What Is The Importance Of A Shareholders Agreement?
If you have business partners, you need a shareholders agreement. And here’s why:
If you have a partner or several partners of your corporation, you will need a shareholders agreement. A corporation that has multiple shareholders is inevitably going to need an agreement that outlines what happens when one of those shareholders wants to leave the corporation, sell his or her shares, or take on more business partners. It also outlines what happens to one’s shares in the event of divorce, death or disability. At a basic level, a shareholders agreement sets out the rights, restrictions and obligations of each shareholder relative to one another, and sets out the rules of the game in the event of an exit or dispute.
If you are business partners with members of your family, you likely need a shareholder’s agreement even more. It’s difficult to anticipate what issues will come up, or what happens when one of the partners dies and his or her interest goes to their children. More contentious becomes the issue where one family member wants to sell, and the other wants to keep the family business for his or her children.
For these reasons, it is best to establish a structure of how to resolve various matters early on. Once a dispute arises, it is too late. A simple issue that could have been resolved with a shareholders agreement may quickly spin out of turn and end up before the courts costing all parties thousands in legal fees.
The importance of a shareholders agreement cannot be understated and is best illustrated with a common example:
You own a plumbing company with your partner Joe. Both you and Joe are plumbers and each work 30 hours a week for the corporation. Your business has enjoyed much success and profits roughly $400,000 a year. Each of your shares are worth approximately $200k a piece (using a basic valuation). Joe suffers through a divorce. The equalization of Joe’s net family property under the Family Law Act requires Joe to transfer $350,000 to his now ex-spouse Jill. Their marital home is encumbered by a heavy mortgage and Joe has little to no other assets. In order to satisfy the equalization claim, Joe is forced to transfer his shares in your business to Jill. Now you are in business with Jill. Jill is not a plumber.
You are in partnership with certain persons because of their specific skillset, whether that be by trade or by education. Or they are simply a great business person. A shareholders agreement could have protected your greatest asset – your business – by easily creating a clause that states the shares of the business cannot be transferred to one’s ex-spouse upon equalization. Simple and done.
The Five D’s: Death, Divorce, Disability, Divesture and Dispute
Shareholders agreements are said to target the 5 D’s – Death, Disability, Divorce, Divesture and Dispute. However, shareholder agreements can be complex and deal with much more than that. Shareholder agreements can cover a wide variety of topics including items such as:
1) the management positions and responsibilities of the shareholders;
2) the method for valuing the shares of the corporation;
3) the method for adding or removing shareholders for misconduct, death or inability to function in the management of the business;
4) the mechanism for valuation and sale of the whole business of the corporation;
5) the method for determining management salaries, bonuses and dividends;
6) non-competition and non-solicitation clauses to prevent a departing shareholder from taking a key part of the corporation’s business and thereby damaging the corporation and its remaining shareholders;
7) a buy-sell provision, sometimes called a “shotgun” clause, which permits a shareholder to offer to buy the shares of the other shareholders subject to the right of these other shareholders to the offering shares at the same price;
8) succession arrangements to spouses or the next generation upon death or disability of a shareholder;
9) life insurance on key management employees and shareholders;
10) the special majority or unanimity required for certain types of corporate decisions such as the sale of the whole enterprise of the corporation or commencing a new enterprise; and
11) dispute resolution including arbitration and choice of law provisions.
The five D’s can be summarized as follows:
If a shareholder dies, his or her shares form part of his or her estate which is then distributed to its beneficiaries upon probate. You are now doing business with your partner’s beneficiary which is something you may not have intended. A shareholders agreement can restrict the shares from forming part of a deceased shareholders estate and instead give the surviving shareholders a right to purchase the shares and provide the family with the cash equivalent of the shares instead of the shares themselves.
Upon divorce, a shareholder’s shares becomes part of the net family property to be equalized with his or her spouse. This could result in the shareholder’s ex-spouse becoming entitled to the shares of the business in the divorce. You are now in business with the ex-spouse and not your old business partner. What if the ex-spouse has voting control and decides he or she wants to sell the business? Your livelihood is now at stake. A shareholders agreement can restrict the ability of the shares from being transferred to a spouse upon divorce.
If a shareholder falls ill, becomes disabled or incapacitated, he or she will no longer be able to act as a director or officer or contribute in any way – yet he will still be entitled to the distribution of profits each year. A shareholders agreement will equalize and apportion the distribution of profits in the event one shareholder is unable to contribute to the business for a long period of time. In this sense, the distribution will be fair as between the active participating shareholder and the passive shareholder.
Divestment refers to the instance where one shareholder wishes to sell his or her shares and leave the business. Can she sell her shares to anyone or does she have to offer to sell her shares to the remaining
shareholders first? Further what if a majority shareholder and gets an offer from a prospective purchaser who wants to purchase the business – can you force the purchaser to buy your shares too? A shareholders agreement will cover this circumstances. It will also provide for a method of valuation of shares in the event one party wishes to sell or exit.
A shareholders agreement will set out the process to resolve disputes between shareholders central issues of the business, such as its name, marketing plan, its investors, its direction, whether it should amalgamate with another company, become a subsidiary or be sold off completely. Does one shareholder have a casting vote to tiebreak when there is a deadlock? Must you refer the matter out to private arbitration for a ruling? A shareholders agreement will address how to resolve disputes relating to fundamental aspects of the corporation.
Get the Shareholders Agreement
Without a shareholders agreement, your investment may be at serious risk. You may not be able to control who the other shareholders are, who you are doing business with, the direction of your business and even whether you can sell your business.
With years of corporate law experience, we can help prepare a comprehensive agreement that best suits the needs of your business. Shareholders agreements don’t need to be complex or lengthy and can be as short as five pages. However small or large your business is, a shareholders agreement will help ensure your greatest asset is protected. Our advice – get a shareholders agreement in place as soon as possible.
-Shira Kalfa, BA, JD, Partner
© Kalfa Law, 2018
The above provides information of a general nature only. This does not constitute legal advice. All transactions or circumstances vary, and specified legal advice is required to meet your particular needs. If you have a legal question you should consult with a lawyer.