By Abhi Mathews CBV, CFA
No business is free from contentious issues, including from within the company. While companies started by a family, friends, or even long-time associates, may run smoothly for a while, a shareholder should never assume that issues will not arise. If a company has more than 1 shareholder, even if it is family members: a shareholders’ agreement is a necessity.
A shareholders’ agreement is like a prenup for a business; an important document for both the shareholders and the underlying business itself, particularly in family owned businesses where the number of shareholders increases as the next generation becomes involved in the business. A corporate lawyer along with either a specialized business valuator or a specialized accountant, with estate planning experience, can greatly assist in drafting and reviewing key sections of the report. Specifically, mid size entities (sales > $5m – 10m) often have valuation clauses, which require annual or bi- annual valuation reports so that the owners can confirm their net worth.
A shareholders’ agreement is effectively a contract between the shareholders of a company and provides additional protection around ownership and the procedures to be taken in relation to certain decisions. A shareholders’ agreements is an obvious choice when a company is co-owned by multiple parties. By establishing plans for addressing disagreements in advance, one can avoid complications later, which often arise. A shareholder agreement may be relevant for you, especially, as part of a plan for future business expansion or in anticipation of milestone events.
Most shareholder agreements provide solutions to the following important topics:
Restrictions on Transfers and Ownership of Shares:
Restrictions on who can become a shareholder is an important aspect of a shareholders’ agreement. Most corporations require the approval of the directors with respect to all transfers of shares, however, depending on the composition of the board, this requirement may not always look out for the interests of the minority shareholders.
Whether at the start-up phase or during operations, or both, a business will require access to capital. A shareholders’ agreement can set out how the corporation will access funds and whether the shareholders are responsible for contributing such funds in accordance with their relative interest in the business.
Death or Disability:
The family of the deceased or disabled shareholder may be in need of the income earned by the deceased or disable shareholder and selling the shareholder’s shares may be their only alternative. Additional issues may arise if the deceased shareholder was actively involved in the business. These issues can be resolved using a shareholder agreement.
Even though it seems that a business run by family members carries minimal potential for contentious disagreements, we have found the opposite to be true, based on our experience, dealing with the different communities (Indian, Chinese, Jewish, Italian, Russian, Arab etc.) present here in the Greater Toronto Area. However, in-fighting occurs more often in the family business dynamic than one would anticipated due to human nature and accumulation of wealth, over time. Contemplating how shareholders can buy one another’s shares in the event of a dispute will save a family business(es) and each shareholder a great deal of time and money. These issues can be addressed in a shareholder’s agreement.
A shareholder agreement provides a great solution to business decision-making. As a general rule, corporate law gives the upper hand to the majority shareholder(s) as decisions can typically be made with the positive vote of a simple majority (i.e. 51%). Sometimes family members want to maintain a particular percentage ownership of a company in order to preserve voting power or ownership. This usually means limiting the ability for the company to issue new shares, which might have the effect of diluting the ownership of existing shareholders. Shareholder agreements can put the control over proportional ownership in the hands of the existing shareholder by giving them the right to buy any shares proposed to be issued in the company, each share purchased would exclude the issuance of that share to a new would-be shareholder.
A well-written shareholders’ agreement will provide for different exit strategies in the event that the shareholders can no longer be in business together. A “shotgun” clause allows a shareholder to trigger a forced buy-sell scenario, meaning the “triggering shareholder” makes an offer to the remaining shareholders to buy their shares at a specific price.
There are a number of tax and legal implications that can arise out of decisions made in your shareholder agreement. A few key tax issues to consider when drafting a shareholder agreement include fair market value, leveraged buy-outs, amicable split, company control, control through buy/sell agreements and non-arm’s length buy/sell (Please consult your local corporate law firm – we can recommend many depending on your area and industry). As each of these situations can result in serious consequences, such as a company losing its CCPC designation, or increased taxation, special care is required when drafting these areas of the agreement. In discussing a shareholder agreement with your family and your lawyer, you should always also involve a tax accountant as there are many tax-driven considerations that go into a shareholder agreement.
We at Minerva Valuations, Inc. provide business valuation services and also provide assistance in the drafting and structuring of shareholder agreements. Minerva Valuations is a mid market advisory firm specializing in business valuations, acquisitions, divestitures, litigation support and shareholder value advisory services. Our clients include accountants, business owners, lawyers and estate practitioners.