Shareholder Agreements: Why They Matter

Any corporation with more than one shareholder should seriously consider adopting a shareholders agreement. Although it is not mandatory when incorporating, the benefits an agreement provides and the problems it prevents can mean the difference between a healthy enduring company or one that succumbs to internal strife.

What exactly is a shareholder agreement? It is nothing more than a contract among some or all of the shareholders, and probably the company as well. When all shareholders are parties it becomes a Unanimous Shareholders Agreement (USA). A USA has some extra significance which will be mentioned later. For ease of reference we’ll consider all agreements USA’s unless otherwise noted.

There is no standard form of USA. This is both a strength and a weakness. It’s a disadvantage because the parties have the responsibility to make sure the agreement covers everything the way they want. But it also means that the contract can be tailored in infinite ways to precisely deal with the parties’ major concerns.

Because there is no standard form, we will talk about the types of things a typical USA includes instead of reviewing actual legal language. Remember that virtually everything discussed can be changed according to the needs of the shareholders and company. Your professional advisors will be invaluable in identifying items which are appropriate for you.

Valuing Shares

One of the most common purposes of a USA is to help shareholders agree on what the company is worth and, by extension, the worth of their own shares. This is not a trivial exercise and even the USA can only go so far given the many different interests and ways of calculating value.

But it is vitally important because at some time or another every shareholder will either want to transfer their shares or the others may want to remove a shareholder. The way this is done is discussed later. For now consider that value will have to be accounted for.

Most USA’s will value shares according to some type of formula or rules. This could be a very detailed financial calculation based on assets, income or other financial information. Alternatively, someone with expertise or familiarity with the corporation might be tasked to figure out the value using specific (or less specific) guidelines. For example, the company’s accountant might be the valuator. There are pros and cons to any system and the most important thing is whether all the parties agree that the method used is acceptable.

Another way of setting value is by periodic agreement of the shareholders. For example, the agreement might provide that the value of shares must be set by shareholders at regular intervals, say every year, and that value will apply for any purposes until and unless a new value is agreed. This can be a good way of handling things if the parties are motivated and disciplined enough to maintain current valuations.

Deciding Control Issues

USA’s often govern how control of the corporation is exercised.

Without a shareholder agreement, control of a corporation rests with its board of directors.  Shareholders have only limited powers, chiefly to elect directors who, as stated, make almost all of the ongoing decisions on behalf of the company. Shareholders also have the right to vote on a relatively short list of what are called “fundamental changes” – things like the sale of a business or a change in a company’s share structure.  Again, without a USA shareholders are entitled to one vote per voting share held. Depending on how a company’s shares are held, a majority shareholder can exercise dominance over matters on which shareholders are entitled to vote.

A USA provides two major differences. First, it can remove certain business decisions from the board, and rest them with the shareholders, where the stated required majority would decide such matters (ranging from a simple majority up to unanimity). A USA also allows a much more granular approach to board and control issues. It might specifically state who is to populate the board and whether some or all shareholders get guaranteed representation or even a majority of directors.

And it can be more detailed than that. The agreement can separate different types of decisions so that “major” ones are handled differently than run of the mill situations. Here’s an example. The USA could provide that decisions are decided by a simple majority of the shareholders except for certain listed cases: say, issuing new shares, adding new debt beyond defined limits, buying major equipment and so on. Those major decisions could require unanimity or a higher level of majority than just 50% +1.

Control is the area where a USA differs most from an ordinary shareholder agreement. If all shareholders are party to the agreement they are allowed to subsume some or all of the statutory rights and duties of directors. In effect, the shareholders can then become the board itself. There are legal consequences of this that are beyond this summary but it can be an effective way of ensuring the company is operated in the fashion the shareholders agree.

Transfers of Shares

All companies face the potential transfer of shares by shareholders at some point. Sometimes this is voluntary, such as when a shareholder wants to transfer shares to her children. Other times it might be involuntary, such as when a shareholder dies or the other shareholders wish to remove her. Without a shareholder agreement, fairly broad and inflexible rules apply and might even prevent a transfer. The USA allows for an orderly and commonly understood system in any case the shareholders deem important.

Let’s deal with voluntary transfers first. Some companies may prohibit sales of shares altogether. They could feel the personal involvement of each shareholder is vital to the business’s success and so they will not allow any of them to transfer shares without unanimous consent. That can be easily included in a USA.

A quick digression. No matter what is included in a contract it is almost always subject to amendment if all the parties to the contract agree. A USA is no exception. It is common to include the default “do’s” or “don’ts” as terms in the agreement with the parties recognizing that they can always change things later if everyone consents. The USA exists to protect the minority in the case where unanimous agreement to changes is not available.

Back to voluntary transfers. A USA might allow voluntary transfers but only in certain cases or under specific rules. The seller might have to give a first right of refusal to other shareholders before concluding a sale with a third party, for instance.

You might have heard of shotgun clauses, which can also be used for voluntary transfers. A classic shotgun works like this: one shareholder offers to sell her shares to the other(s) at a stated price. If the other party fails or refuses to buy, they then must sell their own shares to the first party at the same price. A shotgun not only handles a transfer, it eliminates valuation questions to a large extent. One party will not, it is assumed, offer to sell at too high a price because they know they may have to buy the others’ at that inflated rate.

The most common involuntary event that is handled by a USA is death of a shareholder. Without USA provisions, shares held by a deceased shareholder will probably flow according to their Will (or intestate rules if there is no Will) so that beneficiaries now become shareholders. Whether these new shareholders are family members of the deceased or not, the surviving shareholders may not be excited about having them as new partners in the business.

A USA can avoid this problem (and again this is just an example) by forcing the estate of a deceased shareholder to either sell the shares to the survivors or permitting the corporation to redeem shares at a given price. This is a very common case because the deceased’s estate and heirs receive value for the shares but they are not installed as co-shareholders against the wishes of the survivors. The valuation processes described above might be used or some other calculation method could be used.

Other types of involuntary events might include a shareholder becoming bankrupt or going through a divorce. In either case, there is the potential for a third party (the bankruptcy trustee or the estranged spouse) in obtaining shares and becoming a sole shareholder. For this reason, bankruptcy, divorce or similar events might trigger a mandatory sale by the shareholder. Valuation is up to the agreement but there is sometimes a discount applied to compensate the company/other shareholders for the trouble or to discourage the clauses from being used imprudently.

Cash flow becomes a consideration whenever a corporation or its shareholders are called upon to purchase shares. Involuntary events are more often a surprise so it’s common to either have some discount applied to the purchase price or a longer time period over which the shares are to be paid. This helps ensure the company is not crippled by extra debt.

Finally for involuntary events, not everything has to lead to a transfer of shares. The shareholders might agree that if one of them became incapacitated for a period of time that their rights would flow elsewhere. For example, one of the other shareholders or a family member might be able to vote the shares while the original shareholder was temporarily disabled.

Other Agreement Provisions

While the topics covered earlier are the most common in USA’s, also remember that these agreements are enormously customizable. Some other things you might find in a USA are:

  1. Obligations and rights of parties. The agreement might provide for the time and effort that participants are expected to provide. Likewise, if there are certain benefits that will be accruing, they could be included.
  2. Dispute resolution. Since a USA is almost by definition only referred to when there is a disagreement, the contract could include rules on how to resolve these disputes without a full blown lawsuit. This could be an arbitration process, mandatory mediation, appointing a mutually trusted person or persons as adjudicators or something else.
  3. Capital calls. Businesses sometimes need extra injections of capital and the USA might both allow this through existing shareholders and defining the circumstances and rights that would apply.

Incorporating a company is relatively simple and shareholder agreements are not mandatory to create a fully operating business. But most people who have been involved with corporations in the past will agree that planning for future disagreements or differences of opinion can be the difference between the business carrying on for an indefinite period of time or being torn apart by shareholder strife and legal costs. Talk about the agreements with your professional advisors.