When two or more partners decide to start up a company together, they are generally focused on issues involving getting the business up and running, such as obtaining financing, locating and servicing customers, finding suitable business premises, hiring employees, buying equipment, etc.
Shareholders often do not feel it is necessary during this start up phase to invest the time and expense in addressing issues such as restricting transfer of shares, death, disability or bankruptcy of a shareholder, dealing with an uncooperative shareholder, or getting out of the company when shareholders can no longer work together.
However, the expense of preparing a shareholders' agreement in the beginning may be far less than dealing with disputes that arise down the road when the mechanisms in place turn out to be inadequate. Shareholders' agreements are an effective means to address issues up front at a time when all shareholders are "on the same page".
This Lawletter will provide a brief overview of shareholders' agreements, including the advantages of having one in place and the matters dealt with in a typical shareholders' agreement.
Advantages of a Shareholders' Agreement
For all companies, the Nova Scotia Companies Act (or similar corporate legislation in other provinces) and constitutional documents of the company provide standard rules to deal with many of the issues commonly dealt with in a shareholders' agreement.
However, there are several advantages to using a shareholders' agreement:
- Shareholders are able to specifically tailor the agreement to meet their needs;
- A shareholders' agreement generally provides more flexibility with respect to changing arrangements between shareholders. It is easier to amend a shareholders’ agreement than to change the constitutional documents of a company;
- The Companies Act and the constitutional documents of a Nova Scotia company provide that many major corporate actions taken by the shareholders of a company can be legally accomplished by a majority vote of the shareholders. Depending on the action, this may be only a simple majority (50% plus 1) or a special majority (either 75% or 66%, based on when the company was set up). As a result, minority shareholders may have no say in how certain affairs of the company are conducted;
- The constitutional documents of a company are public documents filed at a central registry (in Nova Scotia, the Registry of Joint Stock Companies). This creates an obvious disadvantage in that shareholders may wish to keep certain aspects of their agreement amongst themselves private; and
- There are certain matters, which can be dealt with in a shareholders' agreement that may not be appropriately set out in the constitutional documents. These include allocating responsibility for conducting the day-to-day operational affairs of the company, responsibility for financial contributions of shareholders, distribution of profits, restrictions over who is entitled to hold shares in the company, dispute resolution and death, bankruptcy and incapacity of a shareholder.
Conduct of Affairs of the Company
A shareholders' agreement commonly deals with how the affairs of the company will be managed and who will make the decisions respecting these matters. Matters typically dealt with in shareholders' agreements in this regard are as follows:
- Directors - Issues addressed include: how many directors, how directors will be appointed and removed, quorums and notice provisions for directors' meetings, how to break deadlocks between directors and what decisions a director can make.
- Major Decisions - A list of important decisions affecting the company, which will require unanimous approval or a certain majority level of approval (e.g., 75% or 66%) of the directors or the shareholders. These can include such matters as declaration of dividends, issuance of additional shares, acquisition or disposal of property, major contracts, major capital expenditures and financing.
- Non-Competition Agreement - Shareholders may wish to agree they will not be involved in competing businesses.
These clauses commonly are applicable both while a shareholder is involved with the company and also for a reasonable period of time after the shareholder has ceased involvement in the company. They are also generally restricted both as to length of time and to a particular geographic area, so as not to be subjected to or challenged by a court as being a "restriction against trade".
A "financing" section is often included in shareholders' agreements to provide for how the company can raise funds. It can deal with such matters as preferred sources of financing (e.g., company to obtain financing from a bank before the shareholders being required to put up funds), requiring the shareholders to guarantee the indebtedness of the company, setting rules for loans by the shareholders to the company and remedies against shareholders who fail to contribute their requisite share (e.g., diluting their percentage interests in the company or paying a high rate of interest to those shareholders who do contribute).
The issue of distribution of profits of the company is a complex and often sticky issue. Careful consideration must be given to this issue by the shareholders up front and a shareholders' agreement is often the appropriate place to address it. If this is not addressed in the shareholders' agreement, profits are paid out as determined by the majority of the directors. A shareholders' agreement can address how profits are paid out to the shareholders (e.g., dividends, interest payments on shareholders' loans, repayment of shareholders' loans or bonuses). A desired mix for each company will depend partly on the nature of the contributions made by each of the shareholders and partly on tax considerations. The company's accountants should be consulted in addressing this issue.
Restrictions on Transfer of Shares
In a closely held company, the shareholders are generally actively involved in the business and operations of the company and, accordingly, will want to have some control over who becomes a shareholder in their company. Consequently, most shareholders' agreements make some provision for restrictions on the transfer of shares by shareholders, both while the shareholders are alive and after the death or permanent disability of a shareholder.
A common provision used in a shareholders' agreement to provide some control over the admission of new shareholders is commonly referred to as a "right of first refusal" or "pre-emptive right". These clauses normally provide that existing shareholders have the right to purchase the shares of a shareholder who wishes to depart before that shareholder can sell to an outside party. Commonly, the departing shareholder must have an offer from a third party "on the table" before he can approach the remaining shareholders. In other cases, the departing shareholder may approach the remaining shareholders first without the necessity of having a third party offer "on the table". Sometimes, the remaining shareholders may choose or be required to also sell their shares to an offering third party. These provisions can be tailored to fit a particular group of shareholders' needs.
Other clauses which are sometimes seen in shareholders' agreements with respect to transfer include "compulsory buy-out" provisions which allow one shareholder to compel the company or other shareholders to purchase his/her shares, in the event certain triggering events occur. These triggering events may also allow the remaining shareholders to buy out another.
"Shotgun" clauses are sometimes utilized which provide that a dissatisfied shareholder can put an offer to the remaining shareholders to either buy all their shares or to sell his shares, generally at the same price. The remaining shareholders then have the option to either buy out the dissatisfied shareholders or sell all their shares to him/her. Obviously, this clause is a last resort remedy in the event that the shareholders are no longer able to continue in the company together.
The biggest concern with "compulsory buy-out" and "shotgun" clauses is arriving at a fair value of the shares. This can be done by allowing a third party to do so (e.g., the company's auditors or some independent arbitrator), or by using a formula such as book value, fair market value or based on earnings.
Sale of Shares on Death
Shareholders' agreements commonly provide for the transfer of shares on the death of a shareholder. They are designed to ensure that the shares do not go to the heirs of the deceased shareholder or alternatively, that the interest of a deceased shareholder in a company is purchased from his/her estate at a fair price. A properly drafted shareholders’ agreement is an important part of estate planning for any business owner.
Similar concerns exist on death of a shareholder as with "rights of first refusal" and "compulsory buy-out" clauses - there is a potential for hardship or inconvenience on the remaining shareholders to come up with a purchase price for the deceased's shares which may threaten the viability of the company. In order to alleviate this, various methods are used, including purchasing life insurance policies on the life of each shareholder to fund the purchase of the deceased shareholder's shares, spreading the payment of the purchase price over a period of time, or having the company involved in the purchase of the shares.
Shareholders can also deal with many other matters in a shareholders' agreement. These can include bankruptcy of a shareholder, valuation provisions for shares by an independent third party in the event of a forced or voluntary transfer of shares; dealing with rights that shareholders’ spouses may have under matrimonial property law with respect to the company's shares and terminating the shareholders' agreement upon the occurrence of certain triggering events. The possibilities are limited only by the circumstances and imagination of the shareholders.
A properly drafted shareholders' agreement serves a number of purposes. It can help amicably resolve disputes that might occur down the road by focusing the shareholders' minds on potentially divisive issues early on and by providing a dispute resolution mechanism for disputes when they arise. Dealing with such issues up front can also help promote the relationship of trust and confidence between the shareholders that is essential to the survival and success of a small company. Finally, it can allow the shareholders to focus on the business of building a successful company rather than wasting valuable time and money on organizational disputes.
This information has been provided for general reference only. For advice on an actual matter, you should consult a lawyer. To contact a member of our team call us at 902-469-9500 or 1-866-339-3400 or contact us online to make an appointment.