Whether entrepreneurs are starting a new business or running an existing business, it’s typical and logical for them to focus on business development, customers, marketing, financing and so forth. However, as the business grows and more stakeholders (including business partners and investors) get involved, one aspect of the business which entrepreneurs often neglect is the need to establish the responsibilities and expectations of each shareholder.
The best way to accomplish this objective is by adopting a shareholders agreement. A shareholders agreement is a contractual arrangement between two or more shareholders of a corporation. It is a common tool to set out the respective rights and obligations of shareholders, to confirm the rules that govern the management of the corporation, and to institute a process for resolving potential shareholder disputes.
There is no denying that entrepreneurs have many priorities when running a business – here are five reasons why adopting a shareholders agreement should be a priority.
1) Corporate Governance
The degree of control and input that shareholders want often depends on their intentions with respect to the business. Business partners who bring different skill sets to the table would likely want all material decisions affecting the corporation to be decided unanimously. Unanimous decision making is also important for minority shareholders who want to ensure that majority shareholders cannot make decisions that are not in the minority shareholders’ best interests.
In contrast, passive institutional Investors are generally less concerned with the day-to-day business decisions – instead, they would want to have a say in major events that could affect their economic interests. For example, they may want to hold veto rights with respect to the sale of assets, the issuance of shares, corporate reorganizations or any non-arm’s length transactions.
2) Share Transfer Rights and Restrictions
Another aspect of businesses that entrepreneurs often don’t consider is how much the success of a business depends on those you are working with. In particular, for start ups with a small number of team members, the removal or addition of any member could have a significant impact on the corporation. However, unless there are share transfer restrictions specifically set out in a shareholders agreement or elsewhere, shareholders may be free to sell their shares. A shareholders agreement can implement general restrictions which provide that shareholders are not permitted to transfer their shares unless they have the prior written consent of the other shareholders.
In addition to these general restrictions, shareholders agreements may also include a right of first refusal and/or right of first offer. When a shareholder receives an offer to purchase his or her shares, a right of first refusal provides that the shareholder(s) holding the right will first have the opportunity to purchase the shares from the selling shareholder for the same price and on the same terms. This right mitigates the concern that any unexpected or unwelcome individuals would get involved in the business.
A right of first offer is a similar right but instead of a shareholder receiving an offer, the shareholder offers to sell the shares and they can only do so after offering to sell them to the existing shareholders (who hold the right of first offer). If the existing shareholders do not accept the offer, the offering shareholder can then sell them to third parties on terms that are no more favourable than the offer to the existing shareholders.
3) Anticipating Future Events
A comprehensive shareholders agreement should also anticipate events that would reasonably happen in the future of the corporation and the shareholders, and provide a mechanism for responding to such events.
A continuation of the concern of voluntary share transfers is the worry for involuntary share transfers – unrelated (and unwelcome) parties may become a shareholder as a consequence of the death, bankruptcy or divorce of a shareholder. Existing shareholders can address this concern by granting existing shareholders a right, pursuant to a shareholders agreement, to acquire any involuntarily transferred shares for a fixed period following the transfer.
Shareholders agreements are also very useful in providing a mechanism for shareholders to exit the corporation. Exiting a corporation can become very complex for all parties involved – issues such as valuation, timing, price, and process must be discussed and these discussions are best completed without the added pressure of having a buyer’s offer on the table. Majority and minority shareholders often have different concerns in the event of a proposed exit involving the sale of shares to a third party. Majority shareholders may want the option to compel minority shareholders to sell their shares so as to ensure they have the ability to sell the company as a whole to a third party – this can be accomplished through a drag-along clause. In contrast, minority shareholders often demand tag-along rights, which allows minority shareholders to require that the purchaser of the majority shareholders’ shares to also purchase the minority shareholders’ shares on the same terms – this ensures that minority shareholders have the option to capitalize on their shares upon a change of control of the corporation by a third party.
With respect to the exit of a shareholder, one of the most common source of disputes is the valuation method. There are many options including an agreement amongst the shareholders, calculations based on a formula or a valuation as determined by a third party valuator. The shareholders agreement should set out which of these applies.
4) Dispute Resolution
Shareholder disputes are inevitable, and they can range from being inconsequential to being detrimental to the corporation. In either case, it is beneficial to have a mechanism (which all shareholders agree to adhere to) to help resolve disputes in a productive manner – this mechanism should be set out in a shareholders agreement.
In fact, the very act of contemplating and discussing the entry into a shareholders agreement is valuable because it raises potential topics of disputes and allows shareholders to address them prior to a problem actually arising. When negotiating a shareholders agreement, shareholders inevitably discuss their intentions towards the business and the degree of control they wish to have. In addition, shareholders would begin to consider potential future developments such as succession planning, exit strategy, and funding arrangements. Actively considering and planning for these developments allows shareholders to understand each others’ perspectives and to find common ground as to how they are going to manage their business.
In addition, beyond the value in the discussions prior to an executed shareholders agreement, the agreement itself can provide different mechanisms for solving a range of disputes based on severity of the issue.
5) Flexibility and Certainty
In addition to all the functions that shareholders agreements can do as described above, they can also be tailored to address the specific needs of each business. For example, shareholders agreements can also contain provisions to prevent dilution of share value, to incorporate employee option plans and other convertible securities, to account for transfers to family members, and to allow shareholders to take on the rights and powers of the board of directors.
Ultimately, a shareholders agreement is a very useful tool for entrepreneurs and investors alike to mitigate the potential risks associated with the ownership of a corporation. It provides certainty in face of the many uncertainties that go hand-in-hand with running a business and it should be one of the first items on a shareholders’ to-do list.
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