Why You Need a Shareholders’ Agrement

British Columbia is home to a thriving small business economy. According to the B.C. Small Business Profile, in 2013, 43% of self-employed business owners carried on business through a corporation. It is quite common for the shareholders of a small incorporated business to be close friends, family, or to all work together in the business. These close relationships can be the basis for highly successful small corporations, when the parties are all getting along. Unfortunately many small businesses also collapse due to disputes among the owners. Usually these disputes are caused because one of the owners feels they are being short changed in the business, or that the arrangement between the owners has become unfair. Having a clear agreement that lays out the rights and responsibilities of each shareholder is one of the best steps that you can take to ensure that your small corporation does not ultimately fail or fall apart due to a disagreement between the shareholders. Even the exercise of drafting a Shareholders’ Agreement can help avoid disputes, because the shareholders are forced to turn their minds to the issues that might cause conflict, and decide how best to deal with these issues in a fair manner.

In British Columbia, the primary document that governs a corporation is its Articles. Corporate Articles provide rules for basic corporate governance, like how the directors of the corporation are elected, how the shareholders registry is maintained, and the procedures for shareholder meetings. What the Articles do not provide is a complete system for making decisions or dealing with the rights and responsibilities of the shareholders. The British Columbia Business Corporations Act (the law that governs B.C. corporations) does provide rules and protection for shareholders, but these rules are often not as detailed or comprehensive as many shareholders would like.

A Shareholders’ Agreement on the other hand can, when drafted properly, provide a much higher level of detail for how the corporation’s business is operated, and what protections are in place for each shareholder. The biggest advantage of a Shareholders’ Agreement is that it can be customized to the specific situation of the individual corporation and its shareholders. The following are some of the issues that are commonly addressed in a Shareholders’ Agreement:

Restrictions and Rules on Transfer:

Small businesses are often intimately tied to the relationship between the shareholders. If you start a small company with someone, it is usually in part because you think that the other person is smart, hard-working, and will make a good business partner. What you don’t want is to dedicate time and money to a business only to have the other shareholder sell out their shares to someone else, someone that might be lazy, wasteful, or just a poor business partner.

Shareholders’ Agreements often deal with this problem by placing restrictions on the sale of the corporation’s shares. This can be done in a number of different ways, that each strike a different balance between restrictiveness and freedom to transfer your shares.

It is common to include a right of first refusal. In its most basic form, a right of first refusal means that before a shareholder can sell their shares to a third party, the shareholder must first offer their shares to the existing shareholders on the same terms and for the same price as they would offer the shares to a third party. This gives the remaining shareholders the chance to buy the shares themselves and avoid taking on another shareholder, and it allows the selling shareholder to receive payment for their shares.

Another common provision is to include rights of drag-along and tag-along for situations where a share transfer is going to take place. A drag along right is designed to make the shares more attractive to a third party buyer. Under this type of provision, if the third party buyer makes an offer for one party’s shares, they can trigger the drag-along provision and buy out all of the shareholders on the same terms – giving the third party total ownership of the company. This makes the company a more attractive target for acquisition because a buyer will know that they can buy the entire company and not be stuck with a minority shareholder.

Tag-along rights are a similar concept, but the benefit is reversed. With a tag-along right, if a third party wants to acquire more than a certain amount of shares in the company, then the remaining shareholders can require the deal to become all-or-nothing. The minority shareholders can tag-along on the other deal and get out of the company at the same time, and on the same terms, as the selling shareholder. This protects the shareholders from ending up a minority shareholder in the corporation with a more powerful party that might skew the actions of the corporation to their own benefit.

And of course there is the delicate issue of our own mortality. What happens when a shareholder dies? Without a Shareholders’ Agreement, that shareholder could leave their shares to whomever they wish, in the shareholder’s will. This may be fine depending on the structure of your business, but it may also create problems, especially if you know that the shares would be left to someone that you would not want to work with. Shareholders’ Agreements can give the company or the surviving shareholders an option to purchase the shares of a deceased shareholder from that shareholder’s estate. This is often combined with life insurance policies on the lives of the shareholders in order to give the corporation the money to fund such a purchase.

A final issue in share transfers is valuation of the shares. With a right of first refusal the valuation issue is dealt with because the existing shareholders have a right to buy the shares for the same terms as the selling shareholder is offering the shares to the third party. With other situations like a transfer on death, arriving at a fair value for the shares can be more difficult. There are a number of different methods for valuing an ongoing business, and depending upon the method, the resulting valuation can vary substantially. A Shareholders’ Agreement can specify a method for valuing the corporation, so that if a valuation is necessary, the parties will not be stuck fighting over how to determine the value of the shares being transferred.

Management of the Corporation:

The default with corporations is that the shareholders elect directors, who then appoint officers to run the corporation. This regimented structure of management is generally more suited to large corporations where the shareholders are content to invest and then let someone else handle the company. In small corporations, usually the shareholders are directors, and also officers or managers in the business. Things tend to blur together and it can sometimes be difficult to ascertain the authority upon which someone acts within the corporation. This may be fine when things are running smoothly, but if a dispute develops it can be hugely problematic. A shareholder might discover that they have less legal authority to take part in the operation of the business than they first thought.

A Shareholders Agreement can deal with these issues by clearly setting out who will act as general manager and other key roles within the business. This can provide protection from removal to the shareholders that occupy important positions in the company and want to ensure that they are able to continue to take part in the running of the business.

A Shareholders Agreement can also provide some guidance over how the company is run, and set limits on what can be done without consulting the shareholders. Common restrictions include a prohibition on the sale of major assets of the corporation without shareholder approval, and a limit on how much money the corporation will be allowed to borrow before the shareholders must be consulted. These types of restrictions can be very important if you are a shareholder that takes a less active role in the corporation while others manage the day to day operations.

Conclusion:

Wherever there are people, there is the potential for a dispute, and unfortunately this is especially true when money is involved. Running a small corporation with a few close business partners can be an exciting and rewarding pursuit. Having other shareholders allows you more financial flexibility and opportunity than being in business by yourself, and having more owners in the business can mean that there are more talented and dedicated people to help the corporation grow. Obtaining a Shareholders’ Agreement that is both fair, and clear, is a solid investment in your new corporation. It is vital to have a Shareholders’ Agreement in place before a dispute develops and good will is lost. At Velletta & Company we are proud to work with small businesses to help them grow and avoid legal trouble, and if you need a Shareholders’ Agreement, please give us a call. Every small company is different, and we would be happy to speak with you about your specific needs.