From the desk of:

KEY CONTACT

Howard Manis

Partner

From the desk of:

KEY CONTACT

Michael Carey

Counsel

Owner Operated Businesses Need A Shareholders’ Agreement

Corporations in Canada may be incorporated under the federal laws of Canada or the laws of a particular province. Each of these jurisdictions have a business corporations act which governs the incorporation of the company, the  rights and powers of directors, officers and shareholders, corporate finance, books and records, auditors and financial statements, and liquidation and dissolution.

These statutory provisions are written with a view to prescribing certain minimum standards applicable to all corporations incorporated under the laws of that jurisdiction. This “one size fits all” approach may not adequately protect the interests of a particular shareholder or group of shareholders. As a result, many of these provisions are often amended by way of all of the shareholders of the corporation signing a shareholders agreement.

For example, Ontario’s Business Corporations Act specifies that certain shareholder resolutions require 66 2/3 of the votes of the shareholders cast at that meeting to pass. All other shareholder resolutions may be passed by a majority of the votes cast by shareholders at a shareholder’s meeting. 

If one shareholder owns 70% of the voting shares of a corporation and the other shareholder the remaining 30%, the majority shareholder may outvote the minority shareholder every time, leaving the minority shareholder vulnerable. This power imbalance can be rectified in a shareholders agreement by increasing the percentage of shareholder votes required to carry a specified type of resolution to 80%.

One subject that is not included with the various business corporation statutes is the right of a particular shareholder to buy the shares of the other shareholder(s), or to sell the shares owned by that shareholder to the other shareholder(s) or to a third party. In the absence of a shareholders agreement specifying such right, the shareholder has no such right unless the other shareholder(s) agree. This may result in a shareholder being trapped in a corporation he or she no longer wishes to be involved in.

When a business starts, there are  many demands on the founders’ time and budget. The last thing on their mind is how the business will end. At the outset, the shareholders are the best of friends, there is complete trust, and nothing could go wrong. However, years go by, and it is possible things will go sideways. Perhaps the business is not what it used to be, or there is a falling out between certain shareholders, or another opportunity arises that one of the shareholders wishes to pursue. 

In the case of a small business, shares cannot be readily bought or sold, and purchasers of such shares may not be readily found. There is only one enforceable method for one shareholder to buy shares of (or sell shares to) the other, and that is a shareholders’ agreement.

The time to negotiate a shareholders’ agreement is at the beginning when everyone is getting along. Once there are issues between shareholders, it is much more difficult to reach agreement. It is advisable to negotiate a shareholders’ agreement as soon as possible after incorporation, because while no one expects the shareholders to have a dispute, one is possible any time. If issues do arise between the shareholders, an agreement can provide a path for one party to sell his or her shares, or buy the shares of the other party, expeditiously and fairly. There are several useful clauses that provide these rights.

One common exit clause is (dramatically) called a shotgun clause. In such a clause, one shareholder sends an offer to buy the shares of the other at a given price, and the same offer to sell his or her shares at that same price. The shareholder(s) receiving the offer must decide whether to buy or sell. In the case where there are more than two shareholders, these clauses can become quite complex, as there are numerous parties who might make different decisions. Shotgun clauses favour the party with more money, as a less wealthy shareholder may not have the funds to buy the other, and be forced to sell accordingly. 

Another strategy to exit a corporation is by exercising a put or a call. A put is a right to sell shares at a certain price. The other shareholders, or the corporation would be obliged to purchase the shares of a party exercising a put. Such mandatory transfers could be exercised at any time, or upon the occurrence of certain events, such as the death, incapacity, bankruptcy, retirement or termination of employment, or a material breach of the shareholder agreement.

A call is a right to buy shares. If there is a call right in a shareholders’ agreement, the parties could exercise their right to buy the shares of the other(s). Put and call rights may have prices attached to them, or, may be subject to a valuation clause.

Determining the price for the purchase and sale of shares is called valuation. The methods of valuing companies include regular agreement by the shareholders of the value of a share or, determination of such value by a third party. Although regular valuation by the shareholders is a seemingly inexpensive option, it does have some drawbacks. 

Regular valuation by the shareholders is often forgotten, not documented, or agreement is not reached, or the most recent agreed value is inaccurate when the time comes to rely on it. The alternative, where the value is determined by an accountant  can be more independent but there are wide discrepancies among such third-party valuators. 

The most reliable valuations are completed by experienced chartered business valuators. These individuals are members of a recognized body of trained business valuators which impose objective standards on such valuators. They are experts at valuing businesses and take into account a wide variety of factors.

Some shareholders agreements provide that shares must be sold at a discount to the value in certain circumstances. For example, if a shareholder materially breaches the agreement, or some other misconduct, or becomes insolvent, the shares must be sold at 80% of the value. 

All good things must come to an end, so plan for the end during the good times. Using one or more of the above clauses in a shareholders’ agreement will provide at least one path to exit, or take over, the company when that time comes. 

Michael Carey and John Collins practice corporate-commercial law with Macdonald Sager Manis LLP. Should you have any questions, or wish to discuss shareholder agreements, please contact either of them.

This article is not intended to serve as a comprehensive treatment of the topic and is not legal advice. All legal matters are dealt with pursuant to their specific facts and circumstance. Nothing replaces retaining a qualified, competent lawyer.