Article by Jonathan Wright. Click here for homepage.
I’m a married lawyer without a prenuptial agreement.
I recommend them for clients, but I don’t press too hard. They imply marriage is transactional (it is for some, I know) but I’m a romantic. And yes, I’ll stake half of my TFSA on it.
You can’t say the same about a business. Businesses, even between friends or family members, are transactional. They involve the sharing of knowledge, capital contributions, control and profits. For this reason, I typically recommend shareholders’ agreements for all clients.
In this note I explain why.
First, control. Without a shareholders’ agreement, majority rules. The composition of the board of directors (which makes decisions on dividends and approves major agreements) is decided by the majority shareholder.
With a shareholders’ agreement, you may have clauses that dictate who will be on the board and how any vacancies might be filled. For example, a company with an equity split of 60/40 will often still have two directors: one nominee for each shareholder. A shareholders’ agreement can make this mandatory.
For more significant matters, such as purchases of large capital assets or loans of significant value, a minority shareholder may also argue for a clause in the shareholders’ agreement requiring unanimous approval among all shareholders. This gives the minority shareholder a say in important business decisions.
Put simply, shareholders’ agreements also dictate how a shareholder may buy or sell shares in the company.
Absent these provisions, the risks are clear. One shareholder could sell her shares to a third party, leaving the other shareholder with an unfamiliar new co-shareholder. A third party may wish to buy all the shares of the company, but the minority shareholder could stubbornly hold out. A shareholder with cash could also try and force a sale by a less cash-rich shareholder for an unconscionably low price. A number of provisions seek to prevent this.
First, rights of first refusal. In short, if a third party makes an offer to one shareholder, the other shareholder may first buy at that price, allowing him to opt out of an unfamiliar partner.
Next, the draw along. This provision requires a shareholder to sell his shares to a third party if he has opted out of his rights of first refusal and not purchased the shares of the other shareholder. Thus a shareholder in these circumstances is forced to either buy or sell and not hold out.
The piggyback is the reverse of the draw along. For the piggyback, the minority shareholder can hook himself onto a deal the majority shareholder has entered into. In short, the majority shareholder can’t sell her shares to a third party without the third party also buying the minority shareholders’ shares for the same price and on the same terms.
The shotgun is the nuclear option. A shareholder might use this as a last resort. For this illustration, assume 60/40 shareholdings (although it works under any circumstances). The majority shareholder presents a number to the minority shareholder (say, $600,000). At this time, the minority shareholder would have the option either to purchase the majority shareholder’s shares for $600,000 or sell her shares to the majority shareholder for $400,000 (with that number established by the ratio of shareholdings). Thus no shareholder should over- or undervalue her shares on a shotgun at the risk of being bought out at a discount or being forced to purchase at a premium.
Finally, there should also be clauses for repurchase of shares by the company on the occurrence of certain events such as shareholder resignation, default, physical or mental incapacity or death. For some of these (resignation or default), a discount on the value of the shares on repurchase may be in order. For others (incapacity or death) the repurchase should occur at fair market value.
There are a number of other important provisions. A shareholders’ agreement may stipulate how fair market value of the shares will be determined. It should also have non-compete and non-solicit provisions to protect the goodwill of the company while the shareholders own the company and for a period after they sell (usually two years).
If you are considering whether a shareholders’ agreement makes sense for your company or are looking for general tax or corporate advice, please do not hesitate to contact the author at email@example.com or 604.678.4459, or visit our website at wrightlegal.ca.