Equity investments in privately held companies

By James Comyn, partner at Hunton Andrews Kurth LLP. 

Case law is full of examples of aggrieved minority shareholders in private companies seeking redress from the courts for wrongs suffered at the hands of a majority shareholder. 

A well negotiated and documented shareholder’s agreement, agreed prior to investment, would have avoided many of these disputes.  The absence of those governance and exit rights commonly included in a shareholders agreement, places a minority investor in a difficult position.  In many instances, the courts will not come to their aid.  Further, litigation can erode the value of their shares, by drawing attention to and accentuating areas of disagreement and the lack of enforceable governance and exit rights.

The rights of a minority shareholder in a private company will depend on a number of factors, including the provisions of applicable law and the relative bargaining strength and expertise of the parties.  We consider below the sources of those rights and typical investor rights at differing levels of equity ownership. 

Sources of shareholder rights

Shareholder rights in a privately held company are derived from three principal sources:

• applicable law, in particular the law under which the company is formed;
• the constitution of the company; and
• a shareholders’ agreement between the parties, which frequently supplemented the above

Which source of rights takes priority?

As a general rule, the provisions of applicable law that are mandatory take priority.  In most jurisdictions, the parties have more latitude in drafting the company’s constitution, although some provisions are mandatory and others are prohibited.  Parties have more freedom in drafting the shareholders’ agreement.

Reversing the order of priority

Lawyers have devised a number of mechanisms to reverse the order of priority. A shareholders’ agreement often provides that, as between the shareholders, the terms of the shareholders’ agreement prevail over applicable law and the constitution.  This principle is often buttressed by a general long form further assurances clause in which the shareholders agree to exercise or waive rights granted by applicable law in such manner as gives effect to the shareholders’ agreement.  Shareholders also agree to use their best endeavours to procure that any directors appointed by them do the same.

In addition, the shareholders’ agreement can be drafted to take account of mandatory provisions of applicable law.  For example, a shareholders’ agreement could include a specific provision in which shareholders expressly agree how they will exercise or waive specified rights arising under applicable law. 

Constitution or shareholders’ agreement?

Once governance arrangements have been agreed between investors in a privately held company, counsel need to consider whether those arrangements should be documented in a shareholder’s agreement, in the company’s constitution or in both.

There are a number of considerations to be taken into account here, as summarised below:

• A company is bound by its constitution. It need not be party to a shareholders’ agreement and often there are good reasons for the company not to be party to a shareholders’ agreement.
• A constitution binds all shareholders. A shareholders’ agreement will only bind those parties who have signed or adhered to it.  Shareholders who are not bound by a shareholders’ agreement might include an executor of a deceased shareholder, an insolvency practitioner or secured creditor of an insolvent shareholder or employee shareholders.
• In many jurisdictions, a constitution is a public document. A shareholders’ agreement is a private document.
• Applicable law may restrict what provisions can be included in a constitution. The parties have much more freedom as to what to include in a shareholders’ agreement, the terms of which can also address, for example commercial arrangements.
• Many jurisdictions allow constitutions to be amended by fewer than all shareholders. As a general rule, all parties must agree to an amendment to a shareholders’ agreement.
• A constitution is subject to the laws of the jurisdiction in which the company is incorporated; the parties to a shareholders’ agreement can chose a different governing law.
• Similarly, disputes arising under a constitution are typically may only be resolved before the courts of the jurisdiction in which the company is incorporated. Disputes arising under a shareholders’ agreement can be resolved in a different jurisdiction and by arbitration.
• The remedies for breach of a constitution can include (in addition to injunctive relief and damages) invalidity of the act, forfeiture of shares and the loss of voting or other rights. Remedies for breach of a shareholders’ agreement are typically limited to injunctive relief (typically at the discretion of the court), damages (it may be difficult to show that the value of the aggrieved shareholders’ shares has been affected) and any redress provided by the agreement (e.g., a contractual obligation to sell shares).

Given the above, constitutions normally only include provisions governing:

• The appointment, powers and duties of directors including provisions for the authorisation and management of directors' conflicts of interest;
• Notice and proceedings at shareholder and director meetings (including quorum and voting), often supplementing applicable law;
• Share rights, especially if the company has separate classes of shares with different rights and including provisions relating to the variation of those rights; and
• Procedures for the issue and transfer of shares (including pre-emption rights, restrictions on transfer, drags and tags) or a provision stating that shares may only be transferred in accordance with the terms of the shareholders’ agreement.

 
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