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Shareholders agreements

When co-investing with a private equity fund, institutional investors must have a full understanding of the shareholders' agreement, which outlines the terms and conditions of the deal. Here Cameron McKenna outlines of some of the main features of this type of agreement.

The shareholders' agreement - together with the company's articles of association - regulates the affairs of the company and gives investors their main contractual protections. It will, of course, only be relevant if a corporate structure is being used - but this is by far the most common method for structuring private equity/business angel investment.

The main features of a shareholders' agreement are:

Board appointment rights. It is common for the shareholders' agreement to establish the relative rights of representation that the shareholders will have on the company's board of directors of the company. A minority shareholder may seek to have one director on the board in order to be kept informed of matters discussed at board level. A larger shareholder may seek to appoint a large number of directors to reflect its proportionate holding of shares at board level. Usually, the agreement will provide that any director appointed by a shareholder can only be removed by that party.

Veto rights. A list of material things that cannot be done without the investors' prior consent. These normally range from fundamental matters, such as issuing further shares or charging assets, to more day-to-day matters, such as capital expenditure and so on.

Adoption and amendment of business plans and budgets. The agreement may provide a process for adopting and amending business plans and budgets, to ensure that individual shareholders or their appointed directors are properly represented in that process.

Scope of business. It is common, in particular in a joint venture or a start-up, for the shareholders' agreement to specify the scope of the business that the company will conduct, and provide that consent is required from the shareholders before the company can change the nature of its business.

Intellectual property rights. Where shareholder parties are contributing know-how or proprietary information to a venture, the shareholders' agreement may provide for the ownership and licence of intellectual property rights, preserving certain such rights for the parties themselves and others to the company. Such provisions are particularly common in joint venture agreements.

A right to information. It is extremely important for the investors to monitor performance closely, particularly to give them an early warning if things are starting to go wrong. Accordingly, they will expect a contractual right to receive regular reports, management accounts, cash flow forecasts and so on, together with statutory accounts. The investor will also often seek the right to have its own director appointed to the board. He will expect board meetings to be held regularly and all material decisions to be made by the board.

Warranties from the management team. In general terms, these are a series of statements about the company that the investors would expect to be true and accurate. At a first-stage capital raising, it is unlikely that these statements will be little more than confirmations: that the team stands behind its business plan; that the company is clean; and that the team knows of nothing that has been withheld from investors. However, at subsequent funding rounds, once the company has a track record, the warranties will extend to the company's general trading affairs.

Restrictions on transfers of shares. The investors will be keen to ensure that the management team they are backing, holds on to their shares. In certain circumstances, managers will be permitted to transfer shares to family or to trusts.

Restrictive covenants. These will make it clear that, while members of the management are employed and for a period of time afterwards, they cannot compete with the company or solicit customers or employees. One would expect these covenants to dovetail with restrictive covenants contained in employment agreements but the covenants in the shareholders' agreement will be directly in favour of the investors. It is obviously critical from the management's perspective that they are comfortable with the covenants they are entering into.

Strategic investor rights. Where a shareholder is looking for more than a return on its investment, the shareholders' agreement provides an opportunity to negotiate terms covering ancillary commercial arrangements, such as giving a shareholder or its group first rights of refusal on certain type of business or contract with the company, or (as was common for investors in incubator companies) the right to be informed of and to co-invest in investments to be made by the company.

Exit provisions. A shareholding in a private company is by its nature illiquid because there is no market in the shares. Accordingly, a shareholders' agreement will very often include provisions that are intended to encourage or facilitate a realisation by the shareholders of their investments. Once again, this is particularly important for minority shareholders who are unable to control an exit process.

There are, of course, many other detailed provisions in an average shareholders' agreement. It is normally a sophisticated legal document. No business angel, private equity firm or institutional investor, should invest a substantial amount in any company without protecting himself or herself with contractual rights in a shareholders' agreement.

Chris Southorn is a partner in CMS Cameron McKenna's corporate and commercial group in Hong Kong. Chris specialises in corporate finance, M&A and private equity transactions. He has advised on numerous start-up and development capital deals and buy-outs, and has extensive experience of cross-border mergers and acquisitions, public company takeovers, listings, public equity capital raisings, share buy-backs and stock exchange matters.

CMS Cameron McKenna is a leading international firm with more than 180 partners worldwide. It has offices or associated offices in 35 cities in 23 countries. The Hong Kong office opened in 1980 and has ten partners and approximately 40 lawyers.
The firm has been heavily involved in the private equity markets for many years, acting for institutional and strategic investors. It has extensive experience in the establishment, management of and investment in, funds and limited partnerships in various jurisdictions for private equity, and advise on the regulatory and compliance issues affecting investment funds.

For more information on the firm's private equity capability in Asia please contact Chris Southorn on +852 2846 9137, cns@cmck.com or visit the firm's website www.cmck.com

© CMS Cameron McKenna 2001