shares, you should look at amending the articles rather than trying to do it in a shareholders' agreement.

The reason is who each document binds. The articles are legally binding on anyone connected with the company, including the directors and all of the shareholders, present and future. A shareholders' agreement is really only binding on the people who actually sign it. So if the rights of a new class of shares live only in a shareholders' agreement, a shareholder who never signed it, or a director who is not a party to it, is not bound by those terms.

Share classes and their rights are a good example of something that needs to bind everyone, which is why they belong in the articles. The shareholders' agreement is the right place for private arrangements between the owners; the articles are the right place for the company's constitution. For how the two documents interact when they conflict, see does a shareholders' agreement override the articles?, and for when you need your own set of articles, see model articles of association.

Next steps

Check your current shareholders' agreement for three things: a drag-along provision with a clear threshold, a deed of adherence in the schedule, and anything that is really a matter for the articles, such as share class rights. If any of them is missing or in the wrong place, have a corporate solicitor fix it now, while all the shareholders are still on good terms and willing to sign. For what else to include, see what should a shareholders' agreement include?.