As a minority shareholder, your rights will be limited. However there are a few basic protections you may consider asking for before you invest.
1. Protection against dilution
Make sure you understand the company’s plans for issuing shares in the future, and have these set out in the shareholders agreement. If possible, try to introduce caps or other restrictions on the company’s ability to issue shares without shareholder approval.
It’s unlikely that you will be able to negotiate a blanket prohibition on issuing shares. However you might be able to negotiate:
a right to participate in future fundraising rounds before shares are offered to others;
a requirement that the Board obtain shareholder approval before issuing shares outside certain defined parameters (for example, it might need approval to issue shares below a certain price, or to issue more shares than an agreed limit); and/or
a right to have your stake ‘topped up’ if future shares are issued below a certain value.
2. The right to appoint a director
You won’t have a right to be (or appoint) a director unless you specifically negotiate one.
Whether it’s appropriate for you to have such a right will depend on the proportionate size and value of your holding. It’s unusual for shareholders to be able to appoint a director unless they hold at least 10% of the company’s shares. The minimum threshold is usually higher.
Although being a director carries its risks, it will give you greater access to information as well as the ability to influence the company’s decisions. Also, there are a few things you can do to limit your exposure as a director if you decide to become one.
3. Rights to access information
Particularly if you will not be a director, your rights to receive company information will be relatively limited. If you require any regular reports from the company, or if you wish to be made aware of specific events, this should be reflected in the shareholders agreement.
4. Tag along and buy out rights
Typically, people invest in private companies based on their confidence in the existing management team. Consistent with this, minority investors will often seek protections against key personnel leaving the company.
For example, if the major shareholder(s) find a buyer for their shares, shareholders agreements often contain provisions that will allow the smaller shareholders to ‘tag along’ and participate in the sale.
In a similar vein, some shareholders will require the right to have their shares bought out if the founding shareholder(s) withdraws from the company or reduces their involvement.
5. Pre-emptive rights
Pre-emptive rights give the shareholders the right to buy another person’s shares before they are sold to someone else.
Pre-emptive rights effectively place limits on who can be involved in the company. They allow the existing shareholders to restrict ownership to themselves if that is what they wish to do. They can also allow the existing shareholders to prevent a particular person (or types of people) from being shareholders.
6. Limits on the Board’s control
A shareholders agreement will usually prescribe limits on what the board of directors can do without shareholder approval. In addition, the agreement might specify that certain types of approval are required for certain types of decision, the most common levels of approval being:
Simple majority of shareholders (50%);
Special resolution (75%, with the resolution passed according to the procedural requirements of the Corporations Act); and
Some other proportion of shareholders determined by reference to the make up of the share register.
The shareholders agreement might also give a shareholder or shareholders a right of veto over certain decisions.
7. Protections against breach
Shareholders agreements will often give shareholders express rights where another shareholder breaches the agreement.
For example, it might deprive the defaulting shareholder of certain information if it enters into competition with the company in breach of a restraint. It might give the other shareholders the right to buy the defaulting shareholder’s shares (potentially at a discount).
This article sets out some of the protections you should consider, but it obviously won't cover all of them.
If you'd like a basic overview of shareholders agreements, check out our FAQs or our post on what is covered by a shareholders agreement. If you’re wanting even more detail, we would encourage you to consider our comprehensive guide.
Our due diligence guide contains information about various other investigations that a prudent investor would normally undertake before committing to an investment in a private company.