In this Legal Guide, Toronto business and franchise lawyer, Sukhi Hansra, discusses the key consideration of a shareholder agreements.
In previous Legal Guides we covered Different Types of Business Structures in Canada and explored the Advantages and Disadvantages of Incorporation.
What is a Shareholders Agreement?
A shareholders agreement is an agreement between the owners, or shareholders, of a company that describes how the company should be operated, the rights and obligations of the shareholders and the process for resolving disputes between shareholders.
Do You Need a Shareholders Agreement?
While there is no legal requirement in Canada for the shareholders of a company to enter into a shareholders agreement, it is generally a good idea to have a shareholders’ agreement wherever you have a company with more than one shareholder.
Shareholders agreements help ensure that the owners of the business are clear on issues of control, decision making, voting rights, exits and buyouts, and death or divorce. Having a shareholders’ agreement ensures that the owners of the business can focus their efforts on what’s most important, running a successful business, instead of spending their precious time and effort on resolving business disputes.
Key Considerations of a Shareholders Agreement
Shareholders agreements are very flexible documents that are created based on each unique business context. This means that the shareholders’ agreement of one company can differ greatly from the shareholders agreement of another company. However, the following is a list of a few key considerations that are consistent across every shareholders’ agreement, whether long or short, or whether there are a few shareholders or many:
- Decision Making and Dispute Resolution. Disagreements are common in business. Are decisions going be made by a simple majority (51%), a special majority (66% or 2/3rd) or unanimously (100%)? When shareholders have disputes about how a company should be managed, the shareholders agreement provides a clear process for resolving disputes and ensuring that there are no stalemates and delays.
- Buying, Selling or Transferring Shares. Since the transfer of any interest in a close-knit company can be a major event, it is important to have terms in place that are flexible enough to balance the interests of the company with those of the individual shareholders. What happens if a new investor is joining the company? What if one of the founding shareholders wants to sell their shares? Is the transfer of shares restricted or are there rules for how a shareholder can enter and exit the business? One solution could be a Drag Along clause. If two shareholders want to sell the business and one shareholder disagrees, a Drag Along clause can compel the disagreeing shareholders to sell their shares tin the company to the buyer.
- The Shotgun Provision. A Shotgun clause allows one shareholder to put a price on the table for the value of the business and leave it up to the other shareholder(s) to either take the money or buy the offering shareholder out of the business. Shotgun clauses are typically used as an exit strategy for shareholders when they no longer want to remain in the company, for example when there is a breakdown in the relationship between shareholders. Other exit clauses include a Piggy-Back clause, which entitles any shareholder to participate in the sale of any other shareholder’s sale of shares, and a Drag-Along clause, which allows a shareholder to compel the other shareholders to sell their shares to a third-party purchaser.
- Business Valuations. There are several methods of valuating your shares once a shareholder wants to exit. Is there a specific exit formula? What happens during a share buyout upon the death or disability of a shareholder – will the valuation be reduced? The typical belief is that if a shareholder cannot contribute to building value in the company, then the value of business is reduced in proportion to that decrease in contribution. Typical valuation methods for setting the price of shares are independent valuator, valuation formula, fixed price negotiated annually and Shotgun offer prices (See Point 3 above for more information about Shotgun clauses).
- Non-Competition Clauses. A Non-Competition clause simply means that a shareholder will not compete in the business of the company once they have exited. Non-Competitions are typically set to a certain period of time (1 – 5 years) and geographical location (i.e. Greater Toronto Area). Non-Competition clauses must be crafted carefully since the courts are unlikely to enforce an overly restrictive Non-Compete.
- Non-Disclosure and Non-Solicitation. Non-Disclosure clauses simply mean that the shareholder will not disclose confidential information about the company, which will help protect proprietary information about the company’s inner dealings. Non-Solicitation clauses prevent shareholders that leave the company from soliciting employees, customers or shareholders of the business. Small, privately held companies often have shareholders taking on some, if not all, of the duties of directors. Thus, such terms can be put in place to ensure that they do not abuse their powers if they eventually exit the company, and to ensure the protection of the corporation.
- Financing Liability. Banks will typically require the owners of a business to personally guarantee any money they borrow to operate or expand the business. A shareholders’ agreement can be structed so that any liability for borrowed money will be shared in proportion to each business owners’ shareholding within the company. While banks will usually go after every business owner, the bank will only be able to collect from the shareholder(s) who actually have money. However, the shareholders’ agreement can protect the shareholder that actually had the money and rightfully empower him or her to recover the share of financial liability from the other shareholders. Therefore, instead of one shareholder taking the brunt of the liability, every shareholder will share in the financial liability in proportion to their shareholding.
One of the benefits of negotiating a shareholders agreement is that in the process of doing so, the shareholders may gain a better understanding of the aims and direction of other shareholders and the business as a whole. This ensures that every shareholder is on the same page and that easily avoidable disputes can be handled in an efficient and timely manner.
Although these are great starting points to consider, shareholders agreements can get immensely complex and often must be structured to match each unique circumstance. Just as no two businesses are alike, no two shareholders’ agreements are alike either.
A good first step would be to speak to someone who has been through it, or someone who has had shareholders or helped other shareholders – such as an Accountant or Business Lawyer.