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What Happens if a Contracted Shareholder Leaves the Company?

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As a company grows its business, it may consider bringing on key people as shareholders. In particular, startup companies strapped for cash may decide that giving away equity in the company is worth it if they can receive valuable services (such as developing their key software platform or product) in exchange. This is commonly understood as “sweat equity.” Where a company cannot pay for services using cash, it can give up equity. However, what happens once a contracted shareholder receives their shares in exchange for providing services?

Different rules may be involved for how this shareholder may continue to hold their shares. The rules will depend on whether the company has a shareholders agreement. This article will explore these different possibilities and discuss the general rules for a contracted shareholder holding company shares. 

No Shareholders Agreement

If there is no shareholders agreement, the usual understanding is that a contracted shareholder who stops providing services to the company is free to sell or keep their shares. 

The shareholder has provided a service that the company previously required, and they have earned their shares in return. Depending on how much equity the company gives, a shareholder may continue advising the company on an informal ad-hoc basis. Doing so can increase the value of their shares. On the other hand, if a shareholder has a very small amount of equity (1 or 2%), they may find it not worthwhile remaining involved in the company. Likewise, they may hold onto their shares while becoming inactive.

While the base understanding is a fair arrangement for the shareholder, it may not be advantageous for the company. It is often not a clean process for the company, which may not want an inactive shareholder with a very small percentage of shareholding in the company. This is because certain company decisions might require their approval. 

Additionally, with no shareholders agreement, any shareholder is free to sell their shares to another party. There may be no mechanisms (such as pre-emptive rights) to protect the company from the shares being sold to an unknown third party. A shareholder is free to sell their shares to another third party willing to pay the best price. Accordingly, the company may not want a third-party shareholder involved in the company’s decision-making or day-to-day operations.

Shareholders Agreement

On the other hand, a company with a shareholders agreement usually has a clearer process for a shareholder holding their shares in a company. The agreement may outline that a shareholder who no longer provides their services to the company becomes a good leaver. Accordingly, the company or its shareholders can buy back the shares for fair market value. 

The fair market value recognises the uplift in value that the shareholder’s services have provided for the company. It is also advantageous for the company to ensure that the person no longer holds shares after leaving the company. 

Alternatively, the company could decide that the shareholder has made a key contribution to their business and can allow the shareholder to retain their shares and continue to benefit from their uplift in value. Having a buy-back process avoids the situation where the shareholder becomes inactive and stalls decision-making. A buy-back also avoids the situation of a shareholder selling their shares to a third-party that the company does not approve.

Instead of a share buy-back, a company may decide that the shareholder is free to retain their shares if they still provide some sort of value to the company on an informal, casual, ad-hoc basis. Allowing the shareholder to keep their shares means that as the company grows in value over time, the shareholder will continue to benefit from the uplift in value (despite not providing their services to the company). However, depending on the nature of the relationship, and if the company’s shareholders do not want to front up money for a buy-back of the shares, a company may decide the shareholder who no longer provides their services can keep their shares.  

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Reasons to Implement a Shareholders Agreement for an Exiting Shareholder

A company without a shareholders agreement is not protected from the actions of the shareholder who has stopped providing services to the company. The leaving shareholder may have assisted in producing intellectual property (IP), which the company needs to commercialise its business. It is important that the shareholder has assigned the IP to the company. This is so the company can legally claim that it owns all of its IP and that the IP does not belong to the previous shareholder. 

Additionally, you should clearly outline IP and confidentiality provisions in the shareholders agreement and the contractor or employment agreement between the shareholder providing the services and the company. Other important company protections to include are restraints of trade and confidentiality clauses. These clauses ensure that the leaving shareholder keeps the company’s secrets and does not use the information for their own benefit or the benefit of the company’s competitors.

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Key Takeaways

Depending on whether a company has a shareholders agreement, there are different rules for shareholders holding their shares in a company. There are also relevant exit procedures for these contracted shareholders. It is advantageous from a company perspective to have a shareholders agreement in place for these situations. You want to ensure the rules governing this process are clear. Further, you can detail the company’s ownership rights to IP that the contracted shareholder may have created in their role and to keep certain information confidential.

For assistance drafting your shareholders agreement, our experienced corporate lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 0800 005 570 or visit our membership page.

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