A business without a clear vision and framework is doomed to fail. Regardless of the nature of the business, shareholders agreements form an important foundation of any company. They provide a legal substructure for imminent financial and functional decisions while establishing obligations and control of the parties involved. By establishing certain rules, rights, and obligations early on, shareholders agreements unify the owners of a company into a cohesive framework that aids growth and manages risk.
What Is A Shareholders Agreement?
A shareholders agreement is an agreement between the owners (shareholders) of a company. They can be comprehensive wherein they address a variety of issues, or they can be limited in scope and designed for a special purpose. There are two types of shareholders agreements:
- A General Shareholders Agreement;
- A Unanimous Shareholders Agreement.
A general shareholders agreement is treated as a commercial contract between the parties and is subject to a corporation’s articles and by-laws, together with applicable statutes.
They typically deal with a wide variety of issues and there is no statutory requirement for the content that they contain. As a result, they are extremely difficult to negotiate because they are entirely dependent on the context of each scenario, and thus are custom-tailored to meet the needs of the parties involved.
A well-drafted shareholders agreement requires time to understand the business and its goals in order to create customized terms to meet the needs of the parties.
Consequentially, one the benefits of negotiating a shareholders agreement is the process of doing so, as the shareholders may gain a better understanding of the aims and direction of other shareholders and the business as a whole.
Functions of a General Shareholders Agreement
Because of their nature, shareholders agreements fulfill a wide range of functions. Some of the key functions that many shareholders agreements address are:
- Management and Governance
- Terms and Restrictions on Selling Interests
- Management of Disputes
- Valuation
- Non-Compete, Non-Disclosure, Non-Solicitation
Management and Governance
There are several provisions relating to the management and control of a corporation that can be contained in a shareholders agreement. Some specific kinds are:
-
Board Nomination Rights
Since directors, either directly or through subordinates, are ultimately responsible for the day-to- day operations of business, having nominees of one’s choosing to sit on the Board of Directors can serve as a strong influence that a shareholder can have on corporation. However, directors owe a fiduciary duty to the corporation, and not the shareholder that nominated them. Moreover, provisions in a shareholders agreement can prevent majority shareholders from deciding the entire board. This allows for minority shareholders to have representation in proportion to their share ownership, or in complete equality if they agree that decisions are to be unanimous.
-
Observer Rights
If the interests held in a corporation by a shareholder are insufficient to warrant a nominee director, and the shareholder wants to participate in board meetings, they can be granted an Observer Status. This will allow the shareholder to receive notice and attend board meetings to provide input. However, the shareholder will not be allowed to vote.
-
Shareholder Veto Rights
For certain types of shareholders, such as private equity investors, having certain veto rights can prove to be beneficial. Veto rights can be created by requiring shareholder approval for certain actions. Some of the actions associated with veto rights can include amending articles of incorporation, approving the budget, incurring debt, issuing of shares, and replacing the CEO.
-
Meeting Quorums
Shareholders agreements can outline the quorum requirements for board and shareholder meetings. This can be as simple as defining the number of directors or shareholders required to be present. Consideration should also be given to other circumstances such as the number of adjournments allowed before a meeting can be authorized to proceed, the effect the death of a director will have on the quorum, or requiring certain shareholder representatives to be present.
-
Approval Thresholds
Shareholders agreements are useful tools in ensuring effective governance of a company and protection for its shareholders by establishing approval thresholds for certain matters. For example, shareholders agreements can set out a class of material decisions which require unanimous approval, thus protecting the interests of the minority shareholders.
Terms and Restrictions on Selling Interests
An advantage for small, privately held companies is that shareholders agreements set out the terms by which shareholders may exit the business and transfer their interests. Since any transfer of shares for close-knit companies can be deemed as a material event, it is important to have terms in place that are flexible enough to balance the interests of the company with those of the individual shareholders. A few common transfer terms are:
-
Right of First Refusal
Rights of first refusal require any shareholder that intends to sell their shares, to first offer them to other shareholders in the corporation. These rights come in two forms: hard and soft.
Hard rights of first refusal require holders to first obtain a bona fide offer from a third party before the shares are offered to other shareholders in the corporation. This can make it difficult to sell the shares since few third party investors will want to put forth the effort of making an offer only to not end up with anything. Soft rights of first refusal require the selling shareholder to first offer to fellow shareholders, and if they refuse to purchase, the shares can then be offered to third parties. A consideration to keep in mind is whether rights of first refusal apply to all shareholders or a subset of all shareholders (i.e. founders).
-
Pre-Emptive Rights
These rights provide shareholders with the right to maintain their current percentage of share ownership and avoid dilution. Some key factors to consider when granting such rights include a minimum ownership threshold, issuance of securities that do not trigger pre- emptive rights (i.e. shares of certain percentage or class), and the implications of the right on founders and when they exit the company.
-
Mandatory Share Sales/Right to Repurchase
In some cases, it is desirable to include a right wherein the corporation can repurchase shares owned by a founder on the basis of death, insolvency, disability, or the founder’s involvement in a division of family assets such as in a marital breakdown. With these provisions, the affected shareholder will be obliged to sell his/her shares back to the corporation (or other shareholders). These provisions often contain a valuation mechanism for the repurchased shares.
-
Piggy-Back Rights
A piggy-back right entitles an applicable shareholder(s) to participate in any third party offer made to purchase the shares of another shareholder, on a pro-rata basis. This device ensures that shareholders with the benefit of the right can exit a company at the same time and rate as the shareholder subject to the right. Because of their nature, Piggy-Back Rights usually discourage shareholders from finding purchasers. Strategically speaking, they should be sparingly applied to only crucial, irreplaceable parties of the corporation, such as those essential to the business’s success.
-
Drag-Along Rights
Holders of such rights can compel other shareholders to sell their shares to an offering third party and not use their dissent and valuation rights under certain circumstances. The requisite circumstances to trigger a drag-along are an approval of the holders of a specified percentage/class of shares.
-
Buy/Sell Provision (“Shotgun Clause”)
The shotgun clause allows a shareholder to make an offer to the other shareholder(s) to purchase their shares or sell all of his/her shares. The offer states the specific terms and price that the offering shareholder is willing to buy or sell. The other shareholder(s) must then either accept the offer to sell their shares or buy the offering shareholder’s shares at the stated price and terms. They are typically implemented as an exit strategy for shareholders when they no longer have an interest to remain in the company, for example, when relationships between shareholders breakdown.
-
Put/Call Option
This is a mechanism usually implemented to handle dispute among shareholders. It provides minority shareholders with put option against the majority shareholder and gives the majority shareholder a call option on the minority shares.
Management of Disputes
Disagreements or breakdowns in relationships are common in business. A major objective of the shareholders agreements is to ensure that there is a mechanism to handle such situations. This can be done by way of implementing some of the terms and conditions of selling interest as discussed above (i.e. Put/Call Option, Shot-Gun Clause, etc.). Other methods include mandating methods of dispute resolution such as mediations before the commencement of a legal proceeding, or requiring arbitration.
Valuation
There are often provisions that set out valuation methods to be used when shares are transferred. The particular valuation method used is usually specific to certain “triggering” events that give rise to the need to transfer shares (i.e. death, disability, bankruptcy, etc.). Typical methods for setting a price for shares under these various triggers can include:
- Price determined by an independent valuator
- Price determined by a formula
- A fixed price negotiated in advance by the parties (often updated annually)
- Price determined by shotgun clause
Non-Compete, Non-Disclosure, Non-Solicitation
Small, privately held companies often have shareholders taking on some, if not all, of the duties of directors. Thus, such terms can be put in place to ensure that they do not abuse their powers if they eventually exit the company, and to ensure the protection of the corporation. The strategic advantage of including this in the shareholders agreement is debateable. At minimum, these clauses are applied to managers, employees, consultants, agents, and other parties by way of an independent contract.
Unanimous Shareholders Agreements
A unanimous shareholders agreement (“USA”) is a specific type of shareholders agreement. In addition to managing the relationship between shareholders, as is done with general shareholders agreements, a USA can transfer authority from directors to shareholders. The Ontario Business Corporations Act[1], and the Canadian Business Corporations Act[2] both allow for shareholders to restrict the powers of directors to manage, or supervise the management of, the business and affairs of the corporation[3]. They override the common law rule against fettering the discretion of the directors. Though directors are to serve the interests of the shareholders, from time to time shareholders are not pleased with their decisions. In such cases, it can be cumbersome to requisition a meeting to remove the incumbent director(s) in order to appoint a new director(s) and effect change of policy.
A USA removes the need for these time-consuming formalities and gives shareholders certain decision-making authorities from the onset. As a result, USAs are particularly useful for closely held companies such as start-ups. It should be noted that a consequence of removing the powers from the directors is that the Acts impose the same legal and equitable obligations on the shareholders, including liability that would normally be imposed on the directors. For example, under the CBCA, directors may be liable to employees of the corporation for up to six months’ of wages owed to employees. [4]This liability can be shifted to shareholders under a USA.
To qualify as a USA, the document must be written, signed by all shareholders, and must in some way restrict the powers of directors in managing the corporation. Some of the duties of directors that can be transferred to shareholders in a USA include issuance and redemption of shares, declaration of dividends, amending the corporation’s by-laws, etc.
Unlike traditional contracts, USA’s are treated as constating documents of a corporation. As a result, they can bind future shareholders without requiring their signature on the USA or require the creation of a new USA, provided that the share certificates bear a notice of the USA’s existence. [5]If a new shareholder is not given notice of the USA’s existence, they can rescind the transaction within 30 days after they become aware of the USA’s existence for federally incorporated companies [6] or 60 days after receiving a copy of the USA for Ontario corporations[7].
Termination Of A Shareholders Agreement
Most shareholders agreements can be terminated with the consent of all the shareholders subject to the agreement. However, considerations should be given to the nature of the business, and its stage in the business cycle and financing. For example, it may be beneficial for a growth company to have the shareholders agreement terminate at the option of the corporation. Additionally, when a company is seeking financing, investors often require a new shareholders agreement to be in place that protects their interests. In such cases, it may not make sense to require unanimous consent from all shareholders due to the possibility of financing transactions being held up unilaterally by a single shareholder refusing to provide consent. Thus, implementing a voting threshold that is not unanimous would be helpful in preventing such a situation.
Conclusion
As it can be seen, shareholders agreement provides a flexible tool to help manage the risks and growth of a corporation. By strategically managing the various facets of a shareholders agreement such as governance measures, and transferring of interest, it is an effective means for providing a unified framework for the shareholders and the corporation. When drafting a shareholders agreement, great care must be taken to ensure that it is custom tailored to meet the interests of all parties are involved relating to the immediate and long-term future of the corporation.
Hummingbird Lawyers LLP has two offices for your convenience. Providing qualified, skilled and experienced lawyers in Toronto and lawyers in Vaughan, we are committed to giving our clients the convenience, expertise and guidance they need.
If you have any inquiries regarding shareholders agreement contact Hummingbird Lawyers by emailing corporate@hummingbirdlaw.com to get in touch with a corporate lawyer.
Related Articles
