Shareholder Agreements: What You Need to Know
By: John Walker
Partner, HGR Graham Partners LLP
You are a shareholder in a corporation with a few other people who are friends and/or family members. In running the corporation to date, you have all agreed on the major decisions and the direction of the business. You have a general idea about what a shareholder agreement is but you have never bothered to see a lawyer about one because all of you get along and it seems like an unnecessary expense right now.
Does this sound familiar to you?
We deal with shareholder clients on a regular basis who do not see the need for a shareholder agreement. They tell us that a shareholder agreement in their case is not necessary because all of the shareholders get along and they have never had any sort of dispute about the operation of the business in the past.
The problem with this line of thinking is that these clients are failing to protect themselves, their investment and even the future success of their corporation from unexpected developments.
Why do you need a shareholder agreement?
A shareholder agreement sets out how the shareholders will deal with potential issues before they become problems and/or there is a falling out among the shareholders. For example:
- Have you given any thought about how major disputes or differences of opinion will be resolved when they arise? What happens if the other shareholders make a significant business decision that you do not agree with? What happens if there is a deadlock among the shareholders on a specific issue?
- Have you thought about what happens if one of the shareholders die? To whom will the shares of the deceased shareholder go? Are the other shareholders expected to buy those shares from the estate of the deceased? Will the shares pass on to the deceased’s family members? If the other shareholders can buy the shares from the estate, how will the purchase price be determined? How can the deceased know that his/her family will receive a fair price?
- What happens if you want out of the business but none of the other shareholders are prepared to buy your shares? Are you permitted to sell your shares to a third party? Are you entitled to have the first opportunity to buy the shares of a fellow shareholder if he/she decides to sell or can he/she sell to a third party at any time without notifying you beforehand?
What kind of issues can a shareholder agreement address?
There is no “one-size fits all” form of shareholder agreement – each shareholder agreement is unique and deals with specific issues related specifically to the shareholders of a given corporation. However, there are several issues that are addressed in most shareholder agreements since the majority of shareholder clients want to ensure certain items are dealt with. Here are a few issues that should be addressed in most shareholder agreements:
Shareholders should come to an agreement about how certain fundamental and important decisions can be reached. Will unanimous approval be required for important decisions (such as whether to take out loans from the bank, whether the corporation should purchase or sell significant assets or whether to provide a dividend)? Or can such decisions be made by a 51% majority (or by some other percentage approval)?
Shareholders should have a plan for how the corporation will be financed in the future. If money is to be borrowed from the bank, will all the shareholders be obliged to provide personal guarantees if the bank requests them? If bank financing is not the preferred method of financing, will all the shareholders be required to advance sums of money to the corporation to finance it or keep it afloat if the business takes a downturn? If shareholders are required to inject money into the Corporation, what happens if a shareholder refuses to pay his/her contribution? Can the other shareholders buy him/her out or will there be some other form of penalty?
Shareholders should consider if their shareholder agreement will contain non-competition provisions. Shareholders typically wants assurance that the other shareholders in the corporation will not be set up a business that is competitive with the corporation since they are all working together to have the corporation succeed. Similar provisions regarding the non-solicitation of customers and/or employees should also be considered and may prove particularly important if a shareholder leaves the corporation after a dispute.
A shareholder agreement should always address the issue of what will happen upon the death of a shareholder. Will the shares of the deceased be passed onto his/her family? Will the other shareholders be required (or have an option) to purchase the shares? Can the estate of the deceased shareholder sell the shares to a third party? How will the value of the shares be determined? How and when will the purchase price be paid? These are all examples of questions that are best considered and addressed before the shareholders are thrown into a situation where a shareholder has died. By having these issues resolved ahead of time, each shareholder will have his/her voice heard in the discussions, there will be a fixed process for the treatment of the shares and potential disputes among the estate and the shareholders can be avoided.
Shareholder agreements typically prohibit any shareholder from selling his/her shares to anyone else unless the sale is conducted in accordance with the agreement. The reason for this prohibition is that most shareholders do not want their fellow shareholders to sell their shares to a third party without prior consent being obtained. A shareholder agreement should contain mechanisms and a set procedure for the ways in which a shareholder is permitted to go about selling his/her shares.
Common provisions in a shareholder agreement relating to the transfer of shares include those dealing with:
- to whom a shareholder can sell his/her shares (it is common for the other shareholders to have the first opportunity to purchase shares put up for sale before they are offered to third parties);
- how the price of the shares being offered for sale will be calculated (for example, whether the price will be determined by a formula, by the accountant for the corporation or at annual meetings of the shareholders);
- how and when the purchase price will be paid (for example, will the purchase price be payable in cash on the closing date or will it be paid in equal annual installments over a period of several years); and
- whether the remaining shareholders will have a right of first refusal on an offer by a third party to purchase shares (it is not uncommon for the remaining shareholders to want to keep third parties out of the ownership of the corporation).
All of the uncertainty that can arise in the examples outlined above can be resolved by entering into a shareholder agreement before such issues materialize and become problematic. In addition, having a shareholder agreement in place when things are good will provide a set of rules that everyone will have to follow if the going gets rough and will help ensure the smooth operation of the corporation.
Protect Your Investment
A shareholder agreement not only establishes the ground rules for the relationship between the shareholders and their corporation, but it is also the fundamental basis for protecting a shareholder’s investment in a corporation. Without a shareholder agreement in place, shares owned in a corporation can be difficult to sell because of the lack of a formal sale mechanism and an agreed upon method for calculating a fair purchase price. In addition, a shareholder agreement can give a shareholder the comfort that his/her investment will be dealt with fairly in the future in relation to significant and issues and problems that may arise.
What many people fail to realize is that a shareholder agreement provides a mechanism for dealing with issues that may arise in the future when everyone is not getting along or something completely unexpected happens. The perfect time to negotiate and enter into a shareholder agreement with your fellow shareholders is when everyone is getting along and there can be frank and honest discussion about its contents. A shareholder agreement does not need to be referred to on a daily basis and the shareholders of a corporation can always unanimously agree on courses of action that may run contrary to what is provided for in the shareholder agreement. The true value of a shareholder agreement emerges when parties cannot reach an agreement on a fundamental issue or something unexpected occurs.
We like to tell our clients that the best shareholders agreement are those that sit in the bottom corner of your desk drawer and are never referred to since everyone knows the “rules”. Think of a shareholder agreement as a form of insurance policy – everyone hopes to never have to actually need it or be forced to use it, but it is there when an unexpected situation arises.
**This article is not intended to provide legal advice. For more information please contact HGR Graham Partners LLP
Phone: 705.526.2232 ext. 226