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ABOUT
SHAREHOLDER AGREEMENTS |
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INTRODUCTION
This article
discusses the uses of formal agreements between
shareholders of a private company and the company.
The term
"shareholder agreement" is used to describe
such agreements, although differences in scope of such
agreements means that the term is not really a hint as to
the contents of the agreement. Some only set out a method
of having one shareholder buy out another in the event of
a dispute. Others deal with the consequences of the death
of a shareholder. Others set out rules for determining
company policy and management. Yet others give certain
shareholders rights to acquire or dispose of shares in
certain circumstances. Often agreements combine all or
several of these aspects.
Shareholder
agreements are discussed under the following headings
Dispute Resolution
Restrictions on Share
Transfers
Outside Offer
Death
Short Term Disability
Long Term Disability
Management
Puts
Calls
Financing
Defaults
Employment
Management Companies
Key Players
Upkeep
Timing & Conclusion
Where
a bitter dispute arises between shareholders, it may be
that the only point of agreement is that they cannot both
continue in the business together. However decisions as
to who should leave, and the price of that person's
departure may be very difficult and time-consuming. In
addition, conflict between shareholders can cause the
business itself to lose value. This can result from
inattention to the business because of the dispute, or
because customers become aware of the dispute and decide
to find a supplier that they perceive to be less
volatile. Finally, resolving the dispute between
shareholders is likely to require either extended
negotiations or litigation - or both. This usually means
large bills for lawyers, business valuators and tax
specialists. It also involves a lot of time and stress
for the principals.
A
shareholder agreement can minimize both the time frame
and the costs involved. Typically a shareholder agreement
deals with dispute resolution by adopting one of several
possible methods of enforced share sales. These should
determine these points:
A
standard method is the "shot-gun" provision. It
works this way:
Other
methods may involve one shareholder having either the
right or the obligation to acquire the shares of other
shareholder(s) at a price based on a formula, or by a
third party. A formula could include a percentage of
gross (or net) revenues in previous financial periods or
perhaps a percentage of book value of assets. A third
party might be the company accountant, charged with
determining value according to pre-set criteria.
Alternately, it might be an outside person charged with
making a fair market value determination. 2. Restrictions on
Share Transfers In a publicly-traded company, neither the
management of the company nor the shareholders care very
much who owns shares at any given time (except where one
shareholder or a group have a control block of shares).
After all, being a shareholder in a public company does
not involve you in management decisions.
However,
in a small private company, the identity of shareholders
is very much an issue In effect, to the principals, the
company is almost like a partnership - and you want to
pick your partners, not have them imposed on you.
So,
most shareholder agreements contain provisions to deal
with this. A common provision is a right of first
refusal. This means that if a shareholder obtains a
commitment from an outsider to purchase shares, the
shares have to be offered 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
more severe restriction might be a complete prohibition
to sales to outsiders, but that may be quite unattractive
to minority shareholders.
A
middle course might be a pre-emptive offer. A shareholder
desiring to sell shares may be required 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 sharers for sale to
outsiders for another fixed period - but only on terms no
more favourable than the other shareholders were offered.
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.
Typically,
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
contributing to the business, and may need to replace
that person with a new shareholder. The family of the
deceased want to be compensated 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:
The
tax consequences of the two schemes differ. In the past
the second method provided a valuable tax saving
opportunity for the deceased, but not as favourable
treatment for the surviving shareholders. Now, the
situation is less clear because of 1995 changes to the Income
Tax Act, dealing with tax treatment of losses.
Generally,
the amount to be paid for the shares of a deceased
shareholder is determined by:
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. This provides some financial stability
for the disabled shareholder, but 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. In that
case, the company's obligation to keep paying salary will
normally cease on the same date the disability insurance
starts generating payments. An alternative is to have the
salary continue on a reduced basis where there is no
disability insurance.
Disability
provisions are usually structured to 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.
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. This benefits that shareholder by
turning shares for which a ready market may not exist,
into cash. It benefits the working shareholder(s) by
ensuring that profits do not have to be split with a
shareholder who is, in effect, no longer contributing to
the company's success.
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%. An example might
be:
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.
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.
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 amy
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.
When
loans are made to the company by institutional lenders,
shareholders may be required to sign "joint and
several" unlimited guarantees. This means that each
shareholder is personally responsible for 100% of the
amount owed by the company to the lender. Where one
shareholder is virtually without assets, this may mean
very little - you can't get blood from a stone. But the
other shareholder(s) should be concerned. For if one
shareholder does not cover a proportionate share of the
guarantee, the other(s) will be forced to pay more than a
fair share. It may be possible to negotiate with the
lender to either "cap" the guarantees at an
amount less than the entire indebtedness, or to make the
guarantees several but not joint so that each shareholder
is only responsible for a proportionate share.
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. There
are two reasons for the high rate. The first is to make
it more attractive for the defaulter to meet the
financial obligations, even if that means borrowing the
funds to do so. The second is to compensate the other
shareholder(s) for having to step in and put up more than
a proportionate share of the money.
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.
The reduction is that justified on the basis that it is
the defaulter who created the situation, not other
shareholder(s). The timing of a buy-out may well not suit
the other shareholder(s).
Events
of default usually include:
Other
events of default might include:
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.
In
some small companies, the principals do not own any
shares in the company at all. Instead, they control
personal (or family) holding companies which own shares
in the company which really runs the business. 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.
As
well, a number of additional provisions come into play.
Foremost is a restriction on the shareholdings of each
holding company. Without such a restriction, the shares
of a holding company could be sold by a principal to a
third party. The practical effect would be to defeat 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.
There
are a number of people who are or should be involved in
the creation of a shareholder agreement. These include:
Generally, all shareholders should
be party to an agreement, although it is possible
to omit, for example, non-voting shareholders.
Obviously, if spouses are
shareholders, they should be included in the
agreement. Like the other shareholders, spouses
should each receive independent advice. This
ensures that they have an opportunity to protect
their interests in the agreement. It also reduces
the likelihood of a spouse later challenging the
enforceability of the agreement on the basis that
the spouse did not sign voluntarily or failed to
understand the meaning of the agreement.
Most shareholder agreements that
deal with the consequences of death or disability
rely on insurance. It is essential to involve the
insurance agent in the preparation of those parts
of the agreement to ensure that the insurance
policies and the agreement mesh properly.
The complexities of shareholder
agreements are such that they should not be
drafted by the shareholders. In fact, only
lawyers with considerable commercial experience
should draft the agreements.
Unless the lawyer drafting the
agreement is also a tax expert, an accountant
with tax expertise should be involved in the
preparation of the agreement to ensure that the
tax implications are dealt with correctly. This
has a further advantage in that the accountant
will be familiar with the agreement and can raise
an alarm when changes to tax laws create a need
to change the agreement.
As
mentioned above, 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.
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:
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 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.
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