A shareholders' agreement, as the Commercial Code also refers to it in § 66c, is a contract concluded among the (often prospective) members of a company, as well as the company itself. Members enter into an SHA beyond the scope of the company's memorandum of association, which means that an SHA may also contain provisions that cannot be included in the memorandum of association. Unlike the memorandum of association, which is filed in the collection of deeds of the Commercial Register, an SHA is a non-public agreement whose content is known only to its contracting parties. An SHA therefore does not belong among the so-called corporate documents of a company, which include the memorandum of association or the articles of association. Where a decision of a company body (e.g. the general meeting) conflicts with the SHA, that conflict does not render the adopted decision invalid.
Under § 66c of the Commercial Code, an SHA is a written agreement between members governing their mutual rights and obligations arising from their participation in the company. It concerns in particular the manner and conditions for exercising the rights associated with participation in the company; the manner of exercising the rights relating to the administration and management of the company, the conditions and extent of participation in changes to the registered capital, or ancillary arrangements relating to the transfer of participation in the company.
So what arrangements does an SHA most often contain?
Pre-emption right
The parties to an SHA may agree to regulate the pre-emption right beyond the scope of the memorandum of association, or where their memorandum of association does not regulate the pre-emption right at all. Where one of the company's members wishes to transfer its ownership interest to a third party, the other members (or only some of them) have the right to acquire the ownership interest on a priority basis under the pre-emption right.
It is common for the pre-emption right to take precedence over the tag-along or drag-along right. Within an SHA, the parties typically agree on the manner of notifying the intention to sell an ownership interest, set time limits for exercising the pre-emption right, and may agree on the details of the ownership interest transfer agreement. A breach of the pre-emption right may result in the obligation to pay a contractual penalty or the member's departure from the company as a Bad Leaver.
Tag-along
The tag-along right, or the right to join the transfer of an ownership interest to a third party, may be agreed in favour of all members of the company, or only for the majority member, depending on the relationships between the members. Where a member of the company wishes to transfer its ownership interest to a third party outside the company, it should inform the other members of its intention.
Under the tag-along right, members who have been informed of the intention to transfer one member's ownership interest to a third party have the right to join the transfer and to require that the third party also acquire their ownership interest. The tag-along right is intended to protect the remaining members of the company, who, following the transfer of one member's ownership interest, might potentially no longer wish to remain in the company with a new member unknown to them.
Where the tag-along right of the entitled member is breached, a common sanction is a contractual penalty, the member's departure from the company as a Bad Leaver, or a put option.
Drag-along
The drag-along right, i.e. the right to require others to join the transfer of an ownership interest, is the right of a member who wishes to transfer its ownership interest to a third party to require the other members to also transfer their ownership interests to that third party as the acquirer. In this case, the member of the company who has exercised the drag-along right is obliged to ensure that the third party to whom it transferred its ownership interest also concludes ownership interest transfer agreements with the other members of the company.
Put option
Where the tag-along right of the relevant member as a party to the SHA has been breached, that member is entitled, under the put option, to require the member who breached its tag-along right to purchase its ownership interest. The party whose tag-along right was breached therefore has a choice, namely whether to exercise the put option or the claim for payment of the contractual penalty.
The put option can, of course, also be agreed in connection with another breach of a member's rights under the SHA.
Deadlock
In SHA terminology, the term deadlock refers to a situation involving a disagreement between the company's members on material matters. Such situations most often arise where the company's members hold ownership interests of equal size, which prevents them from adopting a decision on a particular matter. It is precisely for this reason that an SHA should contain a resolution mechanism for this stalemate.
This may involve, for example, a forced transfer of an ownership interest. One member may send the other member an offer stating a sum of money as the equivalent for the other member's ownership interest. The other member is then obliged to sell its ownership interest to the member sending the offer. Another solution is for both members to value each other's ownership interests, whereby the member who offers the higher amount has the right to require acquisition of the ownership interest.
Good Leaver / Bad Leaver
The concept of a protection period is also associated with the terms Good Leaver and Bad Leaver. An SHA should contain a definition of the protection period, which is usually a period lasting several years.
Where a member does not breach any obligation arising for it under the SHA but voluntarily decides to leave the company during the protection period, it is a member departing as a Good Leaver. However, such a member is obliged to offer the other members for sale the portion of its ownership interest specified in the SHA.
Conversely, if a member breaches the SHA, it is regarded as a member forced to leave the company as a Bad Leaver. In this case, however, the member is obliged to sell its entire ownership interest, and it is not uncommon for the sale price of this ownership interest to be set as the nominal value of the transferred ownership interest.
Agreements on the exercise of voting rights
In an SHA, members may also agree on how they will vote at the company's general meeting on specific matters set out in the SHA. This may concern, for example, granting consent to the transfer of an ownership interest, the distribution of profit, or the appointment or removal of the statutory body. The members undertake not to unreasonably withhold their vote at the company's general meeting, or the SHA specifies the majority required to adopt a decision of the company's general meeting.
Rules for selecting members of the statutory body or supervisory board
It is not uncommon for an SHA to contain provisions on the manner of selecting the company's statutory or supervisory body. Where there are multiple members, it may be agreed that each member has the right to nominate one managing director of the company, or a member of the supervisory board. However, an SHA should also contain the manner of removing a managing director nominated by a member from office, or the nomination of a new managing director.
Contractual penalties
Contractual penalties should motivate members to fulfil the obligations arising from the SHA. Nevertheless, it cannot be ruled out that members' obligations will be breached. It depends on the will of the members when creating the SHA which obligations will be secured by a contractual penalty. Typically, these will be contractual penalties for breaching the tag-along, drag-along or pre-emption right, or other obligations laid down in the SHA.
Confidentiality
Given the nature of an SHA as a non-public agreement, it is advisable for the SHA to also contain provisions on the duty of confidentiality. Through confidentiality provisions, members protect confidential information, know-how or other information that the members have an interest in protecting. Compliance with this obligation may also be secured by a contractual penalty.
In addition to the provisions commonly found in an SHA as set out above, an SHA may also govern a non-compete clause, so-called anti-dilution provisions (i.e. provisions against the dilution of ownership interests), or other provisions depending on the members' needs. Where an investor enters the company, an SHA often also contains a method of valuing the ownership interest using EBIT, EBITA or EBITDA.[1]
In a future article, we will look at the most common mistakes that can occur in an SHA.
[1] EBIT (Earnings before Interest and Taxes) is a term denoting a company's operating result before taxes and interest. EBITA (Earnings before Interest, Taxes and Amortization Charges) represents profit before taxes, interest and amortization of long-term intangible assets. EBITDA (Earnings before Interest, Taxes, Depreciation and Amortization Charges) denotes EBIT increased by depreciation.