Business Advisor: December 2013

Five years ago, two friends who had known each other for many years decided to establish a business.

Five years ago, two friends who had known each other for many years decided to establish a business. Their focus was on establishing and growing the company. Contemplating a shareholders’ agreement and incurring the related legal fees was not high on the priority list. What could go wrong?

The two shareholders decided that each would be responsible for different functional areas of the company. After years of hard work, the business was profitable and further growth was anticipated. The business required additional working capital for operations. A shareholders’ meeting was called. One shareholder believed that the company should increase its credit line, as the company simply didn’t have the funds available. The other shareholder disagreed, preferring that the shareholders provide the necessary funds, as it would be in the best interest of the corporation not to take on the additional risk of increased bank debt. The shareholders were deadlocked.

Having a shareholders’ agreement will not resolve all shareholder differences, but it will determine the structure that will assist in resolving disputes.

Every ship needs a captain. One of the most important elements of a shareholders’ agreement is that it sets out a framework for governance. The agreement should outline who is going to be in charge of key decisions that need to be made on a daily basis. The agreement also should stipulate how this person is appointed and replaced. The agreement would provide guidance for matters that require unanimity (such as major acquisitions or disposal of the business) and a mechanism to break stalemates. Normally there would be an approved annual budget that would authorize certain expenditures outside the normal day-to-day expenses. There also may be limits on the amount of expenditure that can be incurred without obtaining prior approval. 

The terms of a shareholders’ agreement may address unequal shareholder contributions by requiring shareholders to pay interest on any excess contributions or possibly giving each shareholder the right to require a defaulting shareholder to sell his or her shares.

It also may be prudent for the terms of the shareholders’ agreement to allow the shares of any shareholder who is in default to be bought. A shareholders’ agreement could provide a “shotgun clause” whereby one shareholder could offer his shares to the other shareholder at a specified price. If the other shareholder does not agree to buy the shares at the offered price, the other shareholder must then sell his interest at the same price. In certain circumstances, it may be more appropriate to have an auction whereby sealed bids are received from the shareholders and the person offering the highest price will be the buyer. 

Some shareholders’ agreements provide a formula describing how shares are valued in various circumstances. A chartered business valuator would determine the valuation. Alternatively, the shareholders may meet annually to set a value for any transaction that takes place from one year to the next. Often provision is made for the value of shares to be discounted in the case of default.

There are numerous factors to consider on a buyout of a departing shareholder, including:

• the period of time during which an acquiring shareholder (or the corporation) can pay any balance owing to a selling shareholder
• a provision for interest to be paid on any unpaid balance
• a stipulation for certain restrictions on the payment of dividends and increases to the remuneration of shareholders while there is an unpaid balance
• a provision for the entire outstanding balance to become immediately due if the business is sold
• a determination that the selling shareholder (or his representative) continue to be a director until the entire balance has been repaid

Shareholders’ agreements also should address what happens in the event of the disability, retirement or death of a shareholder. It is important to define “disability.” It is common to have an automatic buyout after a specified period and for the determination of remuneration as to amount and period. If there is no shareholders’ agreement outlining the buyout of a shareholder experiencing a prolonged disability, difficult issues may arise such as how to determine the remuneration of the working shareholders and the appropriate compensation to the non-active share-holder so that he receives an appropriate return on his investment. A shareholders’ agreement will stipulate whether or not it is intended to insure the lives of the shareholders to provide funds in the event of death. Further, the agreement will usually mandate an automatic buyout on death and provide for the terms of payment of the balance not covered by insurance.

Our experience has shown that the shareholders’ agreement is one of the most neglected documents in business.

Failure to make one leaves the door open to unnecessary problems.

This article is co-authored by Bruce Roher and Howard Joffe. Bruce Roher is a partner in the business valuations practice at the Toronto office of Fuller Landau LLP, Chartered Accountants. He can be reached at broher@fullerlandau.com or at 416-645-6526. Howard Joffe is a principal at Fuller Landau LLP, providing advice in the areas of shareholders’ agreements, income tax, insurance and estate planning. He can be reached at hjoffe@fullerlandau.com or at 416-645-6534.