Shareholders' agreement in Saudi Arabia: what should it regulate before a dispute begins?

A shareholders' agreement is not just an extra document alongside a company's constitutional contract. Its basic job is to handle the relationship between the owners in the areas that need clearer regulation: who decides? Which decisions need special approval? What happens if a partner wants to sell? How is his share valued? And what happens if the partners reach deadlock?

The Companies Law allows the founders, partners or shareholders, whether during formation or afterwards, to conclude one or more agreements regulating the relationship among them or with the company, including how heirs enter. The Law provides that the agreement is binding, and it may become part of the constitutional contract or articles of association, provided it does not contravene the Law or the company's constitutional documents.

So the question is not only: do we have a shareholders' agreement? The more important one is: does the agreement address the decisions and positions on which the partners are actually likely to disagree?

This is one of the most important points to clarify.

A shareholders' agreement can be a stand-alone document, and some of its provisions can go into the company's constitutional contract or articles. But the Law requires that the agreement not contravene the constitutional documents.

The executive regulations also provide that if the shareholders' agreement becomes part of the constitutional contract or the articles of association, amending the agreement is subject to the formalities and quorum for amending the constitutional document according to the form of the company.

Practical analysis

We do not recommend putting a substantive provision in the confidential agreement and leaving the constitutional contract to say something different.

When drafting, each clause should be identified and the question asked: is it enough for it to be a contractual commitment between the parties? Or does its intended effect also need to appear in the constitutional contract or articles, with the relevant registration steps completed?

The Companies Law itself provides that the constitutional contract and articles of association, and their amendments, cannot be invoked against third parties before registration in the commercial register.

There is no single list suited to every company. An agreement between founders of a startup differs from one between two families investing in a company, and differs from a joint venture between two companies.

But in practice there is a set of questions to discuss before drafting:

The aim is not to write the largest possible number of clauses, but to handle the friction points expected in this particular company.

Two partners may own the company in equal proportions, but that does not automatically answer how day-to-day management works.

In a limited liability company, the constitutional contract or a partners' resolution determines how the company is managed and the majority needed where there are several managers or a board of managers. The constitutional contract must also contain particulars relating to management, partners' resolutions, assignment of interests and the distribution of profits and losses.

A shareholders' agreement can add a more detailed layer, such as specifying the ordinary operational decisions the manager may take and the fundamental decisions that require referral to the owners.

One of the most useful clauses is the definition of what are called in practice Reserved Matters.

That is, the agreement lists decisions that may not be taken without a certain level of approval, even if the manager can run the day-to-day business.

The matter may, depending on the company, relate for example to the entry of an investor, large borrowing, the sale of a fundamental asset, a change of activity, or signing a deal with a related party.

But this mechanism should not be drafted in a way that conflicts with the quorum the Law or the constitutional contract imposes.

For example, amending the constitutional contract of a limited liability company in principle requires the approval of one or more partners representing at least three quarters of the capital, unless the contract requires a higher percentage, while some specified decisions require the unanimity of the partners.

This is one of the issues that most exposes a weak agreement, years after the company was formed.

A company owned 50/50 by two partners may operate excellently for years, and then a fundamental decision appears that neither side can pass and neither wishes to withdraw.

If there is no clear mechanism, the disagreement may become: a stalled decision, then stalled management, then a decline in business, then a personal dispute, then litigation.

A shareholders' agreement can design a mechanism to handle deadlock, such as internal negotiation stages, referral of the matter to a higher level of decision-makers, or an agreed exit mechanism.

But drafting a deadlock mechanism is not simply copying a ready-made clause from a foreign contract; it must suit the form of the company, the ownership split, each party's financial capacity, and the provisions of the Companies Law and the constitutional documents.

Not always in the way the partner imagines.

For a limited liability company, if one of the partners wants to assign his interest to a person from outside the company, the Law set a mechanism for notifying the other partners of the name of the assignee or buyer and the terms of the transaction, and gave the other partners rights within the statutory procedures. Also, the transfer of ownership of an interest is not effective as against the company or third parties until it is registered in the commercial register.

So the shareholders' agreement should be consistent with this mechanism, rather than assume that any special clause permits bypassing the statutory procedures.

The Companies Law allows the constitutional contract of a limited liability company to include provisions which, after the approval of those representing at least 90% of the capital, provide two main arrangements:

The first enables the majority to compel the minority to accept a good-faith offer to buy all the company's interests on the terms and at the price applying to the majority's interests, which is close to what is known commercially as Drag-Along.

The second enables the minority to compel the majority to ensure the sale of the minority's interests when the majority sells its interests on the same terms and at the same price, which is close to what is known as Tag-Along.

Why is this point important?

Because it shows the difference between writing a general phrase such as "the majority may compel the minority to sell" and designing the mechanism the way the Law allows, with the document and approval required.

A large number of disputes do not begin with the question "will the partner leave?" but with: for how much?

A good agreement does not leave valuation until the relationship is strained.

The parties can discuss in advance the method of setting the value, the valuation date, whether the valuation is by an independent valuer or an agreed financial mechanism, and who bears the cost.

And in some cases the Companies Law itself provides for an accredited valuer to set the fair value where there is no agreement in specified circumstances.

What matters is that the valuation mechanism is not just the phrase "the interest is at market value", but that it is clear how, by whom and when that value is set.

One of the founders may think that owning a certain percentage of the company means he is entitled to the same percentage in cash at the end of every year, whatever the company's needs.

But there is a difference between profit arising in the accounts and the corporate decision to distribute it.

The Companies Law allows the relationship and the distribution of profits to be regulated in agreements and charters, but it also sets provisions for company resolutions, reserves and distribution of net profit according to the form of the company.

So the agreement can set a policy or agreed principles, but they should be aligned with the procedures and statutory resolutions needed for distribution.

Many founders' agreements are written as if the company will never need another riyal after formation.

Then, two years later, the company needs funding.

And here the questions begin: must all the partners fund? What if one refuses? Is the funding a capital increase or a loan from a partner? And will ownership percentages change?

These matters should be thought about before the funding crisis, taking into account the statutory provisions on capital increases and pre-emption rights according to the form of the company. In a limited liability company, the Law provides, when capital is increased by issuing new interests for cash, a priority for the partner in proportion to what he owns, within the framework the regulations set out.

This is not an issue only for family companies.

The Companies Law allowed the shareholders' agreement to regulate how a partner's heirs enter the company, whether in person or through a company they set up for that purpose.

This is a point to discuss when forming companies between individuals, especially if the company's success depends on particular people and not on capital alone.

A good agreement does not wait for a death before the other partners ask: do all the heirs now become partners with us? And what happens to management and voting? It handles the scenario in advance in a way consistent with the Law and the relevant documents.

The Companies Law gave family companies wider scope through the family charter.

The Ministry of Commerce has said that the charter can regulate family ownership, governance, management, employment policy, the hiring of family members, profit distribution, disposal of interests or shares, and mechanisms for resolving disputes.

So we do not recommend using an ordinary commercial Shareholders Agreement for a large family company without considering whether it also needs a Family Charter that handles the relationship between the family and the company across generations.

A partner may obtain, by virtue of his position, financial, commercial and strategic information not available to third parties.

At the level of a limited liability company, the Law itself gives a non-manager partner rights to inspect the company's business, records and documents, and in return obliges him to keep the information confidential and not use it in a way that harms the company or any partner.

A shareholders' agreement can build on this rule by regulating the management of information and confidentiality within the statutory limits, especially if some shareholders work in neighbouring sectors or hold other investments.

Competition restrictions should not be drawn broadly by default.

What is needed is to understand the nature of the company's business, each partner's role and whether there are other interests, then determine the commitments the relationship needs and assess whether they are sound under the relevant laws.

The Companies Law itself also sets duties on conflicts of interest and competition in different contexts according to the form of the company and the capacity of the person.

So we do not advise copying the phrase "the partner is prohibited from any similar activity within the Kingdom for ten years" from a ready-made form and assuming it is suitable and enforceable.

Exit must be designed at the beginning of the relationship, not only at its end.

The agreement can address the scenarios leading to a voluntary exit, a sale of a stake or a specified event, the notice mechanism, valuation, payment, and how continuing obligations are handled.

But one must distinguish between an exit agreed by contract and the forced "removal of a partner"; the latter differs by the form of the company, the statutory basis and the documents agreed.

The last clause in the agreement should not be "any dispute is resolved amicably and, failing that, referred to the competent courts" without thought about what that means in practice.

The relationship may need a defined negotiation stage, or mediation, arbitration or litigation, according to the nature of the parties and the deal.

For a limited liability company, the Law expressly allowed the constitutional contract to provide, except for criminal acts, for the settlement of disputes between partners or between the company and its managers by arbitration or other alternative dispute resolution.

If the parties choose arbitration, the clause should be carefully drafted and tied to arbitration and settlement services, not just add the word "arbitration" at the end of the document.

The best time is usually before one of the clauses becomes the subject of a dispute.

The agreement may be concluded at formation, when a new partner or investor enters, or when the existing relationship is restructured. The Law itself allows it to be concluded during formation or afterwards.

But trying to agree exit rules after one of the partners has actually decided to leave is a dispute negotiation more than partnership planning.

The absence of a shareholders' agreement is not the only problem.

Sometimes there is a forty-page document that does not fit the constitutional contract, the way the company is actually run, the ownership percentages, the authorities, the expected funding, or the way the investor exits.

In that case the agreement itself becomes a new source of dispute.

So the drafting of the agreement should start from: the ownership structure, then the parties' roles, then how decisions are made, then scenarios of disagreement, then funding, then transfer of ownership, then exit, then disputes, and then those relationships are translated into legal provisions consistent with the constitutional contract and the Law.