Starting a business, requires more than just a knowledge of the way of running the business. One must have an understanding of who owns what, who makes decisions, how the profits are divided and what would happen if one of the owners decided to leave. Many of these concerns can be dealt with in a Shareholders Agreement and a Partnership Agreement, but they are different in legal terms and can have very different implications.
The difference is important, as the agreement should be structured to match the legal structure of the business and not the language of the founders. Businesses can be informally referred to as a partnership, although they may be legally incorporated companies. Parties working under a recognised partnership structure, on the other hand, cannot just assume that a Shareholders Agreement is sufficient due to their view that they are co-owners. This is significant in the UAE as the corporate structure may differ for companies based in the mainland, compared with those set up in the Dubai International Financial Centre (DIFC) or the Abu Dhabi Global Market (ADGM).
Definition
What is a Shareholders Agreement?
A Shareholders Agreement is a private agreement between the shareholders of a company that regulates how the shareholders work together and sets out processes for some decisions made about the company. Can cover issues of voting rights, management, transfer of ownership interests, profit distribution, minority protection, deadlock and exit.
Some care needs to be taken with the terminology in the UAE. A Limited Liability Company (LLC)[1] is a company whose members are called the “partners” in the Commercial Companies Law, and their shares are called shares. The term Shareholders Agreement is widely used for an agreement between the owners of an incorporated company, whose ownership is represented by shares.
A Shareholders Agreement is not a substitute for the constitutional documents of the company. It operates alongside the Memorandum of Association and, where applicable, the Articles of Association. The agreement should therefore be framed accordingly and reliance cannot be placed on it for a change of something which is obligatory to be brought in the official record of the company.
What Is a Partnership Agreement
A Partnership Agreement is an agreement that governs the relationship between the partners in a partnership. It can define the contributions of each partner, management roles, profit and loss sharing, authority, transfer limits and withdrawal rights, and dispute resolution.
General Partnership Companies and Limited Partnership Companies are types of companies recognised by the UAE Commercial Companies Law. General Partnership is where two or more people are partners and each will be liable for the obligations of the company to the extent of their property. A Limited Partnership is a partnership made up of one or more General Partners with joint and several liability and one or more Limited Partners whose liability is in general limited to the extent of their capital contributions.
A Partnership Agreement should not be simply casual agreement between persons. It runs in the framework of the law in force to the specific partnership in conjunction with the constitutional documents and registration requirements.
Legal & Regulatory Framework
The main federal law on the mainland that regulates commercial companies is the Federal Decree Law No. 32 of 2021 on Commercial Companies. It will set up the framework for General Partnerships, Limited Partnerships, LLCs and joint stock companies.
Under this framework, liability is an important distinction. General Partners are personally liable to the extent of all their assets for all business obligations of the General Partnership. In a Limited Partnership, the liability of the Limited Partners is limited to the amount of their capital contribution and the liability of the General Partners is not.
Laws are also different in the financial free zones of the UAE. The DIFC and ADGM have their own corporate legislation and registration system. An agreement drafted for a mainland UAE entity should thus should not be similar to an entity incorporated in either jurisdiction. The applicable jurisdiction should be determined prior to drafting the agreement as the rules applicable to corporate structure, ownership and governance might be different.
The UAE’s foreign ownership policy has also undergone significant alterations. In most commercial activities for the mainland, 100 percent foreign ownership is now allowed, with the exception of activities which have strategic impact, which may still be subject to specific ownership or licensing requirements. The longstanding notion that the foreign investor typically needs to have a UAE national majority partner should, therefore, no longer be given as a general rule.
Therefore, it is crucial to consider the business activity and legal entity being proposed with the existing regulations.
Practical Explanation
Þ Liability
Practical differences between a company and a General Partnership include liability.
LLC partners are typically only liable for the amount of capital they contributed to the LLC. It is a legal entity that is distinct from the owners.
The exposure is far greater in a General Partnership. The partners are liable for the company in the full extent of their assets in relation to the company’s debts. This means that the financial liability of the partnership has a much smaller gap from the personal liability of the partners than an LLC.
A Limited Partnership offers an alternative risk distribution. General Partners are always liable and the Limited Partners are generally liable only in the proportion of their respective capital contribution. Restriction on participation in management also applies to Limited Partners, as the law also allows for circumstances in which management participation can have an impact on their liability.
Þ The Law of Legal Personality and Continuity
An incorporated company is a company that has its own legal personality. This enables the company to hold property, make contracts, and exist as a company even though there is a change in the owners, subject to the legal requirements.
The identity and status of the partners need more attention in partnership structures. The death, bankruptcy, insolvency or loss of legal capacity of a partner may result in consequences for the continuity of a General Partnership or Limited Partnership as per the UAE Commercial Companies Law unless the Memorandum of Association stipulates otherwise in accordance with the law. This is important in a Partnership Agreement, especially when it comes to succession.
This is not the case for an LLC. Unless the Memorandum of Association states otherwise, the death of an LLC partner will not automatically trigger the dissolution of the company. The law allows for the transferring of the share of the partner to the heirs.
Þ Ownership and Transfer
Transfers of ownership can be subject to regulation under both agreements, and the legal requirements are different.
A Shareholders Agreement may contain prevention rights, restrictions on transfer to third parties, rights of first refusal and procedure for a proposed sale. For an LLC, these contractual provisions need to also comply with the statutory requirements for the transfer of ownership interests and the partners register.
There may be further restrictions on partnership interests. The transfer of an interest in a Limited Partnership to a third party is subject to the consent of the transferor or to what is provided in the Memorandum of Association and the transfer shall be registered before the transferee is a partner.
The agreement should therefore not include a transfer mechanism that is not feasible under the applicable law and/or registration requirements.
Þ Management and Decision Making
Another crucial difference is management.
An LLC has one or more managers that manage the business in accordance with the constitution. The managers could be partners or third parties. If the LLC has more than one manager, it can have a board and specify its authority in the company’s founding papers.
A General Partnership is managed by the Partners unless the management has been delegated pursuant to the applicable law and constitution. Generally, Limited Partners in a Limited Partnership do not participate in the management of the business but do have certain rights of information and inspection as limited by law.
Thus, a Shareholders Agreement may often include provisions relating to voting, appointment of management positions and reserved matters, and a Partnership Agreement may need to include provisions which restrict powers of the partners to act on behalf of the partnership.
Þ What Each Agreement Covers
The two agreements are directed at different structures, but raise many similar issues of commerce. Neither should be copied from a ‘standard’ template and should be based on the relationship between the owners.
Ownership, voting rights, appointment and removal of managers or directors, reserved matters, dividend policy, transfer restrictions, pre-emption rights, minority protections, confidentiality, restrictive obligations, deadlock and exit arrangements are some of the matters that a Shareholders Agreement can cover.
If a company has minority investors, other contract provisions might be needed. These include rights to information, reserved matters subject to greater approval and protection form dilution. The specific protections will be based on the structure of the company, and the negotiating leverage of the parties.
A Partnership Agreement can include more focus on capital contributions, responsibilities of partners, authority, profit and loss sharing, withdrawals, drawings, additions of partners, transfers of partnership interests, withdrawal, death or incapacity and dissolution.
The agreement must also include provisions for deadlock when there is equal or substantially equal control by owners. A good deadlock clause should determine the result if the owners are unable to agree on a resolution which they must approve, and not cause the business to be unable to make decisions.
Þ Relationship with constitutional documents of the company.
One of the mistakes that is often made is that a Shareholders Agreement is effectively a standalone document that has no connection to the company’s constitutional documents.
Other constitutional documents, such as the Memorandum of Association, continue to be significant as part of the company’s legal structure. A private agreement shall be consistent with such documents and with mandatory provisions of the applicable law.
In the event that the parties agree to make a change in ownership, management or other action that would require formal corporate action or registration, then such corporate action or registration should also be required as part of the same transaction. An ownership or management change on the record from the relevant authority does not imply that the change has emerged as a result of a private agreement.
This is the same for a Partnership Agreement. It should mirror the real partnership structure and should not conflict with mandatory provisions which apply to this.
Key Considerations / Risks
The first risk is getting the agreement before deciding on the legal structure. Prior to choosing the contractual structure, the parties ought to agree on the mode of operation (company or recognised partnership).
The other danger is the adoption of an overseas template without an adaptation to UAE laws.
Failure to plan for exit is the third risk. Equal ownership can be challenging in a business when it is not working well, even if everything’s fine when the business is working well, if there is any disagreement between the parties about funding, management or future direction, it will be hard to maintain equal ownership. A stipulation should be included that specifies how the owner can get out of the agreement, the value of the interest and if there is a right or obligation of the other owners to buy it.
The fourth risk is that there is a lack of consistency between the private agreement and the constitutional documents and/or official records of the company. A person should not be described as an owner in an agreement in a way that contradicts the ownership information given by the relevant authority if not the required legal and registration steps have been taken.
Another potential pitfall is assuming that UAE free zones or ownership requirements apply, without verifying the jurisdiction and business activity. The UAE has no single corporate structure for mainland companies, DIFC, ADGM and all other free zones. Thus, the applicable law and licensing requirements should be determined in advance of the contract.
Conclusion
The decision as to whether to use a Shareholders Agreement or a Partnership Agreement will depend on the nature of the legal entity.
If a business is based on an incorporated company, a Shareholders Agreement can determine the relationship between the owners of the company and provide a supplement to the company’s constitutional documents. If the business is formed as a General Partnership or Limited Partnership, the relationship between the partners can be governed by a Partnership Agreement, under the framework of the relevant statute.
Therefore, there should be three questions to start the decision. Which legal arrangement is being employed, what jurisdiction is it under and how much personal liability are the owners willing to take. The terminology used by the founders to describe their relationship should not dictate the answer to those questions, which should dictate the appropriate agreement.
An ownership, management, profit sharing and exit plan is best done before the business is valuable or when the owners disagree. While no agreement is foolproof in preventing disagreements, a welldrafted contract can certainly help set up clear guidelines for how to handle disagreements before they get worse and costlier.
