Key shareholder provisions

Buy-sell provisions are the key component to most shareholder agreements. They’re designed to lay out rules for when a company changes hands and account for situations in which all the shareholders aren’t able to agree to terms. To that end, most buy-sell provisions include a Forced Sale Clause (also called a Shotgun Clause) which can force one shareholder to sell out to the unhappy shareholder. It also can require a partial owner to buy that person’s shares at a price set by conditions defined in the agreement.

Here are some other key clauses that should be included:

Right of First Refusal – A business is usually built on confidence. Still, what would happen if one owner burns out and decides to sell his shares to a third party; and tries to proceed with a sale without consent of the other shareholders?

A Right of First Refusal Clause helps avoid this by ensuring shares are first offered to existing shareholders before they can be sold to a third party.

Right to participate in a share sale – This clause lets a minority shareholder protect herself when a majority shareholder receives an attractive buyout offer. It protects a minority shareholder from being forced into a situation where their new partner is a stranger.

It’s also smart to include a Resale Right Clause that effectively forces a purchaser to buy all the company shares under the same conditions governing its purchase of the shares of majority shareholders.

Withdrawing from the business – A Mandatory Offer Clause comes into play when a shareholder has to leave the company but won’t sell his shares. Circumstances that trigger this clause include:

• A shareholders declares bankruptcy or becomes insolvent.
• A shareholder retires, violates a non-compete covenant, defrauds or steals from the company.
• A shareholder dies or suffers prolonged incapacitation. (In this situation, an offer to sell shares is automatically initiated and the company or the other shareholders will be able to buy them. This prevents having to deal with the deceased’s heirs.)

Valuation of the company’s shares – Shareholder agreements must lay out methods used to value the company’s shares in the event of a forced sale. These can include:

• An agreed value predetermined by the shareholders. This method is simple and inexpensive.
• The book value is also inexpensive to apply since it’s mostly based on the value of company assets.
• Professional valuation, such as an accredited appraisal. The first two methods may inadvertently undervalue the company. Some intangible factors, such as expertise, competitive advantage, and patronage can increase a firm’s value.

Financing Method – You need to determine how those who buy back shares will bear the costs.

A shareholder agreement can allow for instalments, stipulating payments be made over five years (or some other agreed upon time period). During that period, the estate of a deceased shareholder would receive interest and payment guarantees and might even maintain rights over the company’s administration.

Or, if you anticipate the estate and acquiring company won’t want to cooperate that long, the agreement could require financing via life insurance policy:

• Each shareholder would hold an insurance policy on the life of the other shareholder(s); and proceeds of the policy would be used to buy the shares of the deceased shareholder.
• An insurance policy can be held by the company itself. The company pays the premiums and uses proceeds to buy back shares of the deceased shareholder. There are certain advantages to the company holding the policies, since corporations are usually taxed at lower rates than individuals, less pre-tax revenue is needed to pay the insurance premium. And, if there’s an age difference between shareholders, the variance in premium costs will be split more evenly.

A shareholder agreement’s essential when starting a company. Review these agreements regularly to ensure they continue to meet the objectives of all shareholders.

Staff

The staff of Advisor.ca have been covering news for financial advisors since 1998.