Why your Company needs a Shareholder Agreement

Business Lawyer | August 18, 2020 | Written by Tony Sandhu

A shareholder agreement is a contract between two or more shareholders of a company. Its purpose is to set out the respective rights and obligations of the shareholders.   A shareholder agreement typically addresses the following issues:

Death of Shareholder

What happens when a shareholder suddenly passes away? If there is no shareholder agreement dealing with the transfer of the deceased shareholder’s interest in the company, the shares of the deceased shareholder will form part of his or her estate and will be distributed to the beneficiaries of the deceased’s estate.   As a result, you may end up co-owning the company with your business partner’s spouse and/or children.

If you wish to avoid this outcome, you can include provisions in a shareholder agreement to provide the other shareholders of the company the right to purchase the deceased shareholder’s interest in the company. You should also be thinking about how the buy-out of the deceased’s interest will be paid for. To ensure the buy-out price does not become a liquidity issue for the company, you can include a valuation method and also provide an extended period of time to pay out the price to the beneficiaries of the estate.   The feasibility of life insurance as a source of funds should also be reviewed when working out appropriate provisions for the purchase of the deceased shareholder’s interest.

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Transfer of Shares

Without restrictions on the transfer of shares set out in a shareholder agreement, shareholders may transfer or sell their shares to any person. You may find yourself in a situation where you end up co-owning the company with a third party whom you never intended to be in business with.

A shareholder agreement will include provisions to address this situation by implementing a general restriction that shareholders are not permitted to transfer their shares without consent from the other shareholders. A right of first refusal is often included in the agreement to prevent a third party from becoming a shareholder in the company. In general terms, the right of refusal will provide the other shareholders the right to receive an offer or notice from the selling shareholder specifying the number of shares being offered for sale, the price and terms before they are offered for sale to the third party.

Management and Control of Company

The day-to-day management of a company’s business is generally left to the directors and officers of the company. If there is no written agreement to the contrary, the number of votes required for decisions is a simple majority (51% or greater). According to the majority rule, a minority shareholder (49% or less) would have no control over the running of the business. A shareholder agreement can help identify important issues among the shareholders and set out unanimous approval requirements for certain decision making. This helps to strike a balance between majority and minority shareholders.

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One of the most prudent items to cover off in a shareholder agreement is funding for the company. A clear plan as to how the funds will be obtained is very important to ensure adequate funds are available to the company on a timely basis. Generally, financing for the company is obtained from bank loans or shareholder loans. After the initial contribution, shareholders generally want to avoid making further cash contributions. The following are some of the issues you should consider addressing in a shareholder agreement:

Will the availability of bank financing be considered first?

Will there be an obligation on the shareholder to provide personal guarantees?

Will there be an obligation on the shareholders to provide additional funds if required by the Company?

Who will make the decisions for the cash call? Will this decision be made by the directors or shareholders?

What are the consequences if a shareholder refuses or is unable to provide the financing? Will the complying shareholder get an additional rate of interest? Will any of the defaulting shareholder’s rights get suspended or will it trigger a buy-sell of the shares?

What are the repayment terms of the shareholder loans? Will there be any priority over previous loans made to the company?

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Compulsory Buy-Sell

It may be appropriate to include a compulsory buy-sell provision in the shareholder agreement as a dispute resolution mechanism, often referred to as a “shotgun clause”. This is invoked in circumstances where the parties’ negotiations are no longer amicable and the only resolution is to go their separate ways.

A typical shotgun provision will operate to permit a shareholder to make an offer to the other shareholder to purchase or sell all of his or her shares for a specified price and terms. The other shareholder will then have to make a decision whether to sell his or her shares to the offering shareholder for the price and terms specified in the said offer, or purchase the shares of the offering shareholder for the same price and terms set out in the said offer.  The end result is that one shareholder will be leaving and the other staying.

A shareholder agreement can help business owners ensure resolution of a variety of issues, and more importantly protect the shareholders’ investment and business of the Company.  Depending on your specific circumstances, there may be other provisions that need to be covered in the shareholder agreement. We suggest you consult with your business lawyer if you are thinking of putting a shareholder agreement in place for your company.

© Linley Welwood LLP. The contents of this article do not constitute legal advice. Readers should seek legal advice in relation to their own specific circumstances.

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