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The Importance of a Shareholders Agreement

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Why Every Business needs a Shareholders Agreement

 

If you have a partner or several partners in your corporation, you will need a shareholders agreement. A corporation that has multiple shareholders is inevitably going to need an agreement that outlines what happens when one of those shareholders wants to leave the corporation, sell his or her shares, or take on more business partners.  It also outlines what happens to one’s shares in the event of divorce, death or disability. At a basic level, a shareholders agreement sets out the rights, restrictions and obligations of each shareholder relative to one another, and sets out the rules of the game in the event of an exit or dispute.

The Importance of a Shareholders Agreement

If your business partners are members of your own family, you likely need a shareholder’s agreement even more. It’s difficult to anticipate what issues may come up or what might happen when one of the partners dies and his or her interest goes to their children.  The issue becomes even more contentious when one family member wants to sell, but the other family member want to keep the family business for his or her children.

For these reasons, it is best to establish a process of how to resolve various matters early on. Once a dispute arises, it is too late. A simple issue that could have been resolved with a shareholders agreement may quickly spin out of control and end up before the courts costing all parties thousands in legal fees.

The importance of a shareholders agreement cannot be understated; let us consider the following example for illustrative purposes:

You and your partner, Joe, are plumbers who work 30 hours a week for your own plumbing company. Your business has enjoyed much success, earning profits of roughly $400,000 a year. You and Joe each own shares that are worth approximately $200,000 (using a basic valuation method). Unfortunately, Joe gets divorced and is ordered under the Family Law Act to transfer  $350,000 to his ex-spouse Jill. To make matters worse, their marital home is encumbered by a heavy mortgage and Joe has little to no other assets. In order to satisfy the equalization claim, Joe is forced to transfer his shares to Jill. Now you are in business with Jill, who has no knowledge of plumbing. 

A shareholders agreement could have protected your greatest asset – your business – by easily creating a clause that states that the shares of your business cannot be transferred to an ex-spouse upon equalization. 

Shareholder agreements cover a wide variety of topics including the following:

1) The management positions and responsibilities of the shareholders

2) The method for valuating the shares of the corporation

3) The method for adding or removing shareholders for misconduct, death or inability to function in the management of the business

4) The mechanism for the valuation and sale of the whole business of the corporation

5) The method for determining management salaries, bonuses and dividends

6) Non-competition and non-solicitation clauses to prevent a departing shareholder from taking a key part of the corporation’s business, thereby damaging the corporation and its remaining shareholders;

7) The buy-sell provision, also known as the “shotgun” clause, which permits a shareholder to offer to buy the shares of the other shareholders, subject to the right of these other shareholders to make a counter offer to purchase the shares at the same price;

8) Succession arrangements for spouses or the next generation upon death or disability of a shareholder

9) Life insurance for key management employees and shareholders

10) Provisions that speak to the special majority or unanimity required for certain types of corporate decisions, such as selling the whole enterprise of the corporation or commencing a new enterprise

11) Dispute resolutions, such as arbitration and choice of law provisions

The Five Ds: Death, Divorce, Disability, Divesture and Dispute

Shareholder Agreement

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The scope of a shareholders agreements can be summarized as targeting the 5 D’s – Death, Disability, Divorce, Divestiture and Dispute.

Let’s look at each of these in turn: 

Death

If a shareholder in a business partnership dies, his or her shares form part of his or her estate, which is then distributed to the beneficiaries upon probate. As a result, the surviving partner will now jointly own the business with his partner’s beneficiary, which is something you may not have intended. A shareholders agreement would mitigate against this by restricting the shares from becoming a part of a deceased shareholder’s estate; instead the surviving shareholders will be given the right to purchase the shares and provide the family with the cash equivalent of the shares instead of the shares themselves.

Divorce

Upon divorce, a shareholder’s shares becomes part of the net family property to be equalized with his or her spouse. This could result in the shareholder’s ex-spouse becoming entitled to the shares of the business in the divorce.  Should this occur, you would now be in business with the ex-spouse rather than the  partner with whom you entered into the business. Things could get even stickier if the ex-spouse, subject to his/her voting control, decides to sell the business. Your livelihood is now at stake. A shareholders agreement would mitigate against this by restricting the transfer of shares to an ex-spouse upon divorce.

Disability

If a shareholder falls ill, becomes disabled or incapacitated, he or she will no longer be able to act as a director or officer or even contribute in any meaningful way. In spite of this, he would still be entitled to the distribution of profits each year. A shareholders agreement could mitigate against this by apportioning the distribution of profits, pursuant to what is fair between an active, participating shareholder and a passive shareholder, in the event one shareholder is unable to contribute to the business for a long period of time.

Divestment

Divestment refers to a situation where one shareholder wishes to sell his or her shares and leave the business.  Does the shareholder have a right to sell her shares to anyone or does she have to offer to sell her shares to the remaining shareholders first? 

The Importance of a Shareholders AgreementAnd what if a majority shareholder gets an offer from a prospective purchaser? Can the shareholder force the purchaser to buy her shares too?  A shareholders agreement will cover circumstances such as this. It will also provide for a method of valuating the shares in the event one party wishes to sell or exit.

Dispute

A shareholders agreement will set out the process of how disputes between shareholders will be resolved. Disputes central to the operation of the business may relate to the brand name, marketing plan, investors,  direction, or whether the business should amalgamate with another company, become a subsidiary or be sold off completely. Does one shareholder have the tie-breaking, casting vote when there is a deadlock? When will you have to refer the matter out to private arbitration for a ruling? A shareholders agreement would mitigate against these disputes by addressing how disputes relating to fundamental aspects of the corporation will be resolved.

Get a Shareholders Agreement

Without a shareholders agreement, your business investment may be at serious risk.  Not having this key document puts you in jeopardy of not having control over who the other shareholders are, whom you are doing business with, what the direction of your business is, and even whether you can sell your business.

With years of corporate law experience, Kalfa Law can help prepare a shareholders comprehensive agreement that best suits the needs of your business. Shareholders agreements don’t need to be complex or lengthy. However small or large your business, a shareholders agreement will help ensure your greatest asset is protected. 

F.A.Q’s:

Can a shareholders agreement protect me from having to transfer shares in my business to an ex-spouse pursuant to equalization under the Family Law Act?

Yes, a shareholders agreement would mitigate having to transfer half of your shares in a divorce to an ex-spouse. A clause can be included in a shareholders agreement that states that the shares of your business cannot be transferred to an ex-spouse upon equalization. 

My business partner is sick and I’m worried that his shares will be transferred upon his death to his beneficiaries, who have no knowledge of how to run the business. How can I ensure that my business interests are protected in the event of his death?

A shareholders agreement would mitigate against this situation by restricting the shares from becoming a part of a deceased shareholder’s estate; instead the surviving shareholders will be given the right to purchase the shares and provide the family with the cash equivalent of the shares instead of the shares themselves.

Can a shareholders agreement provide provisions for the possibility of either business partner suffering an injury or disability, resulting in their incapacitation and inability to work or contribute?

Yes, a shareholders agreement could mitigate against this by apportioning the distribution of profits, pursuant to what is fair between an active, participating shareholder and a passive shareholder, in the event one shareholder is unable to contribute to the business for a long period of time.

If I wish to divest my shares in my business, who has the first right to purchase my shares?

The question of whom you can sell or divest of your shares to—whether or not the other shareholders have first of refusal—should be decided in a shareholders agreement. Furthermore, the method of valuation of your shares must also be laid out in the shareholders agreement. Failing to do this will result in disputes that can lead to a deadlock. The shareholders agreement should also include who in the company has the tie-breaking vote in making decisions such as these.

Can a shareholders agreement spell out how decisions that are in deadlock will be resolved?

Yes, a shareholders agreement should include the process of how disputes between shareholders will be resolved. How to resolve disputes central to the operation of the business, including brand name, marketing plan, investors, strategic direction, structure, etc. should be included in a shareholders agreement, including who will have the tie-breaking vote and when to refer the matter to private arbitration.

-Shira Kalfa, BA, JD, Partner

© Kalfa Law, 2020

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 eet your particular needs. If you have a legal question you should consult with a lawyer.

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