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Any corporate entity that has two or more shareholders should seriously consider having a shareholders' agreement to both protect the shareholders and the business itself.
Every corporation is governed by its articles and/or by-laws (often referred to as the "constating documents" or "charter documents") and applicable corporate legislation like the British Columbia Business Corporations Act. However, any business that has two or more shareholders should seriously consider having a shareholders' agreement to set out a mutual understanding of matters either not addressed, or not appropriately address (in the circumstances) by constating documents or corporate legislation – to both protect the shareholders and the business itself.
Too often, the shareholders of a newly incorporated business or start-up are reluctant to spend the time or money to prepare an agreement that addresses the major areas of business operations or potential areas of dispute that may arise in a jointly owned and managed business.
It is generally recommended to have a shareholders’ agreement in place at or soon after formation of a company that deals with most of the anticipated management issues in a business and the areas of potential disagreements. However, the investment of time and further cost, as well as the perceived adversarial nature attributed to the settlement of a shareholders’ agreement, is often enough justification to new shareholders to either defer consideration of such an agreement, or forgo it all together. This can be an unfortunate mistake in hindsight, as deferral can lead to abandonment or neglect, and over time (and often now in the context of a crisis like a need for funding, or potential windfall like the interest of a strategic partner or investor) shareholders may not be as ready to compromise their existing positions and therefore there is less opportunity to find mutual agreement.
Further, although a common perception, there is actually no such thing as a standard, off-the-shelf or “one size fits all” shareholder agreement. While it is true that there are a number of elements, many discussed below, that are often included in a shareholders’ agreement, there is no requirement that any or all of these matters are indeed included, or that any shareholders’ agreement is limited to such matters. Further, how any particular matter – like future financing or share rights – is dealt with can vary significantly and any use of a previous or precedent agreement may contain provisions not appropriate to your circumstances or not reflecting the shareholder parties’ intent. The most effective way to ensure your shareholder agreement meets the needs of the corporation and shareholder parties involved is to involve those parties in the process to determine the scope, intent and terms of the proposed shareholders' agreement and the settlement of any definitive shareholders’ agreement.
So while a perfect shareholders’ agreement is desirable, often something is better than nothing. There may be a number of immediate issues, like board of directors composition or pre-emptive rights, that are material to be earliest shareholders and an interim agreement that takes the form of perhaps three to five pages may be more suitable to a 20 to 40 page agreement that can be hammered out down the road when there is more time and money available, new shareholders are on the horizon, or when a business moves past the start-up phase.
Whether short form or long form, consideration should be given to, at the very least, the following key provisions usually addressed in a shareholders’ agreement:
Management & Operations.
Board of Directors. It is wise to specify the number or composition of the board of directors, and the circumstances where shareholders have a right to designate board nominees. Remember, a current significant shareholder may not be a future significant shareholder and any right to designate board members should come with conditions such as a requirement to maintain a certain threshold of equity ownership.
Meeting Procedures. While generally dealt with in corporate legislation and any by-laws or articles, the procedures and thresholds contained in those governing documents can and should be augmented by specific terms as to notice, initial quorum and any ability to defeat quorum by simply refusing to attend meetings.
Management. Usually left to the discretion of the directors, there is often expectations as to which shareholders will be appointed into which offices, if any, like Chairperson, Chief Executive Officer, President, Chief Financial Officer, etc. Care should be taken here as the determination of management offices can bring with it a number of issues including employment law concerns if any office is set out in something that looks like a traditional employment relationship.
Future Financing. While usually not needing immediate capital, or having enough in the bank at the start-up phase, most businesses will need further financing. Disputes can arise when there is disagreement as to the need, timing or amount of financing; whether any financing should be obtained by borrowing, if possible, or further equity – and, in many cases, what happens if some of the shareholders agree to step up and either put more money in the company or provide personal guarantees for, as an example, a bank line of credit, but others refuse to do so.
Special Approvals. Again, while addressed in corporate legislation and articles, it may be warranted to consider thresholds of shareholder approvals higher than those prescribed by corporate legislation (usually a simple majority, or a special majority such as three-quarters or two-thirds), even unanimous approval for certain fundamental changes such as: the sale of all or substantially all of the business undertaking, a change of business, major capital expenditures, amalgamations, winding-up and revising the by-laws or articles. Again, care should be taken to facilitate agreement and compromise while acknowledging that at times a decision may be needed quickly to stay in business.
Equity Provisions.
Restrictions of Transfer. In most private corporations there will be some form of restriction on the transfer of shares set out in the constating documents – usually requiring the consent of the directors. However, any shareholder agreement should contain provisions restricting transfers generally, unless otherwise done in accordance with the shareholder agreement itself. It is also recommended that any such provision provide for permitted transfers to facilitate, for example, tax or estate planning.
Pre-Emptive Rights. If a company decides to issue new shares, a pre-emptive right allows some or all existing shareholders to buy those proposed new shares before any new investor does and therefore avoid dilution of his or her ownership stake in the company. A shareholder agreement should specify what form of new issuance triggers a pre-emptive right, set out the procedure and timeline for any pre-emptive right, and provide for a waiver if some or all of the existing shareholders consent in writing.
Rights of First Refusal. A rights of first refusal provision (often referred to as a “ROFR” and often including a right of first offer) requires a shareholder who receives an offer from a third party purchaser, or intends to make to make an offer to potential third party purchasers, to give notice of the offer to the other shareholders (and sometimes the company itself). The other shareholders then have the right to match the third party offer or purchase shares in accordance with any proposed offer within a certain time, after which the selling shareholder is permitted to sell its shares, or offer its shares as the case may be, to a third party. These provisions can be complex, have several variations and while usually intended to protect existing shareholders, tend to act as a significant deterrence to third party purchasers because to the potential delay, complexity and possibility that any offer will simply be matched, in whole or in part, by existing shareholders.
Tag-Along or Drag-Along Rights. A tag-along right is related to a ROFR and permits other shareholders to "tag-along" with a selling shareholder (usually one of some size or importance) that's selling to the third party in the same or some designated proportion of shares being sold by the selling shareholder. Any offer received therefore must accommodate the potential for tag-along sellers. If that third party offers to buy the significant or controlling shareholder's shares, a drag-along right allows the selling shareholder to force all other shareholders to sell their shares on the same terms. Corporate legislation in British Columbia contains a form of this drag-along right, providing that if 90% of shareholders accept a third party offer they can force the other 10% to sell on the same terms, however these thresholds are usually modified in a shareholders’ agreement or the right is granted to a particular shareholder in order to ensure that shareholder can divest its shareholdings with the premium often available when a purchaser can buy the whole, and not simply a part, when and if the appropriate offer is received from a third party.
Put/Call Provisions. It is not uncommon to include put (the ability to “put” your shares to other shareholders for purchase) or calls (the ability to “call” other shareholders to sell their shares to you) upon certain "trigger" events which usually include a default of other provisions contained in the shareholders’ agreement; the death or permanent disability of a shareholder; cessation of employment either by termination or retirement; or a marriage breakdown of any shareholder.
Shotgun Provisions. At times a dispute or disagreement between shareholders can lead to a deadlock. A shotgun provision is intended to provide some form of potential resolution in these circumstances by permitting one or several shareholders to make a mandatory offer to purchase all of the shares of one or more other shareholders, with the potential to have those other shareholders acquire the shares of the offering shareholder(s) on the same terms. While a useful option to resolving deadlocks, particularly in arrangements whereby founding shareholders insist on 50/50 ownership, these provisions almost always favour the more affluent shareholder and can lead to abuse when start-ups are premised on one shareholder being the “brains” and the other shareholder being the “money”.
Share Valuation. Related to share purchase and sale provisions above that are not dependent on an existing third party offer (which itself would determine price) is the need to address share valuation. For example, if a put/call option provision is included, the purchase price is usually fair market value or (in cases of default) some discount to fair market value. Positions of fair market value can differ and providing either a periodic or event driven formal determination of value by an independent business valuator or some multiple of earnings or other agreed to metric can give a process some certainty and avoid unnecessary and expensive mediation, arbitration or litigation.
Restrictive Covenants.
Non-Compete Provisions. In some circumstances shareholders will include some form of a non-compete clause which will set out restrictions on the shareholder, while a shareholder and perhaps for a brief time afterward, to be involved in a business in a prescribed region that competes with the original business undertaken by the shareholders. Care, on so many levels, should be taken when considering this approach as Courts in Canada have not always looked on non-compete clauses favourably.
Non-Solicitation Provision. A non-solicitation clause restricts a shareholder from actively pursuing for a shareholder’s own or another entity’s benefit the customers, suppliers and/or employees of a business both while a shareholder or for a specified period after ceasing to be so.
Non-Disclosure Provision. While a degree of protection in this regard can be found in fiduciary duty obligations if shareholders are directors, or through separate agreements other common in start-ups, including a non-disclosure or confidentiality clause in a shareholders’ agreement is not uncommon. Such a clause simply distinguishes certain information that is confidential and/or proprietary to the business and restricts shareholders from disclosing such information to third parties or using such information for purposes other than that of the business.
Other Provisions.
As noted above, shareholder agreements can contain almost any sort of provision as may be agreed between parties. However, in addition to concepts above a typical shareholders’ agreement will include a number of provision related to:
the signing shareholders’ ownership of their respective shares to ensure the parties to the agreement are the registered and beneficial owners of the underlying shares;
insurance matters, particularly if one or more shareholders are also key employees or if there are provisions that facilitate the acquisition of a shareholders’ shares by the company directly;
matters like banking, signing authority for bank accounts, accountants and/or auditors;
alternative dispute resolution mechanisms like mediation or arbitration before any litigation for resolving disputes related to the agreement itself or between shareholders; and
any number of general contractual or interpretation provisions, often despite their utility referred to as "boilerplate" provisions.
Legal Counsel.
It is important to raise a matter related to understanding the role of, typically, the company lawyer and obtaining independent legal advice when dealing with shareholders’ agreements. In most cases, legal counsel initially involved will be or will consider itself to be legal counsel for the underlying company – even if that legal counsel may have familiarity, and have provided past advice, to one or more shareholders in the context of being incorporators and founders. It must be understood that the company and its directors, management and shareholders are all separate “persons” and despite a lawyer haven spoken to a particular director or shareholder on any matter – that lawyer may consider him or herself to have done so on behalf of the company and not on behalf of that director or shareholder. A shareholders’ agreement can affect some or all shareholders differently from the company itself or differently among the various shareholders themselves. It is important for all parties to understand for whom the lawyer drafting the shareholders’ agreement, if any, advises and to obtain in the appropriate circumstances independent legal advice. Acknowledgement of this should be provided in the shareholders’ agreement itself.
Conclusion.
A shareholders’ agreement is a useful and very much recommended document for any privately-held business having more than one shareholder and should be considered vital, in some form, in any business where shareholders or their respective associates hold a 50/50 interest in the business. There is considerable flexibility in the content and complexity that can be contained in a shareholders’ agreement and the right form of shareholders’ agreement, and the appropriate terms therein, should be considered carefully in order to ensure the shareholders’ common intentions are reflected, sufficient flexibility is provided to ensure the business can proceed without interruption and to avoid unintended consequences or disputes. A properly drafted shareholders’ agreement should be determinative of any potential dispute that may arise, but if not can provide a more predictable path to have shareholders resolve a dispute through the Courts or any alternative dispute mechanism.
Endeavor Law can assist on all aspects of a proposed shareholders’ agreement including initial advice; negotiation and settled of a shareholders’ agreement as well as assisting parties resolve disputes regarding interpretation of a shareholders’ agreement or the application of any provisions contained therein. Endeavor Law will always seek to provide competitive pricing for any legal services requested and is pleased to discuss fee arrangements that suit any potential client.
Does not constitute legal or other advice and must not be used as a substitute for legal advice from a qualified legal professional in your jurisdiction who has been fully informed of your specific circumstances. Information may not be up-dated subsequent to its initial publication and may therefore be out of date at the time it is read or viewed. Always consult a qualified legal professional in your jurisdiction.