"Shareholder Agreements" - The essentials

When a company is first created, its founding shareholders determine how a company will be owned and managed. This is when a "shareholders agreement" kicks in. The shareholders agreement may be amended when new shareholders enter the picture for various reasons, i.e. new shareholders may want to add new terms before they become part of the team. Not having such an agreement can lead to serious legal ramification, and future disputes arising amongst shareholders may create irreconcilable harm to the overall well-being of a company.

The incorporation of a company must be in compliance with the law that governs the corporations. Companies are incorporated in a particular jurisdiction (e.g. provincial or federal) and must adhere to the applicable legislation, e.g. the Canada Business Corporations Act, or the Ontario Corporations Act. This legislation lays out the ground rules for corporate governance, i.e. what you can and cannot do, who can be a director, can a company issue shares, how can you buy or sell shares, etc. When a company is formed, it files a Memorandum and Articles of Incorporation (depending on jurisdiction) which are public documents filed with the Registrar of Companies. A shareholders agreement, however, is confidential and its contents need not be filed or made public.

When a company is formed, its shareholders may decide on a set of ground rules over and above the basic legislation that will govern their behaviour. For example, how do you handle a shareholder who wants to sell his or her shares? Should it be possible to buy out a shareholder? How are disagreements resolved? Who can sit on the Board? Who has the decision-making authorities? Can a shareholder (the founder of a company) be fired? 

There is no need for a Shareholder Agreement if the company has only one owner. However, if there are more than one owner, it is very crucial to create a Shareholder Agreement. Each company should have its own tailored Shareholder Agreement depending on the mission & vision and business goals of the owners. When a company  becomes a "public" company, such an agreement is no longer needed, and the relevant law and securities regulations will become applicable.

What to include in a Shareholder Agreement?
(This is a non-exhaustive list)

• what is the structure of the company? 
• how equity is divided amongst the shareholders?
• how are the parties to the agreement?
• are there any vesting provisions? for example shares may be subject to cancellation if a shareholder/manager quits)
• are shareholders allowed to pledge their shares?
• who is on the Board? 
• who are the officers and managers?
• what constitutes a quorum for meetings?
• what are the restrictions on new equity issues?
• how are ownership buyouts to be resolved? 
• how are disputes to be resolved among shareholders? (* very important to review the dispute resolution clause(s)with your lawyer?)
• how are share sales done?
• what are a shareholders' obligations and commitment?
• what are shareholders' rights? 
• what happens in the event of death/incapacity?
• how is a share valuation determined 
• what are the operating guidelines or restrictions (budget approvals, spending limits banking, etc)
• what types of decisions require unanimous board and/or unanimous shareholder approval?
• compensation issues - remuneration of officers & directors, dividend policies
• are other agreements required as well, e.g. management contracts, confidentiality agreements, patent rights, etc?
• should there be any restrictions on shareholders with respect to competing interests?
• what could trigger the dissolution of the company?
• what is the liability exposure and is there any corporate indemnification?
• are there any financial obligations by shareholders (bank guarantees, shareholder loans, etc)?

Some Do's & Don'ts:

• don't confuse shareholder issues with management issues
• don't confuse return on capital with return on labour (i.e. cash investment vs founders' time commitment)
• don't get caught up in legalese - decide what you want, then have your lawyer put it in proper form
• do make sure everyone's objectives and visions are compatible 
• do separate the roles of shareholders, directors, and managers
• do talk to others who have gone through this process
• do ask yourself what the downside is - the most practical question is: what's the worst that can happen to you under the agreement?
• do get some tax advice. It is very important that some tax planning be done early to avoid a headache later when you've made millions. e.g. you want to make sure that you are not compensated by being given shares, you want to make sure you own shares early so that you can use the small business lifetime capital gains exemption, maybe a family trust or holding company should own your shares.

MOST IMPORTANTLY: DO HIRE A LAWYER! 

Business Owners: Why you MUST have a Shareholders Agreement. *

You’re in business with other individuals. They may even be members of your family. The company is growing and all of you are working hard. You all agree with the direction in which the business is heading.

Does this sound like your company? But have you given any thought to how you and your fellow shareholders will resolve disputes should they arise? What will happen if one shareholder dies or becomes disabled?

A shareholders’ agreement is a contract between shareholders of an incorporated business that puts mechanisms in place to deal with important issues before they become problems. For business owners who are carrying on business with others in an unincorporated partnership, the issues discussed in this article are dealt with through the use of a partnership agreement. Both agreements are an invaluable tool you can use to help ensure that your business grows and prospers.

Let’s look at an example where a shareholders’ agreement could have helped to prevent a major problem. Two sisters, Jane and Mary, started an incorporated catering business in the mid-1970s. They had always been close. In fact, their families live in the same town and they vacation together. As issues arose, Jane and Mary were able to discuss them and reach a mutually satisfactory agreement. Due to this, the sisters didn’t think it was necessary to anticipate problems and therefore they didn’t consider a shareholders’ agreement.

You might also be thinking that the sisters don’t need a shareholders’ agreement. They have always been able to resolve differences, so what’s the point of spending the money to document their business relationship in writing?

It turns out that there was one issue that they never could agree to deal with—who would take over the business when they couldn’t run it anymore? Although they realized that a solution would eventually have to be found, they believed that they could deal with it later, once they were closer to retirement.

Then two events occurred which turned the lack of a shareholders’ agreement (and a succession plan) into a major issue. First, children of each sister became actively involved in the business. However, no thought was given to how those children would interact with each other once the two sisters were no longer in the picture.

Then Jane (now in her mid-sixties) suffered a heart attack. After a fairly lengthy recovery, she realized that working long hours in the business was not something she wanted anymore. So, she thought the time had come to pass on the business to the next generation. However, Mary was still in good health and didn’t share her sister’s desire to begin the succession process.

What follows in such a situation varies. In the case of the McCain family, the end result was a public conflict in which lawsuits were filed and the matter was eventually settled out of court by a New Brunswick judge who was hired as an arbitrator. For smaller businesses (as is the case for Jane and Mary), the business itself may not survive such an event.

How could a shareholders’ agreement have helped?

A shareholders’ agreement would have provided two benefits. First, an executed agreement would obviously set rules that would be followed to resolve business disputes and events such as Jane’s illness. But more importantly, the process of working through an agreement would help the sisters identify possible business risks and let them discuss in advance how they would resolve each issue if it arose and perhaps even set aside resources in advance (such as life, disability or critical illness insurance).

This could have been accomplished when they were getting along, in good health and in a good position to be objective over who should take over the business. In particular, the agreement could have provided for a couple of options—a mandated succession plan where each sister would pass on their interests to the next generation or a buy-sell agreement which would allow one sister to buy the other’s shares at a time when she became unable to carry on in the business due to poor health. Although the sisters could try to negotiate such an arrangement now, the point really is that their interests have already diverged and the issue is causing disharmony in their relationship. An added problem is that Jane is potentially at a disadvantage in any negotiations as she is unable to continue in the business.

In addition to buy-sell rules on disability or death and rules for succession, a shareholders’ agreement will usually include mechanisms to help shareholders deal with important issues such as:

Major business decisions such as a merger;
Rules for employing family members;
Rules for disposing of major assets or a business line;
Remuneration of shareholders and setting work expectations;
Corporate financing decisions;
Rules for determining a price of a shareholder’s interest and the conditions under which the interest can be transferred (in addition to illness or death);
Liquidation of a shareholder’s interest in the event of disagreement, disability or death (this would include buy-sell agreements for shares); and
Rules for resolving deadlocks (such as arbitration, mediation or appointing additional directors).

This list is not exhaustive—any issue of mutual concern to the shareholders of a company can and should be covered in the agreement.

The moral

You should put mechanisms in place now to help you deal with major issues at a time when you and your fellow shareholders are enjoying a good relationship, good health and can be objective. This is usually accomplished through the use of a shareholders’ agreement for an incorporated business or a partnership agreement for unincorporated partners.

* article published in BDO tax series -

Standard Outline for a Partnership or Shareholder Agreement

The ideal time to reach unanimous agreement regarding how a company is organized, operated, changed or liquidated is before the investment transaction takes place. In order to have a productive meeting, you need an agenda and you need to make decisions; decisions that stand the test of being committed to writing in order to deal fairly with future events and consequences that may or may not occur.

Here are some examples of required clauses in your agreement:

Describe the partners or shareholders and their investments.
Describe the firm's trade name and style of identity.
Describe the nature and scope of business activity.
Identify the official business office address, and phone number.
Establish a date to review the agreement.
Detail each equity contribution and include the terms of each shareholder loan.
Establish all banking resolutions and signing authorities.
Establish the limits for personal guarantee bonds and postponements before negotiating any bank financing.
Establish a dividend policy.
Establish compensation for per diems, bonuses, salaries or drawings for the term of the agreement.
Establish a policy for the inspection of business records and right of audit.
Establish insurance coverage(s) and the indemnification of directors for contingent liabilities of the firm.
Establish provisions for partners or shareholders:
wishing to retire;
withdrawing equity;
settling an estate;
in arbitration of disputes;
expelling a partner;
selling to an outsider.
Establish provisions to evaluate the share of a retiring or deceased partner's interest.
Establish rights and options for surviving or remaining partners or shareholders to purchase the interest.
Establish the terms for restrictive covenants, conflict of interest, and non-competition agreements for partners leaving the firm.

Many simple companies are forged as 50/50 or equal partnerships in order to avoid the less exciting details of a formal agreement and get on with the business. The buy/sell agreement in these situations is usually just a simple "SHOTGUN" clause (possibly named after a wild west version of the Mexican Standoff). In these situations, one party makes an offer and the recipients of the offer can either sell by accepting the amount, terms and conditions, or turn around and buy on exactly the same basis; thereby forcing the offer back to the issuer. This is quick end befitting a quick beginning!