Australia is a country that is very friendly to small-business owners, and many immigrants choose to partner with others to run a business here. In practice, however, we frequently see businesses run into trouble and become unsustainable, with partners falling out over disagreements and ultimately parting on bad terms — losing both the friendship and the money. The fundamental reason is usually that no “Shareholders Agreement” was signed in advance.

First, let’s understand what a Shareholders Agreement is

A Shareholders Agreement is a binding contract that supplements the company constitution. It sets out the rights and obligations of the company’s shareholders, the shareholders’ control over the company, how the company will be owned and managed, how shareholders’ rights are protected, the transfer of shares, and the circumstances under which a shareholder may exit the company.

In theory, every shareholder’s interests are aligned — everyone assumes that as long as decisions are made that make money, that’s enough. In reality, it’s not that simple. Many practical issues come into play, for example:

– The company has made a profit — should dividends be paid? When?

– Someone wants to sell their shares — should they be sold? Do the others agree? How is the sale handled?

– The business is underperforming and loss-making — what now? How are the losses shared? Should more capital be injected?

– Someone wants to close the company, or someone wants to apply for liquidation — what then?

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Close friends often choose to go into business together, but disagreements between shareholders are extremely common, and we have seen far too many cases where this causes friendships to break down. For Chinese entrepreneurs starting businesses in Australia, many don’t set ground rules before they begin working together, and when operating or taking over a business they often fail to spell out the details in advance — which is a very dangerous way to run a company.

So what is the difference between a Shareholders Agreement and a company constitution?

People often confuse the concepts of a Shareholders Agreement and a company constitution, thinking that having a company constitution is sufficient and that a separate Shareholders Agreement is unnecessary. That isn’t the case — the Shareholders Agreement and the company constitution operate in parallel, not as substitutes for each other. The company constitution is an external legal document that sets out the important and fundamental matters of the company; aside from shareholders, creditors and members of the public can also inspect it. A Shareholders Agreement, however, does not need to be made public. It is an internal document between shareholders, used to regulate the internal rights and obligations among them. At the same time, it provides rules for matters not covered by the company constitution, serving as a more detailed and precise supplement to it.

What clauses does a Shareholders Agreement typically include?

The vast majority of agreements will include:

1. Capital contribution clauses

2. Director (legal representative) appointment clauses

3. Management, responsibility and information clauses

4. Dividend and financing clauses

5. Share transfer clauses

6. Exit mechanism clauses

7. Default clauses

8. Deadlock and dispute resolution clauses

In practice, many core issues need to be agreed between partners in advance — otherwise, by the time the company runs into trouble and negotiations begin, differences between shareholders have already emerged, and negotiating at that point becomes enormously difficult.

A simple case study

Zhang San and Li Si jointly set up a company, each holding 50%, to run a small business. The two did not put a Shareholders Agreement in place before working together. Zhang San was a director of the company but did not participate in actual operations or management — he was a hands-off owner. Because the two held different business philosophies and disagreed on certain operational decisions, Zhang San wanted to use his position as director to demand that the shop be closed, but Li Si was firmly opposed. Li Si was the one actually running the company day to day; all the company’s books and tax records were in his hands, and he refused to provide these to Zhang San. With no way to resolve their differences, the business became even harder to run, and both of them ultimately suffered heavy losses. The reason this situation arose was that the two of them never signed a Shareholders Agreement when the company was founded.

If Zhang San and Li Si had signed a Shareholders Agreement in advance, they could have planned for the following:

1. Each holds 50% — there is no majority shareholder or minority shareholder — so how should deadlocks or disagreements be handled;

2. If one of them wants to transfer shares, does the other have a right of first refusal? If the other doesn’t buy, can the shares be transferred to a third party, and how is the share price to be determined;

3. When the two of them found the company and take up their shareholdings, should there be a minimum holding period;

4. If a dispute arises between them, what resolution mechanism is needed;

If a decision is made to wind up or close the company, what process needs to be followed;

5. How should the company’s books be kept, and what is the basic procedure for inspecting them.

If Zhang San and Li Si had engaged a lawyer to draw up a Shareholders Agreement from the outset, these disputes could have been avoided. The more precisely the agreement addresses potential areas of conflict, the more smoothly any real dispute can be resolved when it arises.

After all that, the essence of a Shareholders Agreement is really just to plan for a rainy day. In many of the partnership disputes we’ve seen end up in court, the parties got along very well when the company was first set up — they thought they were long-time friends and didn’t need to sign an additional agreement — only to regret, once real disputes over interests arose, that they hadn’t planned out their respective rights and obligations from the start. So when going into business with partners, don’t let emotions drive the decision — getting the hard talk out of the way first is essential.