Published
Why a company constitution is not enough
Every company registered in Australia needs a constitution, or must otherwise rely on the replaceable rules in the Corporations Act 2001 (Cth). Many private companies stop there. A constitution sets out basic mechanics: how meetings are called, how directors are appointed, how shares are issued. It rarely deals with the questions that actually cause disputes between shareholders, such as who controls day to day decisions, what happens if a shareholder wants to sell, what happens if the shareholders can no longer agree on a key decision, and how an exit is priced and funded when the time comes. A shareholder agreement is a private contract between the shareholders, and often the company itself, that fills these gaps. It sits alongside the constitution, and where the two conflict, the shareholder agreement generally governs as between the parties who signed it.
The best time to put a shareholder agreement in place is at incorporation, or as soon as a second shareholder is admitted, whichever comes first. In practice we are often asked to prepare one later: before a capital raise, before bringing in a new co-founder or investor, or after a dispute has already made the gap in the constitution obvious. Without an agreement, shareholders fall back on the default statutory rules and whatever the constitution happens to say, which was often drafted from a template and never tailored to how the business, or the relationship between its owners, actually works. Disputes that could have been resolved by a clause negotiated in good faith often end up being resolved by litigation, an oppression claim under the Corporations Act, or a forced and undervalued exit. Businesses deciding how to structure ownership from the outset, including whether to hold shares directly or through a trust, should settle the business structure for the venture before the shareholder agreement is drafted.
Board control and reserved matters
A constitution usually allows the majority shareholder, or a simple majority of directors, to make most decisions. For a genuine partnership between founders, or between a founder and an outside investor, that default can hand effective control to one side even where the parties intended something closer to equal say. A shareholder agreement can correct this by setting out board composition, including who can appoint and remove directors, quorum requirements, and a list of reserved matters that need a higher approval threshold, such as unanimous shareholder consent or the consent of a specific class of shareholder. Reserved matters typically include:
- issuing new shares or options, which dilutes existing holders
- borrowing above an agreed limit, or granting security over company assets
- changing the nature of the business or entering new markets
- related party transactions, including payments to shareholders or their associates
- appointing or removing the chief executive or an equivalent senior role
- selling the business, or a material part of its assets
Agreeing this list at the outset avoids a situation where a minority shareholder later discovers that a decision they would never have agreed to has already been made, and that the constitution gave them no way to stop it.
Pre-emptive rights on share transfers
Without a shareholder agreement, a shareholder in a private company can often sell their shares to anyone, subject only to whatever transfer restrictions happen to sit in the constitution. That is rarely what the remaining shareholders want. Pre-emptive rights, also called rights of first refusal, require a shareholder who wants to sell to first offer their shares to the other shareholders, usually pro rata to existing holdings, before selling to an outsider. This protects the existing shareholders from ending up in business with someone they did not choose and did not vet. A workable pre-emptive rights clause needs a clear pricing mechanism, such as an agreed formula, an independent valuer, or a right to match a genuine third party offer, and a defined timetable for the process. Without those details, the right becomes a source of delay rather than protection.
Drag along and tag along rights
Drag along and tag along rights deal with what happens when the company itself is sold. A drag along right allows a majority of shareholders, above an agreed threshold, to force minority shareholders to sell their shares on the same terms when a buyer wants to acquire the whole company. Without this right, a single minority holder can block a sale that every other shareholder wants to accept, which materially reduces the value of the business to a buyer. A tag along right works the other way. It protects a minority shareholder by giving them the right to join a sale being negotiated by a majority shareholder, on the same price and terms, rather than being left holding a minority stake in a business now controlled by a new owner. These two rights are usually negotiated together, since they address the same underlying problem from opposite sides of the table. The same tension between control and exit rights arises in unincorporated structures such as joint venture agreements for property development.
Good leaver and bad leaver provisions
Good leaver and bad leaver clauses set different consequences for a departing shareholder depending on the circumstances of their departure. A good leaver, someone who retires, dies, becomes permanently incapacitated, or leaves on terms the other shareholders accept, is usually entitled to fair market value for their shares. A bad leaver, someone who resigns without agreement, is dismissed for serious misconduct, or breaches a restraint or confidentiality obligation, may receive a reduced price, or in some drafting, only nominal value for unvested shares. These provisions matter most where shareholders are also working directors or employees of the company, because they link an exit from active involvement to an exit from ownership. Without them, a departing founder can walk away from day to day work while retaining a full economic stake, which is rarely what the remaining, still active shareholders intended when the business was set up.
Deadlock mechanics
Deadlock arises when shareholders cannot agree on a decision the business needs in order to move forward. It is most commonly discussed in the context of a 50/50 company, but the same problem occurs in any structure where a reserved matter requires unanimous or high threshold consent and the shareholders are split. A constitution offers no answer to this beyond whatever default voting rule applies, which in a genuine deadlock simply produces no decision at all. A shareholder agreement can set out a structured process instead: a defined period for direct negotiation between the shareholders, escalation to mediation if that fails, and a resolution mechanism as a last resort, such as an independent expert determination, a shotgun style clause where one party names a price and the other must either buy or sell at that price, or a right to wind up or sell the company. These mechanisms are uncomfortable to negotiate while relations between shareholders are still good, which is exactly why they need to be agreed at that point, rather than after a dispute has already started and trust has broken down.
Dividend policy and exit planning
Shareholder agreements commonly record an agreed approach to dividends, particularly where some shareholders rely on distributions for income and others are focused on reinvestment and growth. This can include a minimum distribution of after tax profit above an agreed working capital reserve, or a statement that dividend decisions sit with the board subject to a reserved matter threshold. The agreement is also the natural place to record exit planning: a target timeframe or trigger event for a sale, whether an initial public offering or trade sale is contemplated, and how founders and investors expect sale proceeds to be shared, including any liquidation preference for investors who put in capital on the basis they would be repaid before ordinary shareholders. Directors negotiating capital raising arrangements alongside these terms should also be alert to the disclosure obligations that can apply outside a formal prospectus process when raising capital without disclosure.
Frequently asked questions
Do we still need a shareholder agreement if we already have a company constitution?
Yes. A constitution and a shareholder agreement do different jobs. The constitution is the company’s internal rule book, adopted under the Corporations Act 2001 (Cth). It is a private document. It does not need to be lodged with ASIC and it is not held on the public record, although the company must keep a copy and make it available to shareholders who ask for one. A shareholder agreement is a private contract that can go into far more detail on control, transfers, exit rights and dispute resolution, and it can bind the parties in ways a standard constitution does not. Most private companies with more than one shareholder benefit from having both.
When is the best time to put a shareholder agreement in place?
Ideally at incorporation, or as soon as a second shareholder is admitted. It is far easier to agree on control, exit and dispute mechanisms while relations between shareholders are good and no one yet knows who will benefit from a particular clause. Agreements negotiated after a dispute has started, or immediately before a sale, tend to be harder to agree and more likely to favour whichever party has more leverage at that moment.
Can a shareholder agreement override the company constitution?
A shareholder agreement is a contract between the parties who sign it, and it generally governs as between those parties even where it differs from the constitution. It does not automatically amend the constitution itself, so well drafted agreements will often be paired with, or trigger, a constitutional amendment where the parties want a rule to bind third parties or future shareholders as well.
What happens if we do not have a shareholder agreement and a dispute arises?
The shareholders fall back on the constitution and the default rules in the Corporations Act 2001 (Cth). These rarely produce a fast or commercially sensible outcome for a genuine deadlock or an exit dispute. Shareholders may end up relying on statutory remedies for oppressive or unfair conduct, which can be slow and costly, or on an informal negotiation with far less structure than a properly drafted agreement would have provided.
If you are setting up a private company, bringing in a new shareholder or investor, or dealing with a dispute between shareholders, contact GRM LAW to discuss your situation.
Disclaimer: This is general information only and is not legal advice. For advice on your circumstances, contact GRM LAW.
Black Shard