An Ounce of Prevention is worth a Pound of Cure
Forming a business is a lot like getting married. At the beginning of the relationship, partners are focused on how bright their future will be and not on what may happen if they hit a bump in the road. But just like a marriage, businesses and their partners, or “shareholders”, will encounter rocky times. The most successful businesses are those that are able to navigate the bumps in the road by agreeing, in advance, upon various mechanisms for addressing various contentious issues that often result in a breakdown in the relationship and the premature end to the business venture.
A shareholders’ agreement is a contract among the shareholders of a company that sets out the mechanisms for addressing the potential problem areas before they become actual problems. In my view, a shareholders’ agreement is essential for all businesses other than those that are wholly owned by one person.
Given how important it is for shareholders to have a shareholders’ agreement, it is only a surprisingly few number of businesses that actually have one. While there are many reasons why this may be the case, I have found that cost is often the determinative factor. While companies must carefully watch their expenditures during their start-up phase, I believe it is more important to spend your money wisely and to carefully consider the big picture.
The legal fees associated with the preparation of the shareholders’ agreement vary in direct proportion with the complexity and comprehensiveness of the agreement. Very basic agreements can cost as little as $2,000 and more comprehensive shareholders’ agreements can cost $10,000 and upwards. But even in the case of an expensive agreement, the costs of preparing the shareholders’ agreement pale in comparison to the costs of litigating a shareholders’ dispute or the breakup of the business.
Surprisingly, even once you get past the cost issue, parties are still often reluctant to enter into a shareholders’ agreement. While there are many explanations for this phenomenon, I feel the marriage analogy probably explains it best. Just as couples who are about to get married are often reluctant to consider entering into a prenuptial agreement; entrepreneurs starting a business are also reluctant to enter into a shareholders’ agreement. As a business lawyer, I’ve heard all the rationalisations for not entering into a shareholders’ agreement – “we’ve been best friends for years, I trust him implicitly”; “she’s my sister, if I can’t trust her, who can I trust?”; “this business is going to be so successful, there’ll be no reason for us to fight”; you get the picture. Moreover, if the partners have already worked together for some time, they may feel that a verbal agreement will suffice and that negotiating a shareholders’ agreement is a sign of a lack of trust by one shareholder towards the others.
But just like a couple about to get married, the best time to form a consensus is right before the formation of the partnership, when everyone is amicable and amenable. By the time there’s something worth fighting about, consensus will be far more difficult (and expensive) to obtain. If there is no shareholders’ agreement in place and problems arise, instead of paying me to prepare a shareholders’ agreement earlier on, they will have to go through the much more costly process (both from a monetary and emotional perspective) of shareholder dispute resolution with our litigation team, or face the premature demise of the business and their relationship.
The legal fees associated with the preparation of a shareholders’ agreement can be mitigated quite effectively by consultation with various other professionals such as accountants and insurance brokers and, of course, by careful planning. To begin with, thought must be given to the share structure of the company. Consideration must also be given to the purchase price of the shares and how they will be paid for. Often shares are acquired for a nominal price with cash being injected by way of a shareholder’s loan. Additionally, shareholders may wish to consider owning their shares through different vehicles such as a holding company or a family trust or even having their shares issued to a spouse or their children. At this point of the planning process, I strongly urge my clients to consult with their accountants to work through the tax planning issues. Too many entrepreneurs ignore this important first step only to find that they have a major tax problem when they are exiting the business. Even the most skilled lawyer or accountant cannot necessarily fix a problem “after the fact”. For instance, if your shareholdings are not structured properly for the two years preceding your exit, the $750,000 lifetime capital gains exemption may not be available to you.
During the planning and consultation process, partners can flush out the major considerations for inclusion in their shareholders’ agreement and I can then begin drafting. The important thing to keep in mind is that a shareholders’ agreement, much like a will, is not intended to be a static document. It is, in fact, a living document that should be revisited and revised as the business evolves and grows. Keeping this fact in mind can ease some of the anxiety associated with the need to “get it right” from the get-go.
While shareholders’ agreements vary wildly in terms of their complexity and comprehensiveness, there are a few basic considerations that most shareholders’ agreements contain. A shareholders’ agreement will often outline the various rights and obligations available to the shareholders; address the problems that arise when a shareholder dies or is unable to work; prescribe mechanisms to deal with the situation where one shareholder wishes to exit the business, while the other shareholders do not (often referred to as the “buy-sell provisions”); and helps address the process to be followed when the partnership breaks up.
In addition to the considerations set out above, a shareholders’ agreement will often include mechanisms that help shareholders address the following important issues:
- the constitution of the board of directors;
- the sale, transfer or mortgaging of the business;
- changes in the authorised share structure of the company and the dilution of ownership interests;
- the amalgamation of the company with another business;
- borrowing by the company in excess of a certain amount;
- the disposition of major assets or lines of business;
- the requirement to obtain life insurance;
- valuation of the company;
- contracts between the company and any of its shareholders;
- the declaration of dividends;
- remuneration of shareholders and the setting of work expectations;
- rules for resolving deadlocks and settling disputes; and
- entering into transactions outside of the ordinary course of business
It goes without saying that while not every company will need to consider all of these issues, this list is by no means exhaustive and the parties should consult legal and other professionals before entering into a shareholders’ agreement.
Despite the importance of having a lawyer draft a shareholders’ agreement, people will still try to cut as many corners as possible and draft the agreement themselves. While there are many “precedents” available online, if the parties don’t fully understand their specific needs and the implications of the provisions contained in the chosen precedent, they may end up doing more harm than good.
Some of the pitfalls that do-it-yourselfers often encounter arise as a result of the following issues: confusion between shareholder and management issues; lack of appreciation regarding the different roles of the shareholders, directors and officers; and their confusion between a return on capital with a return on labour. I have also often encountered parties who believe they require a form of buy-sell provision referred to as a shot-gun clause, but they fail to consider whether they would be able to afford to buy out their partners. For this reason, I think it is important to consult insurance brokers in the planning phase.
If you do it yourself, you may end up getting what you pay for.
One final consideration is the flexibility that a shareholders’ agreement can provide to the parties. While many of the mechanisms that are dealt with in a traditional shareholders’ agreement can be addressed in the company’s Articles of Incorporation, those Articles are public documents that are filed with the Registrar of Companies. A shareholders agreement is confidential and its contents need not be filed or made public. In addition, as mentioned above, shareholders’ agreements can be amended and terminated with ease. It is far more difficult to make fundamental changes to a company’s Articles.
The moral of the story here is that regardless of whether you start a new business with other people or buy into an existing business, a shareholders’ agreement is an essential document that can help you and your partners navigate the rocky times and ensure that you can focus on the more important tasks of running your business and growing it into a success.