The term "Shareholder Agreement" is used to describe formal agreements between shareholders of a private company and the company. These agreements can vary greatly in scope. Some simply set out how one shareholder may buy out another in the event of a dispute. Others deal with the consequences of the death of a shareholder, set out rules for determining company policy and management, or give certain shareholders rights to acquire or dispose of shares in certain circumstances. Often agreements combine all or several of these aspects.
Dispute Resolution
When a bitter dispute arises between shareholders, and it is agreed that they cannot both continue in the business together, decisions as to who should leave and the price of their departure, may be very difficult and time-consuming. Conflict between shareholders can be costly, as a result of inattention to the business because of the dispute, or because customers decide to find a supplier that they perceive to be less volatile. Resolving the dispute is likely to require extended negotiations or litigation - or both. This usually means large bills for lawyers, business valuators and tax specialists, as well as time and stress for the principals.
A Shareholder Agreement can minimize both the time frame and the costs involved, dealing with dispute resolution by adopting one of several possible methods of enforced share sales and answering in advance the questions of who buys and who sells, what is the price, and when the sale takes effect.
Restrictions on Share Transfers
In a publicly-traded company, neither management nor shareholders care very much who owns shares (except where one shareholder holds a control block of shares). After all, shareholders in public companies are not involved in management decisions. However, to the principals in a small private company, the company is almost like a partnership – and you want to pick your partners – so the identity of shareholders can be very much an issue. Most Shareholder Agreements contain provisions to deal with this.
One such provision is a right of first refusal, meaning that a shareholder obtaining a commitment from an outsider to purchase shares must offer the shares under the same terms to the existing shareholders for a specified period. If the other shareholders do not want shares to go to the outsider, they merely have to match the price. A complete prohibition on sales to outsiders is a more severe restriction, but that may be quite unattractive to minority shareholders. The middle course might be a pre-emptive offer, which requires a shareholder desiring to sell shares to send a notice to the other shareholders specifying the offer to sell. The offer must be kept open for a fixed period. If all the shares offered for sale are not purchased by the other shareholders, the selling shareholder then has the right to offer the remaining shares for sale to outsiders for another fixed period - but only on terms no more favourable than the other shareholders were offered.
Outside Offer
Sometimes an outsider will offer to buy 100% of a company, but not all the existing shareholders want to take the offer. A provision may be added to a Shareholder Agreement that those who do not want to sell must buy the shares of those who do want to sell, on the same terms as the outside offer.
Death
The death of a shareholder actively involved in a business creates problems on two fronts. The surviving shareholder(s) no longer have the benefit of the deceased’s contribution to the business, and may need to replace that person with a new shareholder. The family of the deceased want compensation for the deceased's interest in the business. The obvious solution is to provide a mechanism for the shares of the deceased to be sold to the company, the other shareholder(s) or a new shareholder.
The weakness with the concept of a simple sale of shares from the deceased is finding the money. Having just lost an active shareholder, neither the surviving shareholder(s) nor the company itself will have enough spare cash to pay for the shares. If the family of the deceased does not need a lot of cash right away, the problem may be dealt with by providing for a series of payments over a period of perhaps several years. In this case, there should be restrictions on the surviving shareholders to ensure that the payments are duly made.
If the family of the deceased is not able to wait for payments, it may be that life insurance provides the best solution. Two methods are commonly used. Criss-cross insurance is where each shareholder owns coverage on the other shareholder(s), and the proceeds are earmarked for the surviving shareholder(s) to buy the shares of the deceased. Insurance can be owned by the company itself on the lives of each of the shareholders, so that the company will use the proceeds to re-purchase the shares of the deceased. Where shares are repurchased by the company, they are in effect eliminated, leaving the surviving shareholders with proportionately larger interests.
Short Term Disability
Usually, agreements dealing with short term disability will provide for shareholders who are employed by the company to receive full salary for a number of months, even if unable to work, thus providing some financial stability for the disabled shareholder. However, this imposes a burden on the working shareholder(s). For this reason, many shareholders purchase disability insurance, so that a certain number of days after the disability strikes, the disabled shareholder will start to receive monthly payments from the insurer and the company's obligation to keep paying salary will normally cease. Where there is no disability insurance, the salary could continue on a reduced basis. Disability provisions usually ensure that a disabled shareholder cannot remain forever under short-term disability coverage by returning to work for brief periods between bouts of absence from work.
Long Term Disability
It is unusual for agreements to provide for continuing salary payments to a shareholder who is disabled for a long period. Instead, agreements may provide for a forced sale of the disabled shareholder's shares, benefiting that shareholder by turning shares for which a ready market may not exist into cash. The working shareholder(s) also benefits because profits do not have to be split with a shareholder who is, in effect, no longer contributing to the company's success.
Management
Particularly where there are more than two shareholders, or where there is a minority shareholder, provisions restricting management may be important protection for those who can be out-voted. Typically, the agreement will provide that certain decisions require unanimous approval and others a specified percentage in excess of 50%. For example, elections of directors, issuance of new shares, the sale of the entire business, changes to share rights, executive salaries and bonuses, and dividends might require unanimous decisions, while decisions such as expenditures on capital items in excess of $20,000 per item, or decisions to call on shareholders to lend to the company might require a 70% majority decision.
Puts
A "Put" is defined as the option of selling shares at a fixed price on a given date. In a Shareholder Agreement, one shareholder may be granted a Put which allows the shareholder to require one or more other shareholders to buy some or all of his/her shares at either a fixed price or a price determined by a formula. The Put may have a period of time before it can be exercised, or it may expire if not exercised before a specified date, or it may remain in effect virtually indefinitely.
Calls
A “Call” is more or less the reverse. It confers an option to buy stock at a fixed price on a given date. So, one shareholder may be granted the right to buy a certain quantity of shares from one or more of the other shareholders by notice, at a price that is either fixed or determined by a formula. The same comments about time made in relation to Puts apply.
Financing
Typically, agreements provide that the primary source of borrowing funds for the company will be institutional lenders (banks, trust companies, credit unions, and so on). However, if funds are required and cannot reasonably be obtained from conventional sources, the shareholders may agree to each personally lend the company a proportionate share of the amount required.
Where one or more shareholders is unable or unwilling to contribute the required amount, the agreement may provide that that shareholder is in default. This may allow the others to force the defaulter to sell his/her shares, often at a discounted value. As well, there may be a provision for another shareholder to make the loan that the defaulter should have made and charge a high interest rate to the defaulter for doing so.
Defaults
Normally, a Shareholder Agreement provides that certain acts or omissions by a shareholder are considered breaches of the agreement and result in special rights being conferred on the other shareholders. As noted above, financial defaults can result in interest being charged against the defaulter at a high rate.
Another common consequence of default is an option for the other shareholder(s) to buy the defaulter's shares. Often, the price is determined by a formula designed to approximate fair market value, but is then reduced by a percentage, which is justified on the basis that it is the defaulter who created the situation.
Events of default usually include: not carrying out obligations under the agreement; going bankrupt or being insolvent; or permitting any creditors to attempt to seize one's shares. Other events of default might include: having one's spouse apply under the Family Relations Act for a portion of one's shares; or ceasing to be a Canadian resident (under some circumstances, this could adversely affect the company's tax treatment).
Employment
In most small companies, the shareholders (or at least some of them) are also active employees. While written employment contracts for key employees are a wise idea (for reasons ranging from limiting exposure on wrongful dismissal suits, to protection of confidential information, to income tax), Shareholder Agreements often are used to set the ground rules for terms of employment contracts, particularly in relation to salaries and benefits. As well, there may be advantages to putting non-competition provisions in a Shareholder Agreement rather than in the employment contract.
Management Companies
In some small companies, the principals do not own any shares in the operating company at all. Instead, they control personal (or family) holding companies which own shares in the operating company. Reasons for doing this may range from tax implications to estate planning. Tax advice (as always) will be important.
From a corporate point of view, management companies add a layer of complexity to the Shareholder Agreement. The holding companies will be parties to the agreement, since they are the shareholders. The principals must also be parties. After all, all references to the death or disability of a shareholder have to be changed to death or disability of a principal.
A number of additional provisions come into play. Foremost is a restriction on the shareholdings of each holding company, without which the shares of a holding company could be sold by a principal to a third party, effectively defeating the concept that no change in players in the company should occur without existing players having a first option to take over the position of the player leaving the company.
Key Players
There are a number of people who are or should be involved in the creation of a Shareholder Agreement. These include shareholders, spouses, insurance agents, lawyers, and accountants.
Upkeep
Changes to tax laws may make changes to an agreement necessary. Adding new shareholders usually requires at least the signing of a document by which the new shareholder formally becomes a party to the agreement. Changes in the size of the company, its business, the financial circumstances of the shareholders, and other internal matters may justify at least a review of a Shareholder Agreement.
Where shareholders are required to decide annually on an agreed valuation of the company (usually to provide for a sale price where a shareholder dies or becomes disabled within the following year), a diary system may be critical to ensuring that the job is done regularly.
Security Interests
Shareholder agreements can also contain security interests. These are basically mortgages by the company in favour of the shareholders. The property charged by the security interest is the company’s personal property (property that is not real estate). The security interest secures all obligations of the company to the shareholder. Think of shareholder loans, dividends that have been declared but not paid, redemption amounts that have been claimed but not paid, payment for services provided by shareholders, and any other obligations.
Importance of a Shareholder Agreement
Most businesspeople starting up new companies agree that a Shareholder Agreement is important. Two reasons are put forward frequently for not putting the agreement in place at the beginning: “We are too busy getting the business up and running (and anyway, we all get along really well)”; and “We don't have the cash yet.” The first reason really doesn't hold water. Running a small business means you are always busy. So, if you don't have time to get around to a Shareholder Agreement at the beginning, face it: you won't later on. Ever. As far as getting along really well, that is the way almost all businesses start. Yet, like marriages, a significant number of small companies encounter disputes between shareholders. By then, the goodwill between shareholders has evaporated, and it is not possible to sign a Shareholder Agreement.
Shareholder Agreements serve a wide range of purposes. Every small company with more than one shareholder should have one. Really, the answer to the second reason for passing on a Shareholder Agreement is: You can't afford not to have one.
The discussion above is of necessity general. Shareholder Agreements can cover items not mentioned above and are capable of almost unlimited customization. Cardinal Law would be pleased to work with you on a Shareholder Agreement that fits your specific situation and needs.