Legal Corner: The Importance of Shareholders’ Agreements

This month, Herbert Smith Freehills LLP reviews the importance of shareholders’ agreements.

The Importance of Shareholders’ Agreements

Many investors establish a company in DMCC together with a business partner, who will also own shares in the company. This is known as a joint venture or a 'JV Company'. Often the reason for this is to work with a partner who brings necessary specialist regional or technical expertise, or because they have strong market knowledge and contacts which will help the new business to succeed.

Shareholders in new JV Companies often overlook the importance of agreeing the terms that will govern the JV Company beyond the procedural matters set out in the Articles of Association. This can lead to day-to-day problems in running the JV Company and can prove to be a costly mistake if a dispute later arises. Although the general law of the UAE will apply, together with DMCC Company Regulations, these will not be specific enough to your unique business situation to ensure that your interests are protected.

Investors should therefore agree these arrangements in a written shareholders’ agreement. Such an agreement might cover the following points:

Business purpose

What type of business will the JV Company do? Are there activities it should not do? May the shareholders also have their own businesses which compete with the JV Company?

Ownership of the JV Company

How much money (or other assets) will each shareholder put into the JV Company and how many shares will they have? This is an obvious but critical issue; a share represents a right to profits and a right to vote on decisions about the management of the JV Company.

The agreement should cater for any change in shareholders. This might cover scenarios such as allowing one shareholder to sell its shares to a third party; shareholders selling shares between themselves; or for a new shareholder to join the existing shareholders. Can a shareholder block any such changes? Does a shareholder have the first right to any shares being sold? Agreement to have an independent accountant value the JV Company is also important to allow these changes to happen at a fair price.

Management

How will the JV Company be managed – who will be the general manager and what other director or management roles will be created? Who can appoint and remove these people and what will be the scope of their authority? This may be particularly important in relation to the financial management of the JV Company.

How often will the shareholders and the directors meet? Regular meetings are important to ensure that the business is performing and being managed in accordance with shareholder expectations and that management issues are dealt with regularly and efficiently. Keeping records of these meetings is important, in particular if a dispute later arises.

What key matters will require the agreement of both/all shareholders (often called 'reserved matters')? This is a particularly key protection to think about for minority shareholders. Some decisions, such as to change the business purpose, to bring in a new shareholder or to borrow money, are considered important enough to require all shareholders to agree rather than to be decided by management or by the majority shareholder alone.

We recommend that the investors agree to put in place an annual business plan. This will ensure that there is a discussion about business direction, the budget and related issues (for example, should the shareholders use profits to pay dividends or keep money in the business to support growth? This is an area that often leads to disagreement).

Funding

How will the JV Company obtain the cash needed to operate? Will the shareholders provide this or will third party lenders be approached? Will there be any obligations for the shareholders to meet to obtain funding, such as providing guarantees?

These issues can often lead to disagreement and can damage the prospects of launching what otherwise may be a strong business. If there are known significant expenditures, it is best to discuss how these will be covered in advance.

Exit/termination

Is the business to continue indefinitely or can the shareholders give notice to terminate after an agreed period? Should any of the shareholders be made to stay in the business for an agreed initial period to make the most of their expertise/market knowledge?

In the event of termination, who owns the key assets? Identifying what these assets are may not be straightforward. The business may have built up a strong brand – will one party have the right, after termination, to use the brand to the exclusion of the other?

Dispute resolution

What happens if a shareholder breaches an important obligation under the shareholders’ agreement – for example, by competing with the JV Company when it has been previously agreed that the shareholders would not do this? If the parties want events such as this to entitle the 'innocent' party to terminate the shareholders’ agreement or to buy out the party in breach for a very low price, this should be stated.

If a dispute does arise, how should it be dealt with? Will the local Arabic language courts or the English language DIFC courts be preferable? Alternatively, you may want to agree to an arbitration process, which will be confidential. Each option has different advantages and disadvantages. You may also want a 'cooling off' period, requiring the senior management from each investor to speak to each other in good faith to resolve a dispute before a legal claim can be started.

Conclusion

Many of the suggested topics for a shareholders' agreement are about communication: if the shareholders communicate well and regularly, this is the best way to ensure that business runs smoothly. However, if it does not, a clear written agreement that is tailored to your business needs give you the best chance of protecting your investment if a dispute does arise.

This article was written by Stuart Paterson, Partner, and Shazi Askarpour, Senior Associate, of Herbert Smith Freehills LLP in Dubai (www.herbertsmithfreehills.com) Contact Details: stuart.paterson@hsf.com or shazi.askarpour@hsf.com or +9714 428 6300.