Shareholders Agreement: What Is It and Do We Need One?
“It was the best of times, it was the worst of times…” So begins the famous historical novel, “A Tale of Two Cities” by Charles Dickens. Although Dickens was referring to the mood, spirit and events of the years leading up to the French Revolution with the opening line of his novel, the phrase could easily be applied to the ever-evolving relationships of shareholders in closely-held corporations.
In an ideal world, shareholders of a closely-held corporation would have aligned interests and maintain positive relations amongst one another. However, due to a myriad of circumstances, shareholders’ interests may diverge over time and conflicts may ensue. This could be a result of the founders having different strategic visions for the company, the business not performing as well as expected, or any other reason.
In good times or bad, it would be prudent for shareholders of a corporation to have entered into a shareholders agreement. A shareholders agreement serves two main functions. First, it governs the relationship among shareholders and stipulates how their shares are to be dealt with while they are shareholders. Secondly, it allows for certain powers of the board of directors to be transferred over to the shareholders by providing shareholders with approval rights over certain corporate actions.
This article will describe some of the key provisions of a shareholders agreement and illustrate why such provisions protect the interests of shareholders and, ultimately, the corporation. One thing to keep in mind is that a shareholders agreement is an agreement which is negotiated by the shareholders and the corporation and, as such, can be customized according to the shareholders’ and the corporation’s unique needs and circumstances.
- Shareholder Approval Rights
Under Ontario and Canadian corporate law, the directors of a corporation have a duty to manage and supervise the management (i.e., the officers) of the business and affairs of a corporation. In exercising these duties, boards of directors must approve certain corporate actions and transactions which are material to the corporation. Examples of some corporate actions include the issuance of shares, payment of dividends, borrowing money upon the credit of the corporation, capital spending and making acquisitions, among many others.
However, if the corporation and its shareholders have entered into a shareholders agreement, the agreement can contain a provision which provides the shareholders with the right to approve certain corporate actions and transactions, such as the ones listed above. If included, the effect of such a provision would be to restrict some or all of the powers of the directors to oversee the management of the business of a corporation.
- Pre-Emptive Rights
Under a pre-emptive rights clause, no new shares can be issued by a corporation unless such shares have first been offered to the then existing shareholders of the corporation. This right provides existing shareholders with the right to maintain their proportionate interest in the company as the company seeks to raise additional capital.
Sophisticated investors and institutional investors (venture capital and private equity funds) will, in most cases, ask for these rights as a condition of investment.
- Share Transfer Restrictions
One main function of a shareholders agreement is to restrict the transfer of shares to third parties. Below are three common provisions which deal with such share transfer restrictions.
- Right of First Refusal / Right of First Offer
Under a right of first refusal (“ROFR”) clause, if a shareholder wishes to transfer all of its shares, the existing shareholders have the first opportunity to buy such shares at the same price and on the same terms and conditions as a prospective third-party purchaser is willing to purchase the shares.
Under a right of first offer (“ROFO”) clause, if a shareholder desires to transfer all of its shares, the shareholder must first make a written offer to the other shareholders to purchase its shares before being able to offer the shares to a potential third-party purchaser.
In either case (ROFR or ROFO), the existing shareholders have “first dibs” on the purchase of shares if a shareholder wants to voluntarily sell its shares of a corporation. The benefit of either right to existing shareholders is that they may retain control of the company and prevent an unwanted outside party from acquiring an ownership stake in the company.
- Drag-Along Rights (or Carry-Along Rights)
A drag-along right allows a specified majority of shareholders holding a certain percentage of shares of a corporation to require the other shareholders to sell their shares to a third-party purchaser at the same price and on the same terms and conditions that they (i.e., the majority) are selling their shares to such third party.
This right could be invoked by a specified majority of shareholders in a situation where a third-party buyer (e.g., strategic investor) is only willing to purchase 100% shares of a company and nothing less.
- Tag-Along Rights (or Piggyback Rights)
In the event a shareholder receives an offer from a third party to purchase its shares, a tag-along right provides the remaining shareholders with the option to require the third-party buyer to purchase all of their shares at the same price and on the same terms and conditions as is being offered to the selling shareholder. This right is the mirror image of a drag-along right, and it benefits minority shareholders who have the option to “cash out” when the majority shareholders are also cashing out.
- Involuntary Share Transfers
There are certain situations, referred to as “triggering events” or “events of default,” under which a defaulting shareholder could be forced to sell its shares to the other shareholders. These events may include the following: (i) death, (ii) disability, (iii) bankruptcy, (iv) family law proceeding, or (v) termination or resignation of employment with the company.
In some of these events (e.g., death, bankruptcy and family law proceeding), the concern of shareholders and the corporation is that the courts may dictate the treatment of the company’s shares held by a defaulting shareholder if such shareholder (or an estate representative) continued to own the shares.
- Dispute Settlement
Shareholders agreements typically contain mechanisms to resolve disputes or conflicts which may arise among shareholders.
A well-known remedy is the shotgun clause (or buy-sell clause) under which one shareholder can either (i) force the other shareholder out of a company by purchasing its shares, or (ii) compel the other shareholder to buy its shares. This provision is most often included in agreements where there are two shareholders with equal ownership stakes in a company. However, as a commercial reality, most shareholders agreements do not contain shotgun clauses.
Under another common dispute resolution mechanism, shareholders would be required to negotiate in good faith to purchase the shares of a shareholder who declares a deadlock and wishes to sell its shares. If a good-faith sale of shares cannot be consummated, a valuator may be appointed to determine the fair market value of the shares and the shareholders would then be given another opportunity to complete a sale transaction.
Finally, shareholders agreements can contain an arbitration clause under which any dispute or conflict arising among shareholders in connection with the shareholders agreement may be resolved by binding arbitration. Resolving disputes through arbitration is often less costly and time consuming than engaging in litigation through the court system.
In conclusion, a shareholders agreement provides many mechanisms which protect the rights of shareholders. At the same time, it places upon these shareholders certain obligations with which they must comply as a condition to owning shares in the corporation. It is important to remember that no two shareholders agreements are alike and that each shareholders agreement must be drafted in such a way as to address the unique circumstances of a corporation and its shareholders.
This article is for informational purposes only and does not constitute legal advice.
For more information about shareholders agreements, contact David Kim of Crescendo Law at [email protected]. To learn more about Crescendo Law, visit our website at www.creslaw.com.