Shareholders agreement vs company constitution

People setting up a company often hear they need a constitution, a shareholders agreement, or both, and are not sure what the difference is. The two documents do related but distinct jobs. Understanding the difference helps you decide what your company actually needs. This guide explains both.

The two rulebooks of a company

A company is run according to rules, and those rules can come from three places. The Corporations Act 2001 (Cth) contains a set of basic default rules, called the replaceable rules. A company can replace or add to those with its own constitution. And the owners can sit a private contract, a shareholders agreement, on top of both.

The simplest way to hold the distinction is this. The constitution is the company's public rulebook, governing the company itself. The shareholders agreement is a private contract between the owners, governing how they deal with each other. They overlap, but they are not the same thing, and they are not interchangeable.

What a company constitution does

A constitution is the internal rulebook of the company. It governs the mechanics of how the company operates, such as how directors are appointed and removed, how meetings are called and run, how shares are issued and transferred, how dividends are declared, and the powers of the directors.

A company does not have to have a constitution. If it does not, the replaceable rules in the Corporations Act apply by default. Many small companies start on the replaceable rules alone. The problem is that those rules are thin and generic, and they were never designed for the specific deal between a particular group of owners. A tailored constitution fixes the mechanics to suit the company.

A constitution has one important feature. It binds the company and all its members as a matter of company law, and it is not private in the way a shareholders agreement is.

What a shareholders agreement does

A shareholders agreement is a contract between the shareholders, and usually the company as well. It governs the relationship between the owners, and it deals with the things the constitution typically does not, especially what happens when the owners' interests diverge.

A shareholders agreement typically covers how major decisions are made and which ones need special approval, what happens if an owner wants to sell, including pre-emptive rights, how a departing owner is bought out and how their shares are valued, drag-along and tag-along rights on a sale, what happens to a founder who leaves early, how disputes and deadlocks are resolved, and often restraints and confidentiality. There is a separate article in this series on why a start-up needs a shareholders agreement.

Crucially, a shareholders agreement is private. It is a contract between the parties and is not a public company document, which is one reason owners prefer to put the sensitive commercial terms there rather than in the constitution.

How they interact, and which prevails

Because both documents can deal with overlapping subjects, a well-drafted pair will say how they fit together. It is common for a shareholders agreement to provide that, as between the shareholders, the agreement prevails over the constitution if the two conflict, and for the constitution to be drafted consistently with the agreement.

Getting this right matters. We sometimes see a company with a shareholders agreement and a constitution that contradict each other, usually because they were prepared at different times by different people. When that happens, which document wins can become its own dispute. The two should be prepared, or at least reviewed, together.

Which does your company need

For a sole-owner company, a tailored constitution is often enough, and a shareholders agreement has no one to be an agreement with. For any company with more than one owner, our view is that you want both. The constitution sets the company mechanics properly, and the shareholders agreement governs the relationship between the owners and deals with the situations that actually cause disputes, like exit, valuation, and deadlock.

The cost of doing both at the start is modest compared with the cost of a dispute later between owners who never agreed the rules. This is one of those areas where a little money and thought early saves a great deal later.

How we help

We prepare tailored constitutions and shareholders agreements, and we make sure the two work together rather than against each other. For a new company with more than one owner, we usually recommend both, set up at the same time as the company and the share structure, so the rules are clear from day one. If your company has one document but not the other, or has both but they were never reconciled, that is worth a review.

Frequently asked questions

Is a constitution the same as a shareholders agreement? No. A constitution is the company's public rulebook governing the company. A shareholders agreement is a private contract between the owners governing how they deal with each other.

Does my company have to have a constitution? No. Without one, the replaceable rules in the Corporations Act apply. But those rules are basic, so a tailored constitution is usually better for any company with more than one owner.

Do I need both documents? For a company with more than one owner, usually yes. The constitution sets the mechanics, and the shareholders agreement governs the owner relationship and the exit and dispute scenarios.

Which one prevails if they conflict? A well-drafted shareholders agreement usually provides that, between the shareholders, it prevails over the constitution. The two should be drafted to fit together.

Keep reading

• Corporate and commercial law
• Why your start-up needs a shareholders agreement
• How to set up a company in Australia: step by step

This article contains general information only and is not legal advice. For advice about your situation, please contact us. Liability limited by a scheme approved under Professional Standards Legislation.