I talk to a lot of business people about incorporating their businesses. Sometimes I talk them out of incorporating – it isn’t always the right choice for financial or other reasons; but with those who decide to go ahead, I always raise the importance of having a shareholders’ agreement.
When incorporating a company that will have two or more shareholders, you should carefully consider the importance of entering into a shareholders’ agreement.
Usually, a shareholders’ agreement deals with a wide range of subjects including aspects of the day-to-day operation of the business, admitting new shareholders, and the approvals required before spending money, but to my mind, the most important are the provisions dealing with dispute resolution and the transfer of shares.
Why is a shareholders’ agreement important?
To my mind, shareholders’ agreements are a lot like marriage contracts. I often comment that you will never have to look at your shareholders’ agreement as long as all of the shareholders are getting along. As is the case in a marriage, you only look at your contract if you can’t resolve an issue.
Negotiating the contract is a very enlightening process – if you can’t agree with the other side, whether that person is going to be your fellow shareholder or your spouse, you won’t be able to agree if your relationship sours in the future. Agreeing on how disputes will be dissolved can save you a lot of grief in the future.
The shotgun clause.
Shareholders’ agreements often include a clause that allows shareholders to force one of their group out of the company. That is usually referred to as a shotgun clause. A shotgun clause allows a shareholder (or group of shareholders) to offer to purchase the shares of another shareholder on terms spelt out in the offer. A shareholder who receives that offer will have three choices:
- Accept the offer and sell his or her shares on the terms set out in it;
- Reject the offer and instead buy the shares of the other party on the same terms and conditions; or
- Do nothing, in which case he or she will be deemed to have accepted the offer and will be required to sell his or her shares on the terms set out in the offer.
It’s a very handy mechanism for getting rid of someone you no longer want to be in business with; but it can be unfair if the shareholders have unequal bargaining power. For example, if one shareholder has a lot more money than the other, he or she would find it far easier to come up with the cash required to buy the other person’s shares.
Right of First Refusal
Most small businesses want to ensure that they control who owns the shares in the company. This is usually dealt with by including a right of first refusal in the shareholders’ agreement.
A right of first refusal means that if a third party offers to buy a shareholder’s shares, before accepting the offer, the shareholder must first present the offer to the remaining shareholders and give them the opportunity to purchase the shares on the same terms and conditions.
In other words, it allows the remaining shareholders to ensure that no new shareholders are introduced into the company, but still allows the departing shareholder to sell the shares. Without a right of first refusal or some other similar clause, you cannot control what the holders of the shares in your company do with their shares.
You might find that you are in business with someone you don’t want to be in business with.
… but we’re family!
Some clients tell me that they don’t need shareholders’ agreements because theirs is a family business.
Unfortunately, even family businesses have good reasons for putting shareholders’ agreements in place. Take for example how common divorce is today. If one of the shareholders goes through a divorce, you should be concerned about whether the shares will be considered when the assets are divided.
But even if divorce isn’t a concern, you must consider what happens to the shares on a shareholder’s death. Unless you make provisions while the person is alive, on his or her death the shares will go to the person named in the will or to the next of kin if there is no will. This may result in an unfortunate and unintended result.
Most family businesses want to remain family owned. You can only ensure that by contract. In the absence of contracts, you may find yourself having to buy the shares back in order to regain control of them, assuming the person who inherits the shares is prepared to sell them.
Again, you may find yourself in business with someone you don’t want to be in business with.
It is so much easier to put plans in place before problems arise. Failure to do so may result in significant challenges. A shareholders’ agreement is drafted to deal with your company’s specific situation. Failure to have one in place may result in great disruptions, which mean that owners will be distracted from their business operations while they deal with the fall out.
Dealing with the fall out can be both time consuming and expensive. Wouldn’t it be better to talk with those with whom you are in business and put in writing what is fair to everyone while everyone still gets along?
*Please Note: This is article is not legal advice, rather suggestions from a trusted individual.
You can hear Christine Hirschfeld, Q.C., ICD.D speak at The Balsam Fir Forum.