Shareholders' agreements: what co-founders should settle in writing

What is a Shareholders' Agreement and Why Do You Need One?

A shareholders' agreement is a private, legally binding contract between the shareholders of a company. Unlike the articles of association, which are a public document filed at Companies House, this agreement is confidential. Its primary purpose is to govern the relationship between the shareholders, regulate the management of the company, and define their respective rights and obligations. While not a legal requirement under the Companies Act 2006, for any company with two or more founders, it is a fundamental governance document. It acts as a bespoke rulebook, tailored to the specific needs and intentions of the co-founders, providing a clear framework that can prevent costly and damaging disputes later on. It essentially fills the gaps that the standard articles of association do not cover.

The main reason co-founders need a shareholders' agreement is to manage expectations and provide certainty. When starting a business, founders are typically aligned and optimistic, but circumstances change. Disagreements can arise over strategy, finances, or personal commitments. Without a written agreement, resolving these issues can become a deadlock, potentially paralysing the company. For example, what happens if a founder wants to leave, sell their shares, or sadly, passes away? The agreement pre-emptively answers these difficult questions. It provides a clear, agreed-upon procedure for managing share transfers, resolving disputes, and making critical decisions, thereby protecting the investment and interests of every shareholder and ensuring the stable continuity of the business.

The agreement works in tandem with the company's articles of association. The articles set out the basic internal management structure and are binding on the company and its members. However, a shareholders' agreement can include more detailed, personal, and commercially sensitive provisions that would be inappropriate for a public document. If there is a conflict between the two documents, a well-drafted shareholders' agreement will often include a 'supremacy clause' stating that its terms prevail over the articles in the event of any inconsistency. This ensures the private, negotiated terms agreed by the founders take precedence, providing an extra layer of control and protection beyond the default company law framework.

Worth knowing: A shareholders' agreement is a vital, private contract that fills the gaps left by the public articles of association, preventing future disputes.

Core Components: Roles, Responsibilities, and Equity

One of the most fundamental sources of conflict in a startup is a misunderstanding over roles and contributions. A shareholders' agreement should clearly define the position each founder will hold, such as Chief Executive Officer (CEO) or Chief Technology Officer (CTO), and outline their key responsibilities. It is also crucial to specify the expected time commitment, whether full-time or part-time. This clarity prevents 'role creep' and ensures accountability. For example, if one founder is responsible for sales and another for product development, documenting this helps in performance assessment and prevents disputes over who is responsible for a particular business outcome. It transforms vague assumptions into concrete obligations, forming a solid foundation for the working relationship and the operational management of the company.

Deciding on the equity split is a critical, and often sensitive, negotiation. An equal split is not always the fairest or most appropriate solution. The allocation should reflect the value each founder brings to the table, both at inception and in the future. This includes tangible contributions like initial cash investment and the assignment of valuable intellectual property (IP), as well as intangible assets like industry experience, a crucial network of contacts, or the core business idea itself. The agreement should document the final shareholding percentages for each founder and ideally include a vesting schedule. Vesting means that founders earn their shares over a period of time, typically 3-4 years with a one-year 'cliff'. This protects the company by ensuring that a founder who leaves early doesn't walk away with a large chunk of equity they have not yet fully earned.

• Initial cash investment provided by each founder.
• Intellectual property (IP) contributed (e.g., code, patents, branding).
• Time commitment (full-time, part-time, or advisory).
• Relevant skills, experience, and industry network.
• Ongoing roles and level of day-to-day responsibility.
• Guarantees provided for business loans or leases.

Decision-Making and Control: Avoiding Deadlock

While day-to-day operational decisions are typically handled by the directors, certain fundamental decisions should require a higher level of shareholder approval. These are known as 'reserved matters'. The shareholders' agreement should contain a specific list of these critical decisions that cannot be made without the consent of a specified majority of shareholders, often a 'supermajority' (e.g., 75% or 90%) or even unanimous consent. This mechanism acts as a crucial safeguard, preventing a simple majority of shareholders or directors from pushing through major changes that could negatively impact the company or minority shareholders. Defining these matters upfront ensures that all founders have a say in the strategic direction and financial health of the business, fostering a more collaborative and secure governance environment.

For companies with a 50/50 ownership split, the risk of 'deadlock' is a significant threat. Deadlock occurs when the two equal shareholders cannot agree on a reserved matter or a decision requiring their joint approval, bringing decision-making to a halt. A robust shareholders' agreement must include a clear deadlock resolution procedure. This could start with informal discussions, followed by formal mediation with a neutral third party. If that fails, more drastic 'shoot-out' provisions may come into play. For example, a 'Russian roulette' clause allows one shareholder to offer to buy the other's shares at a specified price; the other shareholder must either accept the offer or buy the first shareholder's shares at the same price. While these clauses are a last resort, their very existence encourages compromise and prevents the company from becoming paralysed.

• Issuing new shares or altering share capital, which would dilute existing ownership.
• Changing the company's main line of business.
• Taking on debt or borrowing above a pre-agreed financial limit.
• Selling the entire company or a substantial part of its assets.
• Appointing or removing directors from the board.
• Approving the annual business plan and budget.
• Entering into major contracts outside the ordinary course of business.
• Declaring (or not declaring) dividends to shareholders.

Worth knowing: Defining reserved matters and deadlock procedures is essential for maintaining control and ensuring the company can function even when founders disagree.

'Leaver' Provisions: What Happens When a Founder Departs?

One of the most critical functions of a shareholders' agreement is to set out a clear process for when a shareholder leaves the business. These 'leaver' provisions are vital for business continuity and fairness. They typically categorise a departure as either a 'good leaver' or a 'bad leaver'. A 'good leaver' is someone who leaves for reasons generally considered beyond their control, such as death, permanent disability, or retirement after an agreed age. The provisions ensure their shares are dealt with fairly, usually requiring them to be offered to the remaining shareholders at a 'fair value'. This value is determined by an agreed mechanism, often by an independent accountant, to ensure the departing founder (or their estate) receives a proper return for their contribution to the business's growth.

Conversely, 'bad leaver' provisions are designed to protect the company from a founder leaving in detrimental circumstances. This could include resigning within a short period, committing fraud, being in serious breach of their director's duties, or leaving to join a competitor. In these scenarios, the consequences are intentionally punitive. A bad leaver is typically forced to sell their shares at a significant discount. This could be the price they originally paid for them (the 'subscription price') or even a nominal value like £1. These clauses serve two purposes: they strongly disincentivise disruptive behaviour and ensure that a departing founder cannot profit from damaging the company they helped build. Combined with share vesting, these provisions ensure that equity ownership is tied to long-term, positive engagement with the business.

Share Transfers: Controlling Who Owns the Company

A key objective of a shareholders' agreement is to control who can become a shareholder. Without an agreement, a shareholder could theoretically sell their shares to anyone, including a competitor or an undesirable third party. To prevent this, the agreement should establish strict rules around the transfer of shares. The most common provision is the 'right of pre-emption' or 'right of first refusal'. This stipulates that any shareholder wishing to sell their shares must first offer them to the existing shareholders on a pro-rata basis. The remaining founders get the first opportunity to consolidate their ownership and keep the shares 'in the family'. The agreement should detail the precise mechanism for this, including the timeline for the offer and the process for establishing the price.

For planning a future exit or sale of the company, 'drag-along' and 'tag-along' rights are essential. 'Drag-along' rights protect the majority shareholders. If a majority (e.g., holders of 75% of the shares) agrees to sell the company to a third party, they can 'drag' the minority shareholders along and force them to sell their shares on the same terms. This is attractive to potential buyers, who typically want to acquire 100% of a company. Conversely, 'tag-along' rights protect the minority. If a majority shareholder sells their shares, the minority shareholders have the right to 'tag along' and sell their own shares to the same buyer on the same price and terms. This ensures that minority founders are not left behind in a company with new, unknown owners.

1. 1

   The selling shareholder must provide a written transfer notice to the board and other shareholders, specifying the number of shares and the proposed price.

2. 2

   Existing shareholders are then given a set period, typically 30 days, to exercise their pre-emption rights and purchase the shares pro-rata at the offered price.

3. 3

   If any shares remain unpurchased by existing shareholders, the selling shareholder may, for a limited time (e.g., 90 days), sell those remaining shares to an external third party.

4. 4

   The sale to the third party must be on terms no more favourable than those originally offered to the existing shareholders.

5. 5

   The board of directors must approve the transfer and instruct the company secretary to update the company's register of members to reflect the new ownership.

Worth knowing: Share transfer restrictions, including pre-emption, drag-along, and tag-along rights, are crucial for managing ownership changes and planning a future company sale.

Financial Commitments and Dividend Policy

Early-stage companies often require more funding than initially planned. A shareholders' agreement should address how future funding needs will be met. Will founders be required to contribute additional capital pro-rata to their shareholding? If so, what happens if a founder is unable or unwilling to contribute? This could trigger a dilution of their shareholding. The agreement can also specify rules around company borrowing, such as whether founders must provide personal guarantees for bank loans. Setting these financial expectations upfront prevents difficult conversations when the company is in need of cash. It provides a clear roadmap for financing growth and ensures all founders understand their potential future financial obligations to the business.

A dividend policy outlines how and when the company's profits will be distributed to shareholders. This is a common point of friction, as some founders may want to reinvest all profits to fuel growth, while others may want to take cash out of the business. The agreement should establish a clear policy. For instance, it could state that no dividends will be paid for the first three years, or that 40% of net profits will be distributed as dividends annually once the company achieves a certain revenue target. This aligns expectations and financial planning. The discussion around dividends is also closely linked to directors' remuneration. Agreeing on a framework for setting salaries and bonuses, alongside the dividend policy, creates a comprehensive financial understanding between all parties and is crucial for tax planning, especially when considering the optimal mix of salary versus dividends.

Protecting Company Secrets and Preventing Competition

A company's most valuable assets are often intangible, such as its brand, software, customer lists, and business processes. It is absolutely critical that all intellectual property (IP) created by any founder for the business is legally owned by the company itself, not the individual. A shareholders' agreement should include warranties from each founder confirming they have assigned all relevant pre-existing and future IP to the company. This prevents a situation where a departing founder can hold the company to ransom by claiming ownership of a critical piece of technology or a brand identity. The agreement should also include robust confidentiality clauses, legally obliging all shareholders to keep trade secrets and other sensitive business information private, both during their time with the company and after they leave.

To further protect the business, the agreement should contain restrictive covenants. These are clauses that restrict a shareholder's activities after they cease to be involved with the company. A 'non-compete' clause prevents them from setting up or working for a competing business for a specified period in a defined geographical area. A 'non-solicitation' clause stops them from poaching the company's clients, suppliers, or employees. For these covenants to be legally enforceable, they must be reasonable and go no further than is necessary to protect the company's legitimate business interests. Unreasonably long durations or overly broad geographical scopes can be struck down by a court. Typically, a period of 6-12 months for non-compete and 12-24 months for non-solicitation is considered more likely to be enforceable.

Drafting, Signing, and When to Update the Agreement

While online templates can provide a basic starting point, they are no substitute for professional legal advice. A shareholders' agreement is a complex legal document where the details matter immensely. Using a generic template without understanding its implications can lead to unenforceable clauses or unintended consequences. It is strongly recommended that co-founders engage a solicitor who specialises in corporate law to draft the agreement. A solicitor can ensure the document is tailored to the specific business, the founders' intentions, and is fully compliant with UK law. Ideally, each founder should seek independent legal advice to ensure their personal interests are protected and they fully understand the obligations they are signing up to. This upfront investment is minor compared to the potential cost of a future dispute.

Once drafted and agreed, the document must be formally executed to become legally binding. This means it should be signed as a deed by all individual shareholders and by the company itself (represented by one or two directors). The company being a party is crucial as it ensures the company is also bound by the terms, for example, in relation to share transfers. Unlike the articles of association, the shareholders' agreement is a private document and is not filed at Companies House. It should be stored safely along with other important company records. It is not a document to be signed and forgotten; it's a living agreement that should evolve with the business. It must be reviewed and potentially updated at key moments in the company's lifecycle to ensure it remains relevant and fit for purpose.

• When a new key shareholder or investor joins the company.
• Following a significant change in the company's business strategy or direction.
• Before a major fundraising round (new investors will require it).
• If a founder's role, responsibilities, or time commitment fundamentally changes.
• When planning for a major event like a company sale, acquisition, or merger.
• On a scheduled periodic basis, for example, every two years, to ensure it remains current.

Worth knowing: Invest in professional legal advice to draft a bespoke agreement and schedule regular reviews to ensure it evolves with your business.

Common questions

Official sources & further reading

This guide draws on the official guidance below. Rules, fees and individual circumstances can change; check the relevant source before acting.

• Companies Act 2006
• GOV.UK: Running a limited company
• HMRC: Corporation Tax rates and reliefs
• HMRC: Dividends and tax

General UK information, primarily for private companies limited by shares. This is not personalised legal, tax or financial advice. An accountant or solicitor can help apply the rules to your situation.