The Value of a Well-Structured Shareholder Agreement
A shareholder agreement is a document that prescribes the guidelines that govern the relationship between a company’s shareholders, and may also govern the relationship between a company’s shareholders and the company itself.
Recognizing the importance of a shareholder agreement can go a long way in protecting business owners from unwanted and unnecessary conflicts as the business grows and circumstances change. Indeed, the lack of well-constructed shareholder agreements is a primary cause of shareholder lawsuits -- and typically turns close friends into bitter adversaries.
You see, similar to a marriage -- over time feelings may change, or relationship problems materialize. Sometimes trust becomes an issue. When emotions come into play it is very difficult to have objective discourse. A marriage contract in the case of a married couple, or a shareholder agreement in the case of two or more shareholders, provides a guideline as to the actions that can or must be taken -- thereby preventing emotions from creeping into the discussion, or at least into the solution.
A shareholder agreement generally targets one or more of the following goals:
- Ensures the ratio of shares between the shareholders can remain constant by preventing third parties from becoming shareholders without the consent of the original shareholders (the “buy-sell” provision).
- Ensures there will be a market for the company’s shares if one shareholder decides to sell his shares.
- Prevents the minority shareholder from being harmed by the decisions and schemes of the majority shareholder(s).
- Provides a mechanism allowing an unhappy shareholder to either be bought out or buy the shares of the other shareholder.
- Provides clarity with regard to succession planning.
- Determines whether the company and/or other shareholder(s) have the right to buy the shares of a deceased shareholder.
- Determines the rights and obligations of the company and other shareholder(s) in the situation where a shareholder becomes disabled.
- Determines the nature and breadth of the shareholders’ involvement in the administration and management of the corporation.
A buy-sell provision is often the main reason why a shareholder agreement is prepared. Is there a catch-22 situation that is impossible to resolve between shareholders? A Forced Sale (Shotgun) Clause can be included in order to force one shareholder to sell his shares to the unhappy shareholder, or to buy the shares of the unhappy shareholder, at a price set by the unhappy shareholder and upon conditions defined in the agreement.
Right of First Refusal
An association between two or more people who want to launch a business is usually built on confidence and trust. Having said that, what would happen, for example, if a shareholder wanted to sell his shares to a third party? Can he do it without consent of other shareholders?
To avoid this type of situation, it would be wise to include a Right of First Refusal Clause in the shareholder agreement, thus ensuring that the shares will be offered to the existing shareholder before being sold to a third party.
Right to Participate in a Share Sale
How can a minority shareholder protect himself or herself if a majority shareholder receives an attractive offer to purchase their shares? Who in such a situation would want to be submitted to the will of a majority shareholder, who he or she may not even know? To cover this situation, a Resale Right Clause (Tag-Along Provision) could be included in the Shareholder Agreement in order to force the purchaser to buy all of the company shares under the same conditions that govern the purchase of the shares of the majority shareholder.
Withdrawing from the Business
It is highly recommended that a Mandatory Offer Clause be included in the Shareholder Agreement. A Mandatory Offer occurs when a situation arises that requires a shareholder to withdraw from the company, even if he or she is unwilling to sell their shares.
What does withdrawing from the business entail? This is a broad concept that takes into account many situations, such as:
- One of the shareholders declaring bankruptcy or becoming insolvent.
- One of the shareholders retiring, violating a covenant not to compete, or defrauding or stealing from the company.
- One of the shareholders passing away or becoming incapacitated for a prolonged period of time.
In this type of situation, an offer to sell the shares of the withdrawing shareholder is automatically initiated and the company or the other shareholder will be able to unilaterally buy those shares. This type of clause enables the remaining shareholders to avoid, for example, being associated, against their will, with the heirs of a deceased shareholder.
Valuation of the Company’s Shares
The shareholder agreement must include a clause identifying the valuation method to be used in determining the value of the company’s shares in the event of a forced share sale. Here are some of the methods commonly used to determine share value:
- The agreed value: A value predetermined by the shareholders. This method has the advantage of being simple to apply and inexpensive.
- The book value: This method is also inexpensive to apply. It is for the most part based on the value of the company’s assets.
- The value as determined by a professional, such as an accredited appraiser.
The first two methods are the least expensive to apply, but they can harm the shareholder who relinquishes his shares. They also have the disadvantage of usually ‘under-valuating’ the company. The value of a company is usually greater than a predetermined amount or the sum of its assets. Some intangible factors are very important, such as expertise, competitive advantage, patronage, etc. The third method is generally preferred because it is based on fair market value, but it will lead to considerable fees for the shareholders or the company.
Financing Share Repurchase
A shareholder agreement should also include a method to finance the purchase price when the company is forced to buy back shares. The agreement can offer shareholders the best protection in the world, but if the company does not have the financial means to buy the shares, the protection offered will remain hypothetical.
A shareholder agreement can allow for a mechanism to pay for the shares by installments. This type of mechanism can, for example, stipulate that payments for a deceased shareholder’s shares be made by installments over five years. During that period, the estate would receive interest and payment guarantees and might even maintain rights over the company’s administration.
However, this method is not recommended, as it forces the estate and the acquiring company to ‘cohabitate’ for a long period of time and unduly delays the inheritance receipt for heirs of the deceased.
Financing the purchase price of the shares via a life insurance policy is a more favourable option. In order to do this, a life insurance contract generally needs to be taken on the life of each shareholder.
There are many methods to fund shareholder buy-sell provisions via a life insurance policy. This topic will be covered in another writing.
Tax Considerations of a Share Buyback
When a shareholder disposes of shares in a qualified small business corporation, he or she may be able to claim a capital gains exemption of approximately $825,000; however, the company will have to meet certain conditions in order to be eligible for such an exemption.
One condition is that at the time of disposition, at least 90% of the company’s assets must have been used to earn business income for the company. Secondly, in the two year period prior to disposition, at least 50% of the company’s assets must have been used to earn business income. If the value of immovable property or the investments (which typically earn passive investment income and not business income) held by the company compromises the above thresholds, the company could lose its eligibility for the capital gains exemption.
A rigorous estate plan will be needed and the company’s ‘passive’ assets, such as immovable property and investments, would often benefit from being transferred to a holding company.
A shareholder agreement is an essential tool when individuals join forces to start a company. It can be viewed as the corporation’s “marriage contract” and helps to define the parties’ rights if problems arise between shareholders. Understanding the terms of the agreement can minimize shareholder conflicts and help the company succeed through good times and bad times.
It is essential to consult a legal advisor to discuss the pros and cons of including some of the clauses mentioned above in a shareholder agreement.
Lastly, a shareholder agreement should be reviewed regularly to ensure that it continues to meet the main objectives of the shareholders who enter into it.
Call our office to learn more about shareholder issues and concerns. It is critical as well that you have your shareholder agreement reviewed by a corporate lawyer.