A shareholder agreement is a contract between some or all of the shareholders of a corporation that outlines the details of how the business will operate. It generally deals with issues such as roles of the shareholders in the business, profit and loss sharing mechanisms, dispute resolution, and share transfers in the case of death or disability. They also may include contractual obligations between the shareholders and the company such as non-competition covenants, confidentiality agreements, and obligations to purchase shares in the case of death or disability of a shareholder. This post aims to explain the major issues addressed in a shareholder agreement in order to provide a better understanding of the document and how it may help your company. It is important to remember that each company is unique and comments made below are not legal advice.
a) Conduct of the Affairs of the Company
Many aspects of conducting the affairs of the company may be included in the Article of Incorporation. In fact, some aspects are required to be in the Articles if they are to be effective. However, the Articles are a public document whereas the shareholders agreement allows a company to go into greater detail without revealing to the public how the company is managed.
One major issue often addressed by the “Conduct Affairs of the Company” section in a shareholder agreement is protecting minority shareholders from being excluded by majority shareholders. If one shareholder has a majority interest (anything above %50), that shareholder has the power to outvote the minority and unilaterally determine the direction of the company by determining the number of directors and who will act as director. In order to protect the interests of a minority, a shareholder agreement can predetermine the make up of the board of directors to ensure the minority shareholder has adequate representation. For example, allowing each shareholder to nominate a member of the board may be an effective way to balance majority interests because each board member has one vote rather than a percentage of ownership like the shareholder. A shareholder agreement can also include quorum requirements or unanimous board approval for the transaction of business to ensure a minority interest is reflected business decisions.
There may come a time in a company’s existence where more money is needed to finance expansion or profits are ready to be distributed. A shareholder agreement can provide clarity as to the rights and obligations of a shareholder in these circumstances. With respect to borrowing money, a shareholder agreement can stipulate whether the company must try to obtain funds from an institutional lender prior to turning to the shareholders. Also, it can dictate whether shareholders are obligated to advance funds and if so, how those loans are to be repaid. With respect to distribution of profit, a shareholder agreement can include a statement that distribution will occur after a board resolution showing adequate reserves are held to honour all agreements, the frequency of distribution and any priorities that may exist (eg. repayment of loans).
c) Restrictions on Transfer of Shares
Generally, the Articles of a company contain minimal provisions regarding share transfer, such as approval by the board, but they do not place any other restrictions on transferring shares, thus putting a shareholder at risk of sharing ownership with an unwanted party. The three common ways to mitigate this risk are the right of first refusal, piggyback and draw along rights.
The right of first refusal allows the existing shareholders an opportunity to buy the shares of the selling shareholder prior to those shares being made available to an outside buyer. This can be accomplished in one of two ways. First, the shareholder wishing to sell shares can make an offer to the existing shareholders stating the number of shares available, the price, and the terms and conditions of the sale. Alternatively, the selling shareholder can go out into the market and obtain an offer for the available shares and presenting the existing shareholders with that offer. The existing shareholders have a right to purchase the shares for the stated offer prior to sale to the outside party. The shareholder agreement should stipulate time frames for acceptance of the offer in either circumstance. It should also state whether the existing shareholders are required to buy all of the shares offered or just a portion. This last point is important because it may allow an existing shareholder to obtain a greater percentage of ownership or create a majority interest without having to purchase all of the shares for sale.
Piggyback rights are a condition that may attached to shares when there is a majority shareholder that owns more than 50% of the shares of a company and that shareholder wishes to sell. Piggyback rights are enacted when a majority shareholder receives an offer from a third party to purchase the entire interest of his/her shares. If included in the shareholder agreement, they allow the other (minority) shareholders to “piggyback” on the offer and sell their shares for the same terms and conditions set out in the third party offer. The piggyback is not usually mandatory but it protects the minority shareholder from being under a majority they may not wish to partner with. It also prevents the majority shareholder from reaping the benefits of a lucrative sale without affording the same benefits to the minority shareholders.
Draw Along rights are similar to piggyback rights except they empower the majority shareholder to force a sale of the minority shares. If a majority shareholder obtains an offer from an outside party to purchase the entire majority interest of shares and the other shareholders do not enact their rights to buy the shares under the right of first refusal, the majority shareholder can force the other shareholders to sell their interest in the company for the same terms and conditions accepted by the majority shareholder. The purpose of this clause is to make the potential sale of a majority interest in a company more attractive to potential buyers because they can obtain complete control and ownership rather than simply a majority interest subject to the existing arrangements with the minority shareholders.
d) Shotgun Clause or Compulsory Buyout
The shotgun clause is often a last resort when shareholder disputes become unresolvable. The shotgun clause allows a shareholder to present an offer to force the remaining shareholders to either buy all of the offering shareholders shares at fair market value OR sell the remaining shares in the company to the offering shareholder. The shareholder that enacts the clause determines the fair market value and terms and conditions of the offer. The remaining shareholders are protected from unreasonably low offers because they are the ones who determine whether to buy or sell. If an offering shareholder sets the price too low, he/she will have to sell the shares for the low price. In some cases, the shareholder agreement will want to address how minority interests are protected during the time between when the offer is made and when the sale is complete. For example, if a minority interest enacts the shotgun clause, it may be a good idea to have a clause placing a restriction on issuing dividends to prevent the majority shareholder from reducing the cash flow of the business after the clause is enacted but before the sale is completed.
e) Shares Transfers on Death
This may be one of the more important areas of a shareholder agreement because it plans for the unexpected case of death of a shareholder. Without a shareholder agreement, the death of a shareholder may leave a close relative or spouse assuming control of the shares to the dismay of the existing shareholders. By planning in advance, a shareholder agreement will outline a method for a mandatory sale of the shares either back to the company or to the remaining shareholders at fair market value (determined immediately prior to death). The agreement may also require the company to carry insurance for its shareholders in order to cover the cost of buying shares should a shareholder die. Another type of insurance companies might carry is key person insurance which allows them to go into the market and replace essential personnel in the case of death. It is important to consult with a tax specialist when determining how the shares of the company will be transferred in the case of death because there are different estate and income tax issues that need to be addressed.
Becoming a shareholder in a corporation brings with it certain expectations from the other shareholders with respect to running the business. What happens when a shareholder fails to live up to those expectations? Absent a shareholder agreement, there are few legal remedies available under the BCA and at common law to address the situation when a shareholder fails to fulfill the obligations of the shareholder agreement. Some common circumstances of default are a creditor attempting to fulfill a judgment by seizing shares, failure to comply with a separate employment contract, or becoming incapacitated. A shareholder agreement will provide the defaulting shareholder with an opportunity to remedy the default. If it is financial, the other shareholders may remedy the default in the form of a loan to the defaulting shareholder with a high interest rate. If it is not financial, the agreement may outline a method for selling the shares of the defaulting shareholder to the remaining shareholder.
g) Non-compete covenant
In some cases, a shareholder agreement will contain a covenant to prevent the shareholders from engaging in business that directly competes with the corporation both while they are shareholders of the corporation and after they leave. While it might seem like a good idea, the enforceability of these covenants is not always straightforward. Whether or not a covenant to not compete will be upheld depends largely in how it is drafted. In a commercial context, a court will examine the geographic reach of the restriction, the period of time for which it is effective, and the extent of the activity that is prohibited in relation to the specific business at issue. There is a presumption of freedom of contract but a court will not uphold a covenant not to compete if it is unreasonable in the specific circumstances. Furthermore, if the covenant is drafted in an employment context (if a shareholder is also an employee), there may be different factors that will affect the enforceability of a non-competition clause.
I hope this post has given you a better understanding of shareholder agreements and how they can benefit your company. Discussing the issues upfront and establishing clear guideline at the outset when everyone is getting along could save money down the road when an unexpected event arises or relationships break down. The issues presented here are generalizations and do not address specific situations. Also, this post is not intended to be legal advice. It is important to discuss with a lawyer how a shareholder agreement can be tailored to fit your company’s needs. For more information please contact www.selkirklaw.ca