Shareholder Agreements: Other agreements with shareholders

Employment Contracts

If a shareholder will be running the business, an employment contract is a good idea. A clause can be added so that a breach of the employment contract triggers a default under the shareholders’ agreement.

Non-Competition, Non-Solicitation and Confidentiality Agreements

In general, shareholders should not be involved in competing businesses. A well-drafted non-competition agreement can prevent against that. Similar agreements can be drafted to deal with the non-solicitation of employees, customers or suppliers, and the handling and treatment of confidential information.

The death of a shareholder can paralyze a company that has not prepared for it.

Surviving shareholders will likely not want to be in business with the heirs of the dead shareholder, as they may not have the necessary experience or interest, or simply may not be compatible with the surviving shareholders. On the other hand, each shareholder will want to ensure that his or her investment will be purchased at a fair price upon his or her death.

Where the deceased shareholder’s investment in the company is substantial, buying out those shares may be difficult for the other shareholders. There are several ways to lighten this burden:

• the company could take out life insurance on each shareholder to fund the purchase of his or her shares;

• vendor financing;

• the company could help finance the purchase.

A shareholder agreement can provide remedies in the event that a shareholder defaults in his or her obligations to the company, or if the circumstances of a shareholder change fundamentally.

For example, if a shareholder quits his or her job with the company, goes bankrupt, or becomes physically or mentally incapacitated, the following remedies could be triggered:

• the loss or suspension of the shareholder’s right to appoint directors;

• temporary or permanent loss of the shareholder’s ability to participate in making major decisions such as the ones described above;

• the right of the other shareholders to buy out this shareholder at fair market value or even a reduced price

In situations where a shareholder defaults in his or her obligations to provide financing to the company (when required to do so under the shareholders agreement), the other shareholders might be granted the right to:

• dilute the shareholder’s interest in the company;

• obtain additional shares at a reduced price;

• have their loans repaid on a priority basis; or

• be paid a high rate of interest on funds they provide to the company.

A simple and effective way to facilitate a buy out is to add a “shotgun clause” to an agreement. Under a shotgun clause, one shareholder offers to buy the other shareholder’s shares. The other shareholder can either accept the offer or buy out the offeror’s shares on the same terms. The idea is to ensure a fair price for the shares.

This mechanism can be unfair if one shareholder has considerably greater financial resources than the other. In such situations, the offeror may be in a much better position to force a sale on unfavourable terms.

Such a situation can be avoided by adding a clause that imposes a fair market value on shares subject to shotgun clause offers. Fair market value can be determined by appraisal, formula or arbitration.

Shareholders generally want some control over who the other shareholders will be. At the same time, this expectation needs to be balanced with allowing shareholders to leave the company when they choose, and for a fair price.

A shareholder agreement normally allows shareholders to sell to outsiders only after giving the other shareholders a right of first refusal. The question is: should the selling shareholder be obligated to have a firm offer in hand and to disclose the identity of the prospective buyer? Buyers might not want to invest the time in negotiating a deal when they know there is a good chance they will be refused. The alternative is to allow the selling shareholder to shop his or her shares around after the other shareholders have passed up the opportunity to buy the shares after a certain time period.

What if some or all of the remaining shareholders struggle to raise the necessary funds to buy out the seller? This problem can be solved in several ways:

• extending the right of first refusal to the company, so that the company can use its assets to finance the payment of the purchase price;

• restricting the price to a pre-agreed formula; or

• vendor financing.

“Tag-along” and “drag-along” rights can also help facilitate a deal. “Drag along” rights protect majority shareholders – if the majority shareholder sells his or her stake, minority holders are forced to join the deal. “Tag along” rights protect minority shareholders – if the majority shareholder sells his or her stake, minority holders have the right to join the deal on the same terms.

Without a shareholder agreement, a simple majority of the directors can decide on major decisions such as:

• major capital expenditures;

• borrowing or granting security for capital expenditures;

• distributing profits;

• remuneration of key employees;

• contracts between the company and shareholders;

• conducting non-arm’s length transactions;

• changing signing officers;

• approving budgets;

• entering into major contracts;

• contracts out of the ordinary course of business;

• acquiring or disposing of property; and

• issuing dividends and additional shares.

This can cause major problems for minority shareholders, who can effectively be frozen out of the company. A shareholder agreement can prevent against this by requiring a special majority of two thirds, three quarters or all shareholders to approve such decisions.

However, shareholders also need to ensure that management decisions can be made without undue delay or gridlock, so shareholders should consider carefully which decisions will be subject to special majority vote.

Minority shareholders also might want to negotiate other protections into the shareholder agreement, such as:

• Dilution avoidance – If the company issues more shares, minority shareholders are granted an option to buy the number of shares that would maintain their percentage in the company

• Mandatory buy out – This triggers the buyout of an unhappy shareholder at a fair price

Earnings can be paid out by way of salary, dividends, interest payments on shareholders’ loans, repayment of shareholders’ loans or return of capital. Most companies retain part of their earnings and declare dividends with the rest. However, shareholders may hold very different views on what should be done with profits. One might want profits reinvested in the company, another might want to build the company’s cash balance, another might want dividends.

Without a shareholders agreement, directors have discretion to distribute profits or retain earnings more or less as they please, subject to any special rights and restrictions on shares. Amounts to be distributed, retained as cash or paid out as dividends could be set out in a formula, although this may be too inflexible and it may not be possible for shareholders to predict the financial future of the company. It may be desirable for shareholders to set out general principles and understandings in the shareholder agreement.

In this eight-part blog on shareholder agreements, we will cover areas such as financing, distribution of profits, participation in management and protection of minority shareholders, restrictions on share transfer, shotgun clause, defaulting shareholders, the death of a shareholder, and other agreements with shareholders.

GBC Law can help you draft a shareholders agreement that works for your company. Call us for a free, no-strings consultation.

Shareholder Agreements: 1) Financing

In a typical company, the shareholders make an initial contribution by way of share capital and/or loans. Additional funds are generally obtained by borrowing from a bank or credit union.

But what if the bank says no? Should shareholders be required to lend additional funds to the company, or guarantee its debts? If so, should there be a cap on the interest rate or a pre-agreed repayment schedule? And should a shareholder who is unwilling or unable to provide funds risk having their shareholdings diluted? A shareholder agreement should provide solutions to these issues.

1) Incorporate your business. One of the biggest advantages of incorporating is that it protects your personal assets from creditors. See “When Should I Incorporate?”

2) Secure your loan. You can loan money to your company and secure the loan by signing and registering a general security agreement.  Without security, you would be an unsecured creditor, and unsecured creditors usually receive nothing in an insolvency.

3) Use a holding company. A holding company can protect the retained earnings of your business.  Your holding company would hold shares in your operating company, and the operating company would pay a dividend to the holding company.  If the operating company required funds, the holding company could provide it with a secured loan.  And it’s not just cash that can be protected by the holding company: the operating company’s real estate and equipment can be transferred to the holding company and leased or rented back to the operating company. 

4) Create an Inter-Vivos Trust (Living Trust). A living trust would involve you transferring ownership of your property into a trust, making it much more difficult for creditors to have access to your personal assets or your company’s assets. 

5) Avoid personal liability for company obligations. Be careful to sign company documents as a director or officer of your company and not personally.  Also, try to negotiate out of having to sign personal guarantees for a bank loan or property or equipment lease.

1.      Limited liability

As a general rule, shareholders are not responsible for corporate debts. If a corporation goes bankrupt, its shareholders will lose no more than their investment (unless the shareholder has provided personal guarantees for the corporation’s debts). Limited liability also means that as a general rule, shareholders cannot be held responsible for the company’s acts or omissions.

Directors, on the other hand, can be liable for the following: employee deductions, wages and vacation pay, workers compensation, sales tax, corporate income tax and HST and environmental damage.

2.      Tax

While there can be considerable tax benefits to incorporating, there can also be drawbacks.  Factors to consider here include:

• Small business deduction
• Allowable business investment losses
• Capital gains exemption
• Deferred tax on business income
• Double taxation – on corporate income and on the dividends declared on this income
• Bonuses
• Estate planning
• Splitting income

You should seek tax advice from your accountant to determine whether incorporation would be suitable for your business from a tax perspective.

3.      Raising Capital

Corporations are more appealing to investors than other business structures because shares are easy to transfer and because ownership can be split a number of ways.  Banks may also prefer to deal with a corporation than another type of entity.  

4.      Stability

Corporations exist independently of their shareholders.  This means that all contracts entered into by the corporation remain valid as shareholders come and go.  If you have several investors in your business, this can be an important consideration.

5.      The extra paperwork

Like any vehicle, a corporation needs annual maintenance: filing an annual report, passing resolutions, preparing a separate tax return.  This means time and expense.

6.      Being prepared

Burnouts, marital disputes, cash flow problems, economic downturns, tragedies and new opportunities – every company faces challenges that can change relationships between shareholders.  If your company will have more than one shareholder, you should have an agreement in place to deal with cash calls, transfer of shares, and the death or disability of a shareholder.  See our blog on “shareholder agreements” (coming soon) for more information.