They say that good fences make good neighbours. Similarly, shareholder agreements (also written as shareholders’ agreements) establish the rules of the game between the shareholders of a corporation. First off, if there is only one shareholder in your business, there is no need to have a shareholder agreement. Next, only incorporated businesses (corporations/companies) can have a shareholder agreement. Partnerships (non-incorporated entities involving several partners) can have partnerships agreements which have certain similarities to shareholder agreements, but ultimately are different.

Shareholder agreements address areas of potential disagreement between the shareholders and establish ways to avoid and resolve such issues. As a starting point, have all of the shareholders sit down together and decide how they would like to deal with the following questions:

1. How should your company’s directors be selected?
2. How should the decision-making powers be split and who needs to approve important decisions?
3. What happens if one shareholder wants to sell some or all of their shares?
4. What happens if someone wants to buy all of the shares or controlling interest in your company?
5. What happens if money needs to be injected into your business and certain shareholders don’t contribute their part?
6. What happens if there is a dispute between some of the shareholders?
7. What happens to a shareholder’s shares in the event of death, incapacity or bankruptcy?

1. Selection of Directors

A company’s Board of Directors is responsible to manage the company and to take important decisions in its regard. In fact, shareholders elect the Board of Directors and this is how they exercise oversight over the company and its management. This means that if there is a controlling shareholder (someone who has more than 50% of all of the voting rights), this shareholder controls the selection of the Board of Directors as their vote decides the election of each of the directors, and this to the detriment of all the other shareholders.

To deal with such an eventuality, a shareholder agreement can establish an alternative mechanism for selecting the directors. Two such possible options are cumulative voting and allocated Board seats.

Cumulative voting means that all the shareholders vote for all of the directors at the same time and are given a number of votes equal to the number of directors to be elected multiplied by the number of voting shares which they own (assuming all of the shares vote equally). With this system, the controlling shareholder now doesn’t necessarily have enough votes to elect all of their preferred directors which means that the minority shareholders can now get some directors too.

Allocated Board seats means that particular shareholders or groups of shareholders are awarded a certain number of Board seats to appoint their preferred candidate. This guarantees such shareholder or group of shareholders representation on the Board. If the shareholders each have an equal stake in the company, allocated Board seats can be a good approach to adopt.

2. Decision-Making Powers and Threshold for Important Decisions

Even though the Board of Directors manages the affairs of a company, there is often a desire to establish a higher decision-making majority requirement for certain types of decisions. In addition, in the context where certain directors are appointed by different groups, there may be a desire to ensure that some of the allocated directors are all in agreement for certain types of decisions.

Depending on the type of decision being taken, some shareholder agreements even go as far as to require shareholder consultation and votes on those decisions, sidestepping the directors completely.

In this regard, a list of certain decisions or a threshold of decisions can be drawn up, with the associated majority requirement.

For example, there is often a monetary threshold for decisions after which amount, a higher percentage of the directors must agree, such as 66%. Depending on the size of the company, such a monetary threshold could be $10,000, $50,000 or $100,000.

In addition, decisions such as issuing new shares or paying dividends can also require a higher approval threshold or even direct consultation of the shareholders in particular with respect to the issuance of new shares or the taking out of large loans.

3. Shareholder Share Sales

At one point, a shareholder may want to sell some or all of their shares in your company. An issue may arise if a third party buys those shares, as the other shareholders now find themselves in business with a partner they may not want. Alternatively, if a shareholder sells their shares to another shareholder, this may alter the balance of power between the remaining shareholders or even give one shareholder a controlling interest in your company.

To deal with these possibilities, shareholder agreements often provide for a right of first refusal in respect of all offers received by a shareholder for their shares. A right of first refusal is the right for the other shareholders to match the offer made by the potential purchaser, and if so matched, the selling shareholder is compelled to sell instead to the other shareholders based on the same terms as those received by the potential purchaser.

Another possibility is for a tag-along right for the other shareholders, meaning that the other shareholders have the right to sell alongside the selling shareholder based on the same terms.

4. Consequences of a Change of Control or Company Buyout

Upon a change of control, the dynamics between the shareholders may drastically change. To deal with such an eventuality, shareholder agreements normally once again feature a tag-along right for the other shareholders or the right to insist that the company repurchase their shares.

Flipping the situation on its head, the potential purchaser may be interested in buying all of your company. In such a situation, a dissenting minority shareholder could either scuttle the deal or use their refusal as leverage to get a much better price for their shares.

To address that situation, shareholder agreements often have a drag-along clause which means that the majority of the shareholders can compel a dissenting shareholder to sell at the same price as everyone else.

5. Consequences of a Cash Call

For a number of reasons, your business may require a cash injection from its shareholders. Everything is fine if all of the shareholders are prepared to contribute their percentage to this cash call, but sometimes, one or more shareholders cannot do so or refuse to do so.

This may lead to a dispute over the corresponding number of shares which should be issued in consideration of the injected cash.

If these additional shares are simply issued at the corporation’s previous valuation, there are limited consequences for the non-contributing shareholders. They are simply diluted, meaning that their shares represent a smaller fraction of the ownership of the company as more shares have been issued, decreasing their relative ownership percentage. However, they are diluted based on the pre-raise value of the corporation. This is often an overly rosy valuation of the company which therefore means that fewer shares are issued to the contributing shareholders, and the associated dilution of the non-contributing shareholders is less than it should be.

To address this issue, shareholder agreements sometimes include a multiple with respect to the number of shares to be issued in order to sufficiently reward the contributing shareholders and to penalize the non-contributing shareholders. Alternatively, other shareholder agreements force some valuation of the company (or valuation formula) for the raise in order to simplify the determination of the price applicable to the newly issued shares.

That being said, be cautious with respect to any obligation to use the services of a business evaluator as the cost can be surprisingly high and it can take much longer than expected for the valuation to be completed – the two things which your company will likely be lacking at the time of the cash call: time and money.

6. Disputes Between the Shareholders

Occasionally, businesses are faced with the challenge of shareholders who can no longer work together. Such a dispute poses a real challenge to the business since you cannot simply remove someone as a shareholder. As shares in a company are a form of property ownership, you cannot simply dispossess someone of their rightfully owned property.

If the dispute cannot be resolved directly between the parties, normally the only other options are to (1) go to court to have a judge decide the matter or (2) have one shareholder (or several shareholders) buy out the “problematic” shareholder.

A common approach is for the shareholder agreement to state that disputes which cannot be resolved between the parties should be submitted to mediation. Mediation is a dispute resolution mechanism whereby a mediator goes back and forth between the parties to try to help them reach a mutually acceptable resolution. To give the mediation a better chance of success, have the shareholder agreement designate a mediator and a replacement mediator to avoid a preliminary dispute as to who should act as mediator.

If the mediation fails, once again, the default option is to go to court. However, shareholder agreements can provide for an alternative mechanism called arbitration. Arbitration is effectively a private court hearing with the important distinction that rather than being presided by a judge who is appointed by the State, the decider is selected by the parties themselves. Arbitration has the advantage of normally being much faster, much cheaper and more private than a classic court hearing. On top of that, arbitration decisions are normally final and not subject to appeal.

Similarly to mediation, a dispute may arise as to who should act as the arbitrator, but here, this question is more important since the arbitrator is actually deciding the dispute instead of just helping the parties resolve it amicably between themselves. Therefore, make sure that the arbitration clause designates the arbitrator and replacement arbitrator.

If the issue still cannot be resolved, there is sometimes a mechanism in the shareholder agreement which permits the buyout of the “problematic” shareholder. Although that sounds rather simple, in fact, such clauses are normally some the most contentious.

The issues are twofold. First, as in any dispute, both sides may believe that they are in the right and each may want to continue in the company with the other party getting out. The issue is then who buys whom? Second, how is the price determined for the share purchase? Unlike public companies which are traded on open stock exchanges, private companies don’t have obvious valuations which establish their price per share.

Although share price can be established by a professional business evaluator, this is normally quite expensive and the shareholders may not agree with the evaluation. This third-party evaluation also doesn’t resolve the question of who buys whom?

An alternative is something normally referred to as a “shotgun clause” or a “buy-sell clause.” A shotgun clause means that one of the parties makes an offer to buy the other shareholder’s shares at a given price per share. The other shareholder then has the option to either sell at that price or to buy the initial shareholder’s shares at that price. This means that the party who initially thought he was going to be buying could in fact end up being the one compelled to sell.

The advantage of a shotgun clause is that it should ensure that the share price offered is a fair one since the potential buyer exposes himself to sell at the same price if the price offered is too low. However, that principle only works when both of the parties have sufficient financial resources. Otherwise, the wealthier party can simply make a lowball offer which the other party cannot match, since he lacks the requisite financial resources.

Shotgun clauses are not to be entered into lightly as they are extremely powerful and open the door for you to be kicked out of your own company.

7. Death, Incapacity or Bankruptcy of a Shareholder

Small businesses are built on the back of their shareholders. This group of partners knows the ins and outs of their business, and works very closely together. In such a context, there is a clear desire to ensure that not just anyone can become a shareholder.

If a shareholder dies, their shares would normally go to their estate which could result in a whole new series of people becoming shareholders of your company. The same thing would happen in the context of a bankruptcy were such shares could be sold to a third party to pay the bankrupt shareholder’s debts. Or, if a shareholder becomes incapacitated, they may need to sell their shares.

To deal with such eventualities, shareholder agreements can oblige the company to purchase life insurance and sometimes disability insurance for its key shareholders with sufficient coverage to fund the acquisition of their shares, and compel that purchase upon the occurrence of a triggering events. This ensures that the corporation has the financial resources to purchase the shares in question at a fair price. As the corporation increases in value, it is necessary to increase the amount of the insurance coverage. However, this doesn’t deal with the bankruptcy scenario which normally requires that the company have sufficient cash reserves as you generally cannot insure against bankruptcy. One solution is to have the sale be deemed to be completed immediately prior to the bankruptcy and establish that the payment is to be made over time, say over the course of several years.

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Now for the tricky part. On the one hand, as a shareholder agreement can have such an important impact, you want to have it done right and have it drafted by a lawyer. On the other hand, there is a cost to hiring a legal professional to draft such an agreement and your business may not want to spend such funds when it is just getting off the ground. Although your best option is to hire a lawyer, if this means that the preparation of your shareholder agreement will be delayed, consider writing down the main points of the agreement and have all of the shareholders sign it. Such a document will naturally be imperfect, but it will at least provide a framework to work off of should a disagreement arise prior to the signature of the lawyer-drafted agreement.

As always, feel free to reach out if you want to hand in preparing a shareholder agreement or advice in this regard. Best of luck!