Exit Clauses in Shareholders Agreements | Forced or Otherwise
While much time and energy is often spent on the logistics of entering into a business relationship, far less attention is paid to getting out of one. Unfortunately, many people come to realize that not having a proper mechanism to effect a shareholder’s exit – whether forced or otherwise – is to their detriment – check out our article on Avoiding 50/50 Shareholder Paralysis. Although each corporation and the dynamic between its shareholders differ on a case-by-case basis, the need for a proper exit strategy is universal. A proper shareholders agreement should contain at least some of the following clauses which contemplate a shareholder’s exit from the corporation.
Compulsory Buy-Sell Clause aka “Shotgun” Clause
For many laymen, a “Shotgun” clause is among the few legal concepts that they may have heard of before and have some conceptual understanding of what it entails. This can be primarily attributed to its catchy name; and, just as the name suggests, the inclusion of a shotgun clause can be a dangerous proposition.
A shotgun clause begins with an offering shareholder giving notice (called a “Shotgun Notice”) to a receiving shareholder of their intention to enforce the shotgun clause. The receiving shareholder will thereafter have the option to either sell its shares at the price specified in the shotgun notice or buy out the offering shareholder at the same price. In this way, a shotgun clause is an effective – albeit aggressive – way to ensure that one of the shareholders is removed from the corporation. The danger created from enforcing a Shotgun clause is that the end result is uncertain. A shareholder who has enforced the clause in the hopes of buying out another shareholder may instead find that they are the ones being bought out instead. This is the inherent risk in enforcing the clause.
In terms of best uses, shotgun clauses are best utilized when the business relationship between shareholders has become untenable and its not as important about who gets bought out but rather that the relationship reaches its end. Shotgun clauses may also be a useful tool for a shareholder who is wealthier than the other shareholder(s) in a particular corporation as their deeper pockets provides a natural competitive advantage. This competitive advantage exists regardless of whether they are offering or receiving the shotgun notice.
Non-Participating or Inactive Shareholder Clauses
A non-participating shareholder[1] clause refers to various provisions that deal with what happens to the shares of shareholders who are non-participating in the corporation. Unlike shotgun clauses, which are fairly uniform, the provisions contained in a non-participating shareholder clause may vary greatly depending on the risks each corporation is specifically trying to guard against. Typical provisions include protecting against the possibility of a shareholder not participating in the company for a specified period of time (often due to physical or mental illness or due to prioritizing other business ventures) as well as protecting against the possibility a shareholder goes to jail.
Regardless of the provisions contained in each specific shareholders agreement, the end result for a non-participating shareholder is the forced sale of that shareholder’s shares to the corporation or to the other shareholder(s). In this way, non-participating shareholder clauses are useful tools for preventing situations where some shareholders are generating a disproportionate amount of the corporation’s value due to other shareholder(s) being unwilling or unable to make contributions themselves.
Exiting Shareholder or Put Rights
Rather than just forcing the exit of another shareholder, shareholder agreements may include provisions that allow a shareholder to force their own exit. This can be done through a put right or an exiting shareholder clause. Put rights give a shareholder the right to require the corporation to purchase the shareholder’s shares. The price per share is either specified in the agreement or set at a fair market value to be determined. Exiting shareholder provisions are somewhat similar to put rights except that the clause often requires that the other shareholders themselves purchase the exiting shareholder’s shares rather than the corporation itself.
Death, Disability and Divorce
The death, disability, or divorce of a shareholder in a corporation can lead to a myriad of issues with the remaining shareholders. This is due to the fact that the remaining shareholders may now be dealing with shareholders, or in the case of disability, an attorney having power of attorney over of the shares, that the remaining shareholders did not originally agree to be in business with. It can be an exceptional burden upon a business if a key shareholder dies and suddenly that shareholder’s children own shares, or maybe an estranged spouse owns shares through a separation agreement. The point being that prior to any of these events happening, the original shareholders have a vested interest to make sure they have influence on who they enter into business with. For this reason, clauses dealing with the death, disability and divorce of a shareholder usually contemplate the forced sale of that shareholder’s shares prior to any share transfer taking place to unwanted family members.
Conclusion
A shareholder’s exit strategy is just as important as the entry. Individuals become shareholders in a corporation because, presumably, it makes business sense for them to do so. It’s important to make sure that the shareholders can exit, or force another shareholder’s exit, when it makes business sense to do that too.
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[1] The term inactive shareholder is also used in many shareholder agreements. The terms non-participating and inactive may be used interchangeably in this context.
-Christopher Manderville, Associate Lawyer
Christopher’s practice is primarily focused on corporate-commercial law, including business formations, corporate reorganizations, shareholder agreements, commercial contracts, the purchase and sale of businesses, as well as secured lending transactions. Christopher graduated from Queen’s Law School in 2019. Christopher also completed his undergraduate degree at Queen’s University where he majored in Political Science and graduated as a member of the Dean’s Honour List. Christopher is a lawyer licensed to practice law by the Law Society of Ontario and is a member of the Canadian Bar Association.
© Kalfa Law Firm, 2021
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.
