Canadian Association of Family Enterprise
By GRAHAM A. KNIGHT,
Corporate, Commercial/Trademarks Department
Tuesday June 13, 2006 – Shareholder Agreements
I purchased my first home in 1980. Since that time have been maintaining fire insurance. With the exception of some damage which occurred during the 1985 tornado in Barrie, I have never had need of my policy. Notwithstanding this I do not begrudge the premium payments over the years as they have provided me with security in the event of damage or loss.
Shareholder agreements are somewhat the same. Ask anyone who has had serious difficulties with fellow shareholders, and they will confirm that the time and cost involved in putting a shareholder agreement in place, at the outset, is significantly less expensive and stressful than dealing subsequently with accountants and lawyers when there is no mechanism regulating the rights and obligations as between the parties.
This paper addresses shareholder agreements. For those of you that carry on business in partnership, many of the themes addressed herein will be applicable.
Often businessmen approach a lawyer with a view of incorporating a corporation for some enterprise, or perhaps introducing a new shareholder on timelines that are very limited. Generally the business issue is front and centre and paper behind same is almost seen as a necessary evil which must be endured to get to the business at hand. For this reason, shares are often issued to the shareholders in a new corporation before a shareholder agreement is finalized. Generally all shareholders agree that having an agreement is a good thing, however often a considerable period of time will go by without the shareholder agreement being completed given that there are many pressing business issues at hand. This is the world we live in.
A shareholder agreement should be signed at the time shares are issued. In this manner, rights and obligations between shareholders are set in stone up front and the business is provided with a net should matters get ‘off the rails’ subsequently.
While many investors see the shareholder agreement as a mechanism which regulates relations between investors, a shareholder agreement is put in place for the protection of the company. If circumstances arise where shareholders who are active in the business are not getting along, it is very likely that the dispute between them will affect the performance of the business. Therefore, while understandings are reached as between investors by such agreements, they are primarily for the benefit of the corporation.
Time is money. Shareholder agreements can become expensive, particularly in circumstances where numerous shareholders are involved.
- Great time and expense can be saved in the drawing of a shareholder agreement if the following steps are followed:Contact your lawyer and ask for a checklist of matters that should be considered in the shareholder agreement. Review these matters with your fellow investors and provide your lawyer with notes as to how the group wishes to handle the various headings on the checklist. In this manner, when the lawyer commences work on your agreement he or she has a much better idea of where the investors wish to end up, and consequently less time is wasted.
- When a draft is received from your lawyer, make reviewing and response a priority. Shareholder agreements can be complex. Provisions contained with such agreements can be very important to investors should they ever become relevant. For this reason, particularly in circumstances where there are a number of investors, moving the shareholder agreement through the process quickly bears great advantage. From a lawyer’s point of view, if a draft is forwarded to a client, and no response is received for four or five weeks, the lawyer may be obliged to review the whole agreement again to get the structure clear in his or her mind before suggested amendments can be put in place. These comments are equally applicable to the investors who are viewing drafts forwarded. Set a date by which the agreement must be completed, and make the process of getting there a priority. You will obtain a better and more cost effective agreement.
Shareholder agreements are akin to wills to the extent that they endeavour to address relations between investors as they exist and as they are perceived at the time the agreement is drawn. Things can change over time. I suggest that shareholders review their agreements every two to three years to make sure that provisions of the agreements remain relevant. Sometimes in circumstances of dispute the parties find they have been conducting themselves in a manner which is not in accordance with the agreement they signed previously.
I generally recommend that both the accountant and insurer of the business be provided with an opportunity to review the shareholder agreement. At very least, it will let them know that one is in existence. There are times when the expertise these other professionals possess will yield significant improvements to the shareholder agreement which would not have been accomplished had these professionals not been aware that the process was underway.
While shareholder agreements are generally built by cobbling together precedents relating to the issues, in the end they should be a shoe that fits the foot of the investor’s business.
Below I have set out an number of topics that are normally included in shareholder agreements and provided some discussion of each.
1. The parties and recitals.
The shareholder agreement lists all parties that are involved in the shareholder agreement including the company and in the recitals (being those ‘AND WHEREAS’ sentences at the start of an agreement) there is a brief description as to who the parties are, and what they are trying to accomplish with the agreement. Recitals are particularly helpful to strangers who read the agreement subsequently. Somewhere in the agreement the recitals should be acknowledged to an accurate, and incorporated into the body of the agreement so same can be relied upon.
There may be more parties to the agreement than there are shareholders. From time to time it is advantageous for an investor to hold shares in the corporate vehicle. Generally the investors in a corporation do not particularly care how their fellow investors hold the shares so long as they can be assured the investors they are working with will stand behind and make good on the obligations of the corporate vehicle they use to hold their shares. For this reason, it is not uncommon for Mr. X’s shares being held in X Holdco, with Mr. X joining the agreement as a principal. Mr. X joins the agreement to unconditionally guarantee the performance of X Holdco and to covenant with the other shareholders that Mr. X will not convey ownership of X Holdco to third parties without following provisions of the shareholder agreement.
Often the shareholder is identified by name and the number and class of shares they hold stated in this section.
A shareholder agreement should stipulate that it covers all relations between the investors with respect to the business. While this may sound trite, all relations would include for example, include employment relations. If provisions of that nature are not included, a shareholder lawfully removed within the provisions of the shareholder agreement may still have a claim at law for wrongful dismissal, based on that investor’s capacity as an employee.
2. Management of the company
The section relating to the management of the company sets out how the company will be run from day to day and the number of votes that are required to change matters. Management of the company addresses the number of persons on the board of directors (and who has authority to nominate a director), the officers, signing officers, and the business the company will carry on. If one is investing in a company, implicitly part of the investment decision is based upon the perceived expertise of the other parties to the enterprise in the area of business contemplated. By stating the nature of the business, investors intending to sell computers are protected from the company suddenly building sailboats. This section also generally stipulates that there will be no significant changes to the articles of incorporation, by-laws and the like without a certain percent of votes being obtained.
It is my practice to include a statement with respect to the annual remuneration the investors will receive from their employment. I normally stipulate same as ‘nil’, unless a certain percent of the shareholders agree contrary. There is therefore incentive to agree, by contractual language which does not have to be amended every year.
3. Financial Matters
Often investors loan money to a corporation. It is helpful to have some agreed structure for the return of such loans together with interest that will be paid. I recommend that loans are evidenced by promissory notes, and that interest is either stipulated, or fixed by a majority of the investors. Sometimes investors will want provisions whereunder a certain percent of all after tax profits are allocated to reducing notes.
Whenever possible the amount that each shareholder loans to a business should be equal to the loans that the other shareholders are making. When loans are not equal, then risk is unequal. If risk is unequal, than the number of shares each shareholder holds should be unequal to accommodate the risk. Often there is quality, or near quality in share holdings, and hence both but inequality in the amount of money that has been advanced by one or more investors. This is not a healthy situation.
It is helpful in the financial section to also acknowledge the extent to which the company is indebted at the time the agreement is signed to the various shareholders. This avoids dispute at a later date.
4. Transfer and Allotment of Shares
Most business relationships involve a small number of people. Each investor is in the enterprise because that investor brings either money or expertise.
Bell Canada is not particularly concerned if you or I sell its shares to someone else. In a closely held corporation, it is very important to have the comfort of knowing that your partner cannot sell his shares to a stranger without your knowledge. Consequently, in this section of the agreement, the parties agree that no transfer of shares will be permitted unless it is in accordance with the agreement. It is in this section that the principals will warrant that they are controlling shareholders of the holding companies and they will not divest themselves to such controlling interests without operating within the parameters of the shareholder agreement.
5. Right of First Refusal
A right of first refusal allows existing shareholders to match an offer a third party may make to one or more of the existing shareholders, upon the same terms and conditions. Your lawyer will build the provisions with respect to notice, timing, and what occurs if a party defaults. Sometimes, when there are multiple shareholders, the rights of first refusal become more complicated, to the extent that those that do wish to buy (if less than all) have the opportunity to pick up a fair proportion of the shares.
When a shareholder sells, the agreement should require that debts owing by the parting shareholder to the company, or the company to the departing shareholder, be settled as part of the sale.
6. Buy-Sell (Shotgun)
Shotgun provisions are put in an agreement so that if a shareholder or shareholders wish to go their separate ways, their relationship as investors will terminate within a reasonable period of time. Shotgun provisions are seen to be a big benefit to a company as they tend to minimize the destructive impact that quarrelling shareholders may have on a company’s performance.
The timeline stipulated in the agreement should be short enough to minimize dislocation of business, but long enough to recognize arrangements for financing that may have to be made.
Shotgun provisions should be very carefully considered. Sometimes they may be simply unfair, particularly if one investor is considerably wealthier than another. Further, when a business enterprise commences, one would expect some level of commitment to see the project succeed. There are times that while buy-sell provisions are in the agreement, the parties agree that they cannot use them for a period of two or three years following the signing of the agreement. This is a method of the investors acknowledging that they are committed and will try to make the business work, in the short run.
As with first rights to refusal your lawyer will introduce methods of notice, timelines, and consequences should one party or another fail to live up to his or her obligations once the shotgun has been exercised.
7. Death by Buy-Sell
Provisions should be included in a shareholder agreement which deal with the death of an investor.
When same occurs, generally the estate wants to be paid the value of the deceased investor’s shares, and those continuing the business want control of the business. This however is not always the case and each enterprise should consider what works best for it. For example companies that are involved in more passive forms of business, like holding properties, may not particularly care if one or more of the investors passes on.
Shareholders should also consider whether the surviving shareholders ‘may by’ or ‘must buy’ the deceased shareholder’s shares.
As with right of first refusal and shotgun provisions, your solicitor will build in timelines with respect to when decisions must be made as to whether to purchase the shares or not and provisions with respect to valuation.
Some shareholder agreements require the parties to determine, annually, the value of the common and special shares in the capital stock of their corporation. While this is helpful, more often than not the process is overlooked.
Particularly in ‘must buy’ circumstances shareholders must be sure that they have the resources to purchase a deceased shareholder’s shares. Investors should contact their insurance agent with respect to obtaining policies to cover such circumstances.
Often, at the outset of the business, there is not sufficient value to warrant the cost of insurance. It is therefore not purchased. While this may work in the short run, shareholders should be vigilant to ensure that the value of the business does not get beyond the shareholder’s financial ability to purchase another investor’s interest.
8. Arbitration
Disputes will arise between investors. Often they are settled. Many shareholder agreements include a provision whereunder disputes must, at first instance, be mediated or arbitrated before resort to more formal legal remedies. Generally, while the quality of adjudication is better in the courts, the advantage of having disputes settled quickly and privately make such mediations/arbitration provisions very attractive. They have become a standard feature in shareholder agreements.
9. Marital Breakdown
An investor may get divorced. While this paper does not presume to touch upon family law, in very simple terms when people divorce, each party to the relationship calculates their assets and subtract their liabilities. The resultant number is compared as between husband and wife and the party with the higher amount of assets ‘equalizes’ with the party with the lower value of assets.
There may be circumstances where one has considerable wealth, but that wealth is not liquid. Land and shares are good examples of such circumstances.
Because of the foregoing, many shareholder agreements contain provisions which stipulate that should an investor be required to make an equalization payment, and is unable to do so without conveying shares, then the other investors have a right to purchase the divorced investor’s shares at fair value thereby providing the investors spouse with the payment the court requires while maintaining control of the corporation among the other investors.
From time to time you will see agreements which stipulate that should a divorce occur, the shares are deemed to be worthless or seriously discounted. A court will not tolerate this type of provision.
The marital breakdown provisions in a shareholder agreement are however counter productive unless they can provide the divorced shareholder with some incentive to carry on applying his or her expertise to the business. Specifically, it is unhealthy to have a situation where as a result of the divorced shareholder’s efforts, the value of his or her shares continues to increase and that increasing value makes it less and less likely that the divorced shareholder will ever be able to buy his shares back again.
To remedy this, some agreements stipulate that for a certain period of time (perhaps three to five years) the divorced shareholder may repurchase his or her shares at the same price the other investors purchased the shares for at the time of divorce.
As with death provisions some agreements are not mandatory in requiring the other investors to purchase a divorced shareholder’s shares. Often they are ‘may buy’.
10. Sale of Assets
Someone may approach a business and may offer to buy its assets. Let us suppose that some of the investors are keen on accepting the offer while others are not. Many shareholder agreements will contain provisions whereunder those who are not keen on selling the business can purchase the shares of those who are interested in selling upon the same terms and conditions that the shareholders interested in selling would have received from the buyer.
11. General Provisions
The shareholder agreement usually ends with general provisions which include where notices are sent, that time is of the essence and that the agreement expresses all understandings between the parties, etc.
It is important to appreciate that the shareholder agreement is drawn by the corporation’s solicitor. The corporation’s solicitor does not represent the interests or one or more investors.
Individual investors should be invited to seek independent counsel to review the agreement from their own point of view. I have found on a cost/benefit basis, it is often helpful to have a meeting with all shareholders present so anyone having questions or concerns can raise them. The company’s solicitor can explain the provisions and why they are included in the agreement. If people want to go beyond this, then they can retain a lawyer on their own.
The foregoing sets out a general format for shareholder agreements. As mentioned in this paper, an agreement should accommodate business relations that exist in your enterprise. Consequently, in some businesses there may be a number of other sections added to the agreement to address specific and peculiar concerns that relate to your business.
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The above is not intended to constitute
legal advice. Please contact a lawyer to clarify your
legal rights.
