Shareholder Agreement

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

1.Dispute Resolution
2.Restrictions on Share Transfers
3.Outside Offer
4.Death
5.Short Term Disability
6.Long Term Disability
7.Management
8.Puts
9.Calls
10.Financing
11.Defaults
12.Employment
13.Management Companies
14.Key Players
15.Upkeep
16.Timing & Conclusion


--------------------------------------------------------------------------------

1. Dispute Resolution
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:

Who buys and who sells?

What the price is?

When does the sale take effect?

A standard method is the "shot-gun" provision. It works this way:

The first dissatisfied shareholder gives a notice to the other shareholder(s), naming a price per share.

The other must either buy the first shareholder's shares at the price or sell his/her shares to the first shareholder at the same price.

A time period is pre-set for a response to the notice, and the time until the sale takes effect is also pre-set.

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.

3. Outside Offer
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.

4. Death
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:

criss-cross insurance, where each shareholder owns coverage on the other shareholder(s), and the proceeds are earmarked for the surviving shareholder(s) to buy the shares of the deceased.

insurance owned by the company itself on the lives of each of the shareholders, so that the company will use the proceeds to re-purchase the shares of the deceased. Where shares are repurchased by the company, they are in effect eliminated, leaving the surviving shareholders with proportionately larger interests.

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:

the amount of life insurance proceeds available; or

reference to a value determined between the shareholders by agreement every year; or

a formula based on recent financial statements.

5. Short Term Disability
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.

6. Long Term Disability
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.

7. Management
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:

Unanimous Decisions

Elections of directors

Issuance of new shares

Sale of the entire business

Changes to share rights

Executive salaries and bonuses

Dividends

70% Majority Decisions

Expenditures on capital items in excess of $20,000 per item

Decisions to call on shareholders to lend to the company

8. Puts
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.

9. Calls
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.

10. Financing
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.

11. Defaults
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:

not carrying out obligations under the agreement

going bankrupt or being insolvent

permitting any creditors to attempt to seize one's shares.

Other events of default might include:

having one's spouse apply under the Family Relations Act for a portion of one's shares

ceasing to be a Canadian resident (under some circumstances, this could adversely affect the company's tax treatment).

12. Employment
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.

13. Management Companies
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.

14. Key Players
There are a number of people who are or should be involved in the creation of a shareholder agreement. These include:

Shareholders
Generally, all shareholders should be party to an agreement, although it is possible to omit, for example, non-voting shareholders.


Spouses
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.


Insurance Agents
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.


Lawyers
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.


Accountants
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.

15. Upkeep
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.

16. Timing & Conclusion
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:

we are too busy getting the business up and running (and anyway, we all get along really well)

we don't have the cash yet.

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.

Disclaimer: The information provided on Rikvin international is not intended to be legal advice, but merely conveys general information related to Shareholder agreement issue.