Shareholders Agreements: What is it and why do you need it?
A shareholder’s agreement, also called a stockholder’s agreement, is an agreed-upon arrangement among a corporation’s stockholders. This agreement dictates how the company is operated and outlines shareholders’, directors’, and management’s rights, powers and obligations. The shareholders’ agreement should ideally involve the participation of all of the shareholders.
A corporation will list each of the shareholders names as well as the number and type of shares each shareholder owns at the time the shareholders’ agreement is signed. This provides a measure of clarity and confidence among the shareholders as it makes clear to other shareholders and creditors as to how many shares there are and who owns them.
The shareholders’ agreement can end when all shareholders agree to end it or on a specific date stipulated in the agreement.
A shareholder should be issued with a share certificate as proof of purchase of shares of a private corporation prior to entering into a shareholders agreement.
Types of Shareholders Agreements
Shareholders agreements have a host of provisions focused on (a) who makes decisions relating to the management and operations of the company, and (b) how shares can be transferred, distributed, and sold.
Shareholders’ agreements will also set out the rights, roles duties and responsibilities of the directors and officers, create options to buy or sell shares, determine what will happen in the case of death or retirement of a shareholder, establish the number of directors on the board and their duties, and provide existing shareholders with the right to approve future shareholders.
Let’s look at the different types of shareholders’ agreements:
Unanimous Shareholders Agreement
A unanimous shareholders agreement is an agreement shared among all the shareholders that restricts the powers of the directors to manage and operate the corporation. The agreement is a contractual agreement enforced by the Canada Business Corporations Act or Business Corporations Act (Ontario) depending on the incorporating jurisdiction of your corporation, which allows shareholders to unanimously relieve directors of some or all of their managerial powers.
Unanimous shareholder agreements often function to help resolve and settle disagreements between shareholders by laying out the procedures, which will govern in the event of a dispute.
Shareholder Agreements in Private Equity Transactions
Private equity investors are high net worth individuals who invest in private equity corporations in exchange for shares. The company, thereby, is able to raise additional capital, while the private equity investor hopes to make a financial return. There are two relationships that are governed by the private equity shareholders’ agreement: the relationship between the private equity and the founder/owners as well as the relationship between the shareholders and the directors of the company.
The private equity shareholders’ agreement will also stipulate the following:
- Control of the business strategy, particularly when the private equity investor will exit to maximize profit through the selling of shares;
- Restrictions on directors’ rights to make decisions, as well as appoint and remove directors of the Board;
- Control of the sale and transfers of shares so that their value is not diluted;
- Control to borrow or issue dividends;
- Protection of intellectual property and restrictions on competition if founders leave;
- Disclosures (warranties) subsequent to the private investor’s due diligence that reveal any financial obligations to third parties.
Minority Shareholder Agreements
A minority shareholder owns less than half of a company. As a result, if a dispute arises over the sale or distribution of assets, or another issue requiring shareholder votes, a minority shareholder doesn’t have voting strength on his own. This type of shareholder relationship is typically established in a small business, where initial funding comes from a group of friends or family. In exchange for the investment, a business owner gives you a percentage of ownership through stock.
A shareholders agreement that protects minority rights should list specific issues you foresee occurring for the business. The agreement should also outline how shares will be distributed and whether there is a right of first refusal, piggyback rights, and pre-emptive rights added.
Types of Important Clauses in a Shareholders Agreement
- Right of First refusal
Right of first refusal allows shareholders to buy the shares another shareholder would like to sell first before the shares are sold to outside third parties. However, if the shareholders cannot afford the shares, they may be sold to third parties. This allows shareholders to retain their percentage and protects them from unwelcome shareholders. However, this may cause delays in the sale of shares and discourage institutional investors from investing because they will have smaller proportional shares.
- Pre-emptive rights
Similar to a ROFR, pre-emptive rights protect the rights of shareholders in cases where the corporation decides to sell newly issued shares from treasury to a third party. This will allow shareholders to buy shares before they are sold to third parties and consequently retain their percentage share in the corporation. The disadvantage is that this may delay the sale of the shares and discourage institutional investors from investing in the company because they may get a smaller proportionate share.
- Piggyback rights
Piggyback rights, also known as “tag-along” rights protects minority shareholders in the event of a third party buyout of a majority shareholder’s shares. This allows the minority shareholders to sell their shares at the same price and terms if they so choose, effectively piggybacking on the transaction. This protects minority shareholders from being in business with an unwanted new co-owner and from being forced to accept less attractive offers.
- Drag-Along Rights
A drag-along right is the mirror opposite of a piggy-back right; it is a provision that enables a majority shareholder to force a minority shareholder to join in the sale of a company. The majority owner doing the dragging must give the minority shareholder the same price, terms, and conditions as any other seller. Drag-along rights are designed to protect the majority shareholder.
- Valuation Clause
A valuation clause sets out a method for determining the value of shares. Not being a publicly traded company, which can easily determine the value of its shares, a private corporation is well served to have a valuation clause for a variety of reasons. This clause will set out how the value of the shares will be determined, which will become necessary when shareholders want to sell their shares or when a shareholder dies and the other shareholders want to buy those shares. A valuation clause is key and is primarily intended to avoid disputes at such time as when a shareholder wishes to exit from the business, on retirement or for other reasons.
- Non compete Clause
A non-compete clause refers to situations where one party to the contract agrees to not enter into or start a similar profession or offer the same or similar services in competition against the other party, usually the employer, for a prescribed period of time. A non-comp is fairly standard in a shareholders agreement, effectively preventing the shareholders, officers and directors from setting up a competing company with that of the central business. For a non-comp provision to be enforceable under Canadian law, it must be sufficiently limited in temporal (time) and geographical scope (space).
- Non-solicitation Clause
A non-solicitation clause prevents shareholders or former shareholders from inducing other shareholders, directors, officers or employees of the corporation to leave the corporation or to compete against it. This clause prevents an influential shareholder from poaching other employees. In contrast to the non-compete clause, the non-solicitation clause does not contain a geographic area or apply to only particular types of products or services. Additionally, non-solicitation provisions do not restrict a former principal of the corporation from working for a competitor, in the way that a non-compete would.
- Shotgun Clause
A “shotgun” clause is a method which enables a party to exit a corporation. It is called a shotgun clause because when you pull the trigger, it could have the effect of killing yourself, so to speak. It works by permitted one shareholder, at any point in time, to offer its shares to the other shareholder(s) on certain price terms. The other shareholders can either agree to sell their shares at that price, or they can buy the offering shareholders shares at that same price. The benefit of the shotgun clause is that it forces a fair and reasonable valuation of shares between the parties, as the offering shareholder will either be paying that price or receiving that price, for the shares. If a shareholder pulls the shotgun and places an offer, the other shareholders can accept and in turn use that offer to buy the offering shareholder out. The offering shareholder has thus killed itself and caused its own exit from the corporation.
- Capital Expenditure Approval
Capital expenditures lock up large sums of money. In a small business, minority shareholders may require that they approve any significant expenditure of capital to protect their investment in the business.
- Management of the Corporation
Specifying issues related to the management and operation of the corporation can be specified in the shareholders’ agreement. If these issues are not specified, then the management of the Corporation will fall on the Board of Directors. Shareholders should decide whether or not they want to take an active role in making vital decisions for the Corporation and include all issues that they deem important to the long -term health of the Corporation.
Directors can be elected in several ways: the majority shareholder can elect the directors or each shareholder can elect a representative director. Alternatively, the shareholders may agree to elect a list of specified directors. All Directors have a duty to act in the best interest of the corporation no matter how they were elected and which group of shareholders they represent. It is advisable to appoint alternate directors should there be a vacancy on the Board of Directors. This way, shareholders can continue to control the appointment of Directors.
Officers of the Corporation can also be elected to maintain consistency in the operation of the corporation. This way, officers will not be subject to termination by new shareholders who may acquire majority share.
Types of Shares
To further lend clarity to shareholders’ agreements, it is pertinent to understand the different types of shares that can be issued and how capital is raised through their sale.
Shareholders may own common voting shares, non-voting shares, or preferred shares, each conferring a different level of power over how a company is run or dictating how dividends are distributed.
Voting Shares/Common Shares
Voting shares are most typically common shares that give the person who acquired them one vote per share they own. If you own these shares, you are partial owner of the company. Issuing these types of shares generates a larger potential investor pool, gives investors more control over how the company is run, and inhibits the possibility for company owners to take advantage of the company’s resources. While this type of share entitles its holders to a number of rights, it does have one major drawback: common stock shareholders are the last in line to receive the company’s dividend payments–after preferred shareholders have been paid. It also means that if the company goes bankrupt, the common stock shareholders receive whatever assets are left over only after all creditors, bondholders, and preferred shareholders have been paid in full.
Non-voting shares are common shares that do not give the person who has acquired the right to vote on issues regarding the management and operations of the company. While this may reduce the potential investor pool, issuing non-voting shares preserves management and initial investors’ control of the company and its revenue-generating opportunities. Non-voting shareholders can protect the value of their shares by having provisions in the shareholders agreement regarding a hostile takeover of the company by the shareholders and/or Board of Directors.
Preferred shareholders always receive their dividends first, and, in the event the company goes bankrupt, preferred shareholders are paid before common stockholders. Like common stock, preferred shares represent partial ownership in a company, although preferred stock shareholders do not enjoy any of the voting rights of common shareholders. Preferred shareholders are normally issued to investors.
Consideration shares are issued in consideration of its non-monetary value, typically to purchase non-cash tangible and intangible assets, such as property, land, buildings, vehicles, skilled workers, top-level professionals etc. For example, if a company wants to purchase land, it can acquire it in exchange of company stock instead of cash. While this is a common practice, it is often difficult to establish valuation. The general rule is to record these transactions on the basis of fair market value of the non-cash asset acquired or the fair market value of the stock issued, whichever can be more reliably determined. One of the main considerations is establishing what the future value of the shares will be when they get monetized, and will the eventual return compensate the seller for the associated risk of holding them?
Increasing Share Capital
There are different ways to increase share capital of a corporation; a corporation’s shareholders can sell their stock or a corporation can issue new shares, which can be purchased either by existing shareholders or by new investors.
Issuing New Shares
If a Corporation wants to create new shares, it can increase the capital of the company by “allotting’ new shares. This is usually done when a corporation wants to raise additional funds without the need for existing shareholders to sell any of their stock. However, issuing new shares will dilute the percentage of ownership and control of the current owners.
Bringing on New Shareholders
New shareholders can purchase stock in a corporation at any point after incorporation. Existing shareholders can transfer or sell their shares to a new shareholder. If the articles of the shareholders’ agreement confer pre-emption rights to the existing shareholders, they should first waive their pre-emption rights so that the new shareholder can purchase the shares.
Shareholders’ agreements are important documents that should cover all the rights and obligations of the shareholders, officers, and directors of a corporation. The health and long-term financial success of a corporation can be determined in the details and clauses of the shareholders’ agreement. That is why it is crucial that you hire a qualified lawyer with experience in the preparation of shareholders’ agreement to help you determine what kind of shareholders’ agreement best serves your interest. Would like to discuss whether your business can benefit from a shareholders agreement? We’re Here To Help™. Call one of our business lawyers at Kalfa Law.
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-Shira Kalfa, BA, JD, Partner and Founder
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