Shareholder agreements explained

Buy-sell provision

A buy-sell provision is often the main reason why a shareholder agreement is prepared. Is there a catch-22 situation that is impossible to resolve between shareholders? A Forced Sale (Shotgun) Clause can be included in order to force one shareholder to sell his shares to the unhappy shareholder, or to buy the shares of the unhappy shareholder, at a price set by the unhappy shareholder and upon conditions defined in the agreement.

Right of First Refusal

An association between two or more people who want to launch a business is usually built on confidence. Having said that, what would happen, for example, if a shareholder wanted to sell his shares to a third party? Can he do it without consent of other shareholders? To avoid this type of situation, it would be wise to include a Right of First Refusal Clause in the Shareholder Agreement, thus ensuring that the shares will be offered to the existing shareholder before being sold to a third party.

Right to participate in a share sale

How can a minority shareholder protect themselves if a majority shareholder receives an attractive offer to purchase their shares? Who in such a situation would want to be submitted to the will of a majority shareholder that he or she doesn’t know? To cover this situation, a Resale Right Clause could be included in the Shareholder Agreement in order to force the purchaser to buy all of the company shares under the same conditions that govern the purchase of the shares of the majority shareholder.

Withdrawing from the business

Lastly, it is highly recommended that a Mandatory Offer Clause be included in the Shareholder Agreement. A Mandatory Offer occurs when a situation arises that requires a shareholder to withdraw from the company even if unwilling to sell his shares.

What does withdrawing from the business entail? This is a broad concept that takes into account many situations, such as:

In this type of situation, an offer to sell the shares of the withdrawing shareholder is automatically initiated and the company or the other shareholder will be able to unilaterally buy those shares. This type of clause enables the remaining shareholders to avoid, for example, being associated, against their will, with the heirs of a deceased shareholder.

Valuation of the company’s shares

The shareholder agreement must include a clause stating the valuation method to be used in determining the value of the company’s shares in the event of a forced share sale. Here are some of the methods commonly used to determine share value:

The first two methods are the least expensive to apply, but they can harm the shareholder who relinquishes his shares. They also have the disadvantage of usually ‘undervaluating’ the company. The value of a company is usually greater than a predetermined amount or the sum of its assets. Some intangible factors are very important, such as expertise, competitive advantage, patronage, etc. The third method is generally preferred because it is based on fair market value, but it will lead to substantial fees for the shareholders or the company.

Financing Method

A shareholder agreement should also include a method to finance the purchase price when the company is forced to buy back shares. The agreement can offer shareholders the best protection in the world, but if the company does not have the financial means to buy the shares, the protection offered will remain hypothetical.

A shareholder agreement can allow for a mechanism to pay for the shares by instalments. This type of mechanism can, for example, stipulate that payments for a deceased shareholder’s shares be made by instalments over five years. During that period, the estate would receive interest and payment guarantees and might even maintain rights over the company’s administration.

However, this method is not recommended: it forces the estate and the acquiring company to ‘cohabitate’ for a long period of time and unduly delays the inheritance receipt for heirs of the deceased.

Financing the purchase price of the shares via a life insurance policy is a more favourable option. In order to do this, a life insurance contract generally needs to be taken on the life of each shareholder.

There are many methods to fund buy-sell provisions via a life insurance policy, such as the following:

There are certain advantages if the company holds the insurance policy. Because corporations are usually taxed at lower rates than individuals, less pre-tax revenue is needed to pay the insurance premium. Furthermore, if there is a substantial age difference between shareholders, the difference in the cost of the premiums will be allocated more evenly amongst them. Lastly, with corporate owned insurance, it is often easier to track insurance premium payments to ensure the policy is always in effect.

Many tax consequences can apply in this type of situation. It is always recommended you and your clients consult a lawyer to draft a Shareholder Agreement that meets the needs of your clients.

Tax considerations of a share buyback

When a shareholder disposes of shares in a qualified small business corporation, he or she may be able to claim a capital gains exemption of up to $750,000; however, the company will have to meet certain conditions in order to be eligible for such an exemption.

One condition is that at the time of disposition, at least 90% of the company’s assets must have been used to earn business income for the company. Secondly, in the two year period prior to disposition, at least 50% of the company’s assets must have been used to earn business income. If the value of immovable property or the investments (which typically earn passive investment income and not business income) held by the company compromises the above thresholds, the company could lose its eligibility for the capital gains exemption.

A rigorous estate plan will be needed and the company’s ‘passive’ assets, such as immovable property and investments, would often benefit from being transferred to a holding company.

A shareholder agreement is an essential tool when your client joins forces to start a company. It can be viewed as the corporation’s “marriage contract” and helps to define the parties’ rights if problems arise between shareholders. Understanding the terms of the agreement can help you work with your clients to plan for success.

It is essential to consult a legal advisor to discuss the pros and cons of including some of the clauses mentioned above in a shareholder agreement.

Lastly, a shareholder agreement should ideally be reviewed regularly to ensure that it continues to meet the main objectives of the shareholders who enter into it.