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E-Commerce companies – Specialist Shareholders agreements

Please note that the information herein is of a general nature and you should not act or refrain from acting on it without professional advice on the specific facts of your case. No liability is accepted by the author or Sykes Anderson Perry Limited in respect of this article. This is a basic outline only and is intended only as a general guide.

Shareholders agreements are very common in small to medium sized companies. They set out additional rights and obligations of shareholders in a confidential document. The shareholders agreement compliments the articles of association of the company which is the public document setting out the rules of the company. A standard shareholders agreement will not be suitable for fast growing e- commerce companies.

Key problem areas

  • When the company can be sold.
  • Investor shareholders
  • Directors duties
  • Valuation of shares

Company Sale

E- Commerce companies may be sold early on in their business cycle. This may be during the research and development phase and before the company has made any sales. A bigger company may recognise the value in the product being developed and buy the company to develop the product to market or use it itself. Some shareholders may want to sell the company others may want to keep the company and take the development to the next phase.

A suggested way to deal with this is by using drag-along rights. In simple terms, if a majority shareholder holding 70% of the shares in the company (for example) wishes to sell their shares to a third party outsider, the minority shareholders can be forced to sell their shares to the third party outsider. The minority shareholders will be “dragged-along” with the sale. These rights would allow the business to be sold without minority shareholders being able to prevent the sale.

Investor shareholders

Often shareholders will be passive and not working in the company. They may have obtained tax relief in respect of their investment which requires them to own the shares for a certain period of time. If the directors want to sell early so that the tax advantages are lost this may be opposed by the passive shareholders.

This can be dealt with by pre-emption rights. Often, investor shareholders will be minority shareholders, especially if they are seeking EIS or SEIS relief. These shareholders could be protected by pre-emption rights. Such rights mean shares must first be offered to the existing shareholders. The minority shareholders would have to refuse to purchase these shares before they could be offered to an external party.

Directors’ duties

Directors’ duties are set out in the general legislation but the shareholder agreement may contain specific provisions requiring directors to devote all their time to the company. There may be specific provisions about intellectual property developed by the company. The key point is that the directors will usually also be shareholders and it will be envisaged that the main source of value for them will be in their shareholding and not in their salaries. The other shareholders as well as the company will want to be able to take direct action against any director who may be prejudging the company. This may well involve shareholders getting an immediate injunction against an errant director. If you relied only on their director’s service contract as this is with the company and not the other shareholders only the company could take action.

The implications are important for passive investors who are backing the company. There is a danger that directors with high levels of technical expertise will leave and work for other businesses or set up new ventures on the back of the technology the company has developed.

Using restrictive covenants can potentially deal with this. For example, restrictions can be set so that, for a period of six months after the date that any director or shareholder who leaves the business, that person cannot solicit clients or employees of the business, or use any intellectual property which is owned by the business.

Having such provisions may encourage further investment in the company. Many investors would expect to see such restrictions in the company’s shareholder agreement so that their investment has some protection.

Valuation of shares

In many shareholder agreements there is a provision that if a shareholder leaves his shares are to be bought by existing shareholders or the company. This is very important in e-businesses as the existing shareholders may not want outside shareholders who may be linked to potential competitors to build a stake in the company and access inside information. Existing shareholders may not want the reasons for the exit of a director to become public or for outsiders to perform any sort of due diligence on the company.

The valuation of the shares will be a major issue if say the company has never traded. Most shareholder agreements provide that the shares are to be valued by the auditors of the company. Many valuation methods commonly used for other businesses are obviously not appropriate in a fast growing e- commerce business, where much of its value will be in its goodwill.

One accepted valuation method which is used for e-commerce is a multiple of earnings method. The net profit of the business for the last twelve months is taken, which is then multiplied to determine a value for the business. In many cases, the multiplier will be between 1.5 and 3.5, though there are always exceptions. A number of factors determine what the multiplier will be, including market conditions, business plan and scalability.

November 2017
David Anderson
Sykes Anderson Perry Limited