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Becoming A Shareholder In A Closely Held Company
15 September, 2021 | Peter Smith
This article is intended to help the reader better understand the obligations and responsibilities of becoming a shareholder in a company. From a legal point of view there are four areas of law that should be covered:
Financial Markets Conduct Act;
Types of Shares;
Shareholders Agreements and Constitutions.
Financial Markets Conduct Act (“FMCA”)
Reference to the FMCA is useful because the issues of shares in a company to people who have been employees is regarded as being part of an employee share scheme. The FMCA requires all employees entering into employee share schemes to sign off an acknowledgement or warning that:
- Explains to employees that the acquisition of shares in a company gives them a stake in the ownership of the company that in turn may entitled them to receive dividends.
- That if the company runs into financial difficulties and is wound up that shareholders will only be paid after all creditors and holders of preference shares (if any) have been paid. The FMCA points out that shareholders in the event of the winding up of a company may lose some or all of their investment.
- That employees proposing to be shareholders should ask questions, read all documents carefully and seek independent financial advice before committing themselves.
- That the investment in shares in privately held companies makes liquidity or the sale of those shares difficult from the point of view that the only buyers of the shares are likely to be other shareholders in the company.
- That part of a shareholder’s income that is dependent on dividends depends on the profitability of the company and profits can fluctuate.
- That prospective employee/shareholders should carefully read the Shareholders Agreement for the Company and understand it thoroughly before signing.
The Companies Act
The Companies Act is the act of parliament that sets up a government department called the Companies Office. The Companies Office and the Financial Markets Authority regulate the running of companies. The Companies Act also prescribes the rules for companies and in particular the rights of shareholders.
The rights of shareholders may be modified or altered by virtue of the Shareholder Agreement for the Company and/or its Constitution.
The basic rights of shareholders however are:
- The right to vote at all meetings of shareholders of the company.
- The right to appoint or remove directors and appoint or remove auditors.
- The right to adopt and alter the constitution of the company.
- The right to approve major transactions – major transactions are those transactions prescribed in the Companies Act that require shareholder approval.
- The right to approve the amalgamation of the company with another company.
- The right to vote to put a company into liquidation.
- The right to an equal share in dividends.
- The right to an equal share in the distribution of the surplus assets of the company should it be liquidated or wound up.
Difference between Shareholders and Directors
It is important that prospective shareholders in a company understand the difference between shareholders and directors. While shareholders in a company are the owners of a company, their role is a passive role, as apart from the right to approve major transactions, shareholders do not have a role in the management and strategic planning of a company.
Management and strategic direction is under the control of the directors. It is the directors that prepare the strategic plan, the business plan, financial budgets and forecasts, manage relationships with employees and make sure that the company completes is statutory obligations in terms of tax returns, GST returns, health and safety, etc.
While shareholders can vote for the directors of the company, they do not automatically have a seat at the board of directors of the company. In many instances minority shareholders have no right to be directors or to vote for the appointment of directors.
Types of Shares
Because the Companies Act specifies that the rights of shareholders may be amended or modified by virtue of the Constitution and the Shareholders Agreement of the Company, it follows that there may be in a company, various classes of shares all with different rights.
There may be, for instance, voting shares where the shareholders holding those shares have the right to vote at shareholder meetings and the right to appoint and remove a director. There may also be non-voting shares where the holders of those shares do not have the right to vote at shareholder meetings of the company or the right to appoint a director. It is usual however that all shareholders have an equal right (proportionate to their shareholding) to the pool of money available for payment by way of dividends – although there may be more than one separate pool of money from which dividends to the various classes of shareholders are paid.
SHAREHOLDERS AGREEMENTS AND CONSTITUTIONS
The Constitution is a generic document that covers off things such as:
- The right to issue shares.
- How directors are appointed and removed.
- What are called “pre-emptive rights” for the sale of shares, whereby a shareholder wishing to sell their shares must first offer them to other shareholders. The pre-emptive rights process is set out in the Constitution.
A Shareholders Agreement is a prescriptive document that is unique to each company. There is some cross over with the company’s Constitution from the point of view that the Constitution often has a clause confirming that the Shareholders Agreement of the Company is the pre-eminent document and takes precedence over the Constitution. A Shareholders Agreement often repeats for the sake of clarity the details of the shareholders in a company and the pre-emptive provisions should a shareholder wish to leave the company.
Shareholders Agreements generally cover off the following matters:
- How working capital is raised for the company – working capital comprises money in the bank, money owed to the company by debtors minus creditors, minus any taxation liability. If the company is committed to growth, then the amount of working capital must increase each year and the increase in working capital cannot be funded entirely out of profits. Accordingly, shareholders must commit to either borrowing the money required for the additional working capital from institutions like banks or by lending their own money to the company. Just what is proposed in this regard is set out in the Shareholder Agreement.
- How directors organise themselves in terms of voting on the management issues for the company. There are several alternatives in this space. Directors may like to operate by consensus. They may appoint one of their number as chairperson of the Board with that person having a casting vote. These are just two of the alternatives that are included in a Shareholder Agreement.
Roles and responsibilities of Working Directors and Shareholders
The Shareholders Agreement should set out the roles and responsibilities of the working directors and working shareholders.
Remuneration for Working Directors and Working Shareholders
The profits from which dividends are paid, are calculated after the remuneration paid to working directors and working shareholders. This remuneration and the expenses able to be claimed together with the “perks” for working directors and working shareholders must be transparent and details of how the remuneration, expenses and perks are calculated should be set out in the Shareholders Agreement.
The Shareholders Agreement should set out the dividend policy for the company. A standard dividend policy for instance is that dividends representing 75% of after tax profit are to be paid as dividends.
Do’s and Don’ts
There is always a list of things that cannot be done in a closely held company without the consent of all shareholders, or at least a substantial majority of shareholders. These include:
- Selling part or all of the company’s business.
- Giving security over the company’s assets for borrowing.
- Altering the Constitution.
- Watering down shareholdings by issuing more shares in a company.
These are just four examples of the do’s and don’ts that are set out in a Shareholders Agreement.
Exiting the Company
Shareholder Agreements will often set out the rules relating to how to exit a company in terms of the period of notice to be given and how shares are to be valued. There may be a minimum period during which shares must be held before they can be offered for sale.
Traditionally, employees who become shareholders are often financed into the shareholding by the company. It may be for instance that there is a minimum period during which they must hold their shares before those shares have any value so that if the employee leaves the company ahead of time, then they forfeit their shares without payment.
Restraint of Trade and Confidentiality
There will always be confidentiality clauses in a shareholder agreement under which shareholders pledge to keep the information and business details of the company confidential.
If it is important that shareholders not be able to take away the intellectual property and trade secrets of a company and set up in opposition, then there is often a restraint of trade clause preventing shareholders doing just that for a period of time after ceasing to be shareholders.
The above covers the main points that are set out in shareholder agreements.
LOCKSTEP METHOD OF ENTRY INTO A COMPANY
Entry by employees as, shareholders of a Company, is often done in two or more steps, by way of an example, a two-step path to shareholding is as follows:
A certain number of shares would be issued to each of the employees which shares would have no voting rights. The value of the shares would be lent to the shareholders by the company and repaid out of dividends.
Once the loan by the company to an employee/shareholder for the purchase of shares had been repaid and the shareholder was fully conversant with and committed to the business of the company, then the directors would invite the shareholder to take a further block of shares in the company with together with the shareholders existing shares would be converted to full voting shares. Whether that shareholder was invited to be a director of the company would depend on the skills and management competencies displayed by that shareholder.
We anticipate that this article assists with a better understanding of company law insofar as it affects employees proposing to become shareholders of a company, and the matters covered by constitutions and shareholder agreements.