For mid-market companies the relationship between the owners is the bedrock upon which the business is formed and operates. The owners must trust that each will carry out their respective obligations to make the business a success for all. Like a marriage, the relationship typically starts well with all parties working with the same understanding and common goals. However, the passage of time and life changes may affect an owner’s priorities and commitment to the business and the relationship with the other owners.
This edition of The Battlefront starts a multi-part review of shareholder agreements and the value of clarifying and crystallizing the relationship between the owners. This first part gives an overview of shareholder agreements and their special status under corporate law. Future editions will canvas the typical contents of such agreements.
What is a Shareholder Agreement?
As the Midmarket Lawyer, I frequently get asked questions regarding shareholder agreements, particularly how such agreements work and whether the effort and complication is worth the cost at the start of a business relationship when all shareholders are working cooperatively. Such advice must be customized to the client and the specific business, but there are common threads throughout.
First, a shareholder agreement is simply an agreement between two or more owners of shares in a company. A shareholder agreement typically sets out who owns what shares, who will be directors and officers of the company, how the company will be operated and financed, and how shares can be transferred or sold. However, there is no legislation setting out what is required in a shareholders agreement. While these agreements frequently canvas similar issues, a shareholder agreement can be as short and simple, or long and complex, as the shareholders or circumstances require. One size does not fit all!
Second, shareholder agreements contemplate not just how the business will be operated in the present, but also how the owners agree to handle certain future events. Such future events could include: incapacity due to health reasons; voluntary departures; inter-generational transfer during or after an owner’s lifetime; and various exit strategies (shot guns; buy outs; puts; calls; etc.). Shareholder agreements can be used to clarify the current relationship between the owners and also plan for the future.
Third, a shareholder agreement takes on a special status under corporate law if all the owners of all shares enter into the same agreement. This becomes a “Unanimous Shareholders Agreement” (a “USA”). Corporate law grants a broad range of rights to a USA to govern, or restrict, how the company will be operated. A few key rights that may be included in a USA are:
- Raising approval thresholds above a simple majority vote, i.e. 2/3 approval or even unanimous approval for all or certain matters;
- Restricting issuances of new shares or grant existing shareholders the first right to purchase new shares;
- Prohibiting the payment of dividends (to save cash) or requiring the regular payment of dividends (to force distribution of profits);
- Granting certain shareholders the right to appoint directors;
- Limiting or prohibiting the company from incurring more debt; and
- Requiring regular disclosure of information to shareholders (i.e. additional reporting obligations).
In addition to governing how a company will be operated, a USA can also set out arrangements between the owners regarding their obligations to the company and to each other. A few such key issues between owners typically found in a USA include:
- cash calls to require shareholders to contribute cash if and when needed;
- procedure to resolve voting stalemates;
- buy out rights in the event that any shareholder fails to carry out their agreed obligations;
- shot gun procedure as a means to a simple divorce; and
- dispute resolution procedures (mediation; arbitration; litigation) to handle complicated disputes.
In a broad sense, a USA can crystallize and clarify both the owners’ agreement as to how their company is to be managed, but also the relationship between the owners and their rights as shareholders.
Special Rights of Unanimous Shareholder Agreements
Like any agreement, a USA binds all the parties that signed the agreement, i.e. any person that signs the agreement is obligated to comply with the terms and conditions of the USA. However, under corporate law, the USA is granted additional special rights.
First, the directors of the company are immediately obligated to comply with the USA with regards to the business and affairs of the company. Typically, directors have broad discretion to manage a company, appoint officers, set policy, etc., all in the best interests of the company. A USA can restrict, or even remove, the directors’ discretion to make such decisions. Even though the directors are not party to the USA (i.e. the directors have not signed the agreement), corporate law obligates the directors to adhere to any restrictions imposed upon the company in the USA. The directors must adhere to any restrictions on their authority regardless that they did not sign the USA. This requirement for a non-party to comply with the agreement is a special right granted to a USA under corporate law.
Second, if a third party buys new shares from the company, or buys existing shares from an owner, the third party is immediately deemed to become a party to the USA. This occurs even if the third party does not sign onto the USA or even if the third party did not have knowledge of the USA. However, corporate law does grant an unsuspecting buyer an option to rescind the purchase after receiving a copy of the USA. Nevertheless, a buyer should be aware that lack of knowledge of a USA does not necessarily exclude the buyer from complying with the agreement.
Unanimous Shareholder Agreements with Non-Owners
An agreement between all shareholders and non-shareholders is still a USA. This can be used by third parties (ex: a private lender) to impose conditions or restrictions on how a company is operated and what authorities the directors may have. A third party could also obtain the right to attend meetings and receive additional information from the company. Any change to the USA would require the consent of such third party. This can be a useful technique for a passive investor to lend funds to an operating company without having to actively monitor the business on a day-to-day or week-to-week basis. The directors of the company are personally obligated to operate the business in accordance with the USA and may be personally liable for any contravention.
Thoughts to Take Away
Shareholder Agreements are flexible arrangements that can be customized to fit any business environment and owner relationships. A USA is a special form of shareholder agreement that is given special rights under corporate law. Signing a USA at the beginning of the owners’ relationship is preferred, but the parties may enter into a USA at any time, provided that each party has had an adequate opportunity to seek independent legal advice.
A USA can be viewed as an insurance policy, not one that pays money, but one that insures understanding. If the owners are able to resolve all their future disagreements cooperatively, then incurring the cost and effort to create the USA may not have been necessary.
However, with the passage of time and life events, a USA can serve as a road map as to how certain events are to be handled or resolved. For long term businesses, the owners may change over time due to death or the transfer of shares to the next generation. Memories of the original owners may fade or change over time leading to a divergence of expectations. Creating a USA early can insure that all owners continue to understand their relationship and how future events are to be handled.
While a USA can be entered into at any time, once a disagreement has arisen, it’s too late! Any investment in creating a USA early in the relationship when all owners are cooperating will be far less than the cost in settling a dispute later on. A USA may be the best relationship insurance owners can buy!
About Loopstra Nixon LLP
Loopstra Nixon is a full-service Canadian business and public law firm dedicated to serving clients involved in business and finance, litigation and dispute resolution, municipal, land use planning and development, and commercial real estate. Major financial institutions, insurance companies, municipal governments, and real estate developers along with corporate organizations and individuals are among the wide range of clients we are proud to serve.
About The Battlefront
This article contains general information only. The Battlefront is a brief canvasing of the topic presented and should not be relied upon as professional advice in making any personal or business decisions. Always consult with a licenced legal professional before making any decisions regarding your own personal or business needs. The author takes no responsibility to update any of the information presented in this article. All rights reserved. © Loopstra Nixon LLP 2017