Whenever a private corporation has shareholders from more than one family (and sometimes even within the same family), a shareholders’ agreement should be considered.
A typical situation is where two or three individuals go into business together, and incorporate their business, with each one owning an equal or unequal number of shares of the corporation.
If you do not have a shareholders’ agreement, the normal rule is that a majority of the voting shares can elect the board of directors, and the board of directors can do pretty much what they want with the management of the company. Whoever controls the board controls the business. A minority shareholder might just as well have no votes at all. (In some cases there is Court action that can be taken if the minority shareholder is being unfairly treated, but this is uncertain, slow and expensive.)
A shareholders’ agreement (sometimes called a Unanimous Shareholders’ Agreement) can protect minority shareholders and allow the parties to deal in a planned way with various contingencies that can arise. It can become quite a complex document, as there may be many conditions to plan for.
Some of the issues that a shareholders’ agreement can cover are the following:
• Control of the corporation: who will be on the board? A minority shareholder can be guaranteed one or more seats on the board of directors. The agreement can also guarantee that specific individuals will hold specific positions as officers of the company, such as President or Treasurer.
• What happens if a key player dies, becomes disabled, or wants out of the business? The agreement can provide a mechanism for the remaining shareholders to buy the departing shareholder’s interest, and a method of valuing that interest.
• What if the key owners no longer get along? For a two-shareholder company, one solution is a “shotgun” arrangement. Either owner (“A”) can at any time trigger the shotgun by offering a price for the shares of the other (“B”). B then chooses between selling their shares for that price, or buying A’s shares for that price. This keeps A honest: if the offer is too low, B will simply take A’s shares at a low price, while if the offer is too high, B will sell out and take the cash.
• Options to acquire more shares from the corporation at a pre-specified price.
• Compensation and incentives such as bonuses. These are normally decided on by the directors, but a shareholders’ agreement can override this, or can set limits.
• Tax issues, such as ensuring that the corporation’s capital dividend account (which allows certain amounts of dividends to be paid out tax-free) is used fairly; or maintaining the corporation’s assets in a way that will qualify for the capital gains exemption if shareholders sell their shares.
• Insurance. Should the corporation hold, and pay for, life and disability insurance on the key owners? Should the owners cross-hold policies on each other’s lives, so that if one dies the other will have funds to buy the deceased owner’s shares from the estate? Should the directors be insured against liability, including for unremitted income tax source deductions and unremitted GST/HST?
• What happens if an offer comes along from a third party to buy out the controlling shareholder? The agreement can provide that the controlling shareholder can only accept if the minority shareholders are given the same offer. It can also provide rights of first refusal, so that other shareholders would have the option of matching the third party’s offer.
• Transfers of shares normally require approval of the directors or shareholders of the company. The agreement can provide that such approval is guaranteed for certain kinds of transfers (e.g., to family members, a holding company or a family trust).
• Dividends. Without an agreement, the board of directors has the discretion to declare whatever dividends they want (provided the company is solvent) — or no dividends at all. The agreement can require minimum dividends based on specific levels of profitability, or can require that certain amounts be reinvested in the business.
Obviously there is a vast range of possible considerations for shareholders’ agreements. The above points highlight only some of them. Anyone entering a new corporate venture should seriously consider such an agreement. Although they are time-consuming and expensive to negotiate and draw up, they help focus the parties up-front on some of the issues that are likely to arise during the life of the business. Without such an agreement, disputes between the parties may become unresolvable.
There are many tax planning issues relating to shareholder agreements as well. For example, the existence of an agreement can change the “control” of the corporation for tax purposes. This can affect its status as a Canadian-controlled private corporation, whether it is “associated” with other corporations for purposes of the small business deduction, and many other things. Careful analysis of all the tax implications is crucial when designing a shareholders’ agreement.