A shareholders’ agreement is a contract among the shareholders of a corporation (with typically the corporation also as a party) setting forth the rules by with the shareholders are to act in relation to one another and the corporation. The agreement can document key issues such as how shares can be sold, what happens if a shareholder dies, whether shareholders can work in competition with the corporation when they leave, and whether any compulsory share transfers should take place if a shareholder has acted in contravention of the agreement or other circumstances.
Without a shareholders’ agreement, in the event of a dispute or a breakdown in trust between the shareholders, there will be no agreed method in place to resolve the dispute or to terminate the relationship of the shareholders (other than applicable statutory provisions). In addition, disputes about a corporation’s assets, repayment of loans, and valuation of shares are more difficult to resolve, particularly in smaller corporations where the shareholders also work full time in the business and/or the ownership percentages are equal. If the shareholders are deadlocked and do not have a mechanism to break a deadlock, they may end up in litigation or may need to consider winding up the corporation.
At a minimum, a shareholders’ agreement should always address the following:
Death of a Shareholder.
When a shareholder dies, his or her shares become part of the shareholder’s estate, which is then distributed to his or her beneficiaries. As a result, the surviving shareholders now jointly own the corporation with one (or more) of the deceased shareholder’s beneficiaries. A shareholders’ agreement can restrict the shares from becoming a part of a shareholder’s estate by providing a right to (or obligation of) the other shareholders or the corporation to purchase the shares.
Disability of a Shareholder.
If a shareholder becomes seriously ill, disabled, or incapacitated, he or she may no longer be able to contribute to the corporation in a meaningful way, especially if the shareholder is also a director or officer of the corporation. Allowing for an outright purchase or temporary appointment of voting rights of shares during a disability is especially important in order to avoid having those rights suddenly exercisable by the disabled shareholder’s agent under a power of attorney.
Divorce of a Shareholder.
On a dissolution of marriage, a shareholder’s shares are included in the family property to be equalized with his or her spouse, which could result in the ex-spouse receiving all or part of the shares of the corporation in the divorce. A shareholders’ agreement can restrict the shares from being included as assets in the divorce proceedings by providing a right to (or obligation of) the other shareholders or the corporation to purchase the shares.
Transfer of Shares by a Shareholder.
A shareholder may desire to sell his or her shares and leave the business. Unless there are restrictions in place, the shareholder may be able to sell those shares to anyone instead of being required to first offer them to the other shareholders or the corporation (which would reduce the chance of an unknown third party suddenly becoming a owner of the business). Or, a majority shareholder may receive an offer from a prospective purchaser and desire to sell his or her shares. The provisions in a shareholders’ agreement can cover both (1) the situation where the minority shareholder wants to force the purchaser to also buy all or a proportional percentage of his or her shares and (2) the situation where the prospective purchaser wants to force the minority shareholder to also sell his or her shares. The agreement can also provide for a method of valuation of the shares in all transfer scenarios.
Dispute between Shareholders.
Disagreements over the direction of the business, who the corporation is doing business with, or whether to bring on investors, merge with another company, or sell the business can all cause issues among shareholders and possibly result in deadlock. A shareholders’ agreement can set out the process for resolving disputes, whether by providing one shareholder (or a neutral third party) a tie-breaking vote, referring a matter to private arbitration or mediation, or some other method.
The importance of entering into a shareholders’ agreement while everyone is getting along cannot be minimized. Once a dispute arises, or a shareholder desires to sell his or her shares, or a shareholder’s personal situation changes, it is often too late.
If you have questions or would like assistance in the preparation of a shareholders’ agreement, please contact us.