Proper planning is essential to the success of any business. While most owners have well-written plans for operating their businesses, very few have effective plans to deal with issues that may arise between shareholders.
If you have clients who run businesses with multiple shareholders, ensure they have properly structured shareholders’ agreements to protect everyone’s interests. The best time to implement an agreement is when business is good, shareholders are happy and everyone is talking. Waiting until one of the “D” life events (death, disability, divorce) will be too late. There is no substitute for good corporate governance.
In its simplest form, a shareholders’ agreement is a contract that governs the relationship between the shareholders. If structured properly it can help regulate a company’s operations should this relationship fail or should one party need to leave the company.
Failure to plan properly could impact the company and impact the shareholders’ abilities to realize value on their shares. A well-drafted agreement can also be used as an efficient and effective mechanism for business succession, either to the next generation or to a third party.
No two businesses are alike. While there are a number of issues such as shareholder compensation (e.g., dividend policies), maintaining adequate insurance (on key employees and shareholders) and operating guidelines, this article will deal primarily with those shareholder agreement provisions dealing with a shareholder departure.
If dealt with properly, the company can continue to run smoothly when faced with circumstances such as death, disability or a shareholder’s retirement.
The objectives of a properly structured shareholders’ agreement generally include:
- Determining current and future share ownership
- Ensuring an orderly transition for a shareholder departure
- Restricting the ownership and transfer of shares
- Providing a market (or value) for share transfers
- Protecting the interests of minority shareholders
- Dispute resolution
With these overall objectives in mind, a well-thought-out agreement should be implemented to address shareholder- and business-specific issues. Before drafting an agreement you should address the following questions:
- What will happen when a shareholder leaves the company?
- Will the departing shareholder be subject to a non-competition clause?
- How will a passive shareholder be compensated compared to an active shareholder?
- Can a deceased’s family member become a shareholder of the company?
- Who can purchase the shares and at what price?
- How will the shares be valued?
- How should the buyout be structured to minimize tax and cash flow?
- How will the remaining shareholders fund the buyout?
Once you’ve addressed the above questions, consider the solutions. Some typical strategies are provided below, but each shareholder should obtain his own independent professional tax, legal and accounting advice.
Pre-emptive rights to share offerings
Current shareholders are offered the right to maintain their percentages of ownership by acquiring a proportional number of any new shares issued.
Right of first refusal
Shareholders selling shares must offer them to existing shareholders first. Providing a right of first refusal is an effective method for maintaining a market for the shares as well as controlling who will become a shareholder of the company.
Forced buyouts by the company or other shareholders
This helps prevent shares from going to an outsider, which might occur as a result of the shareholder’s retirement, disability, death, bankruptcy or marital breakdown.
This may include a purchase of the shares by the remaining shareholders or a redemption of the shares by the company. Tax consequences related to such buyout strategies should be reviewed in advance as they vary significantly.
Minority shareholders may be given the option to sell their shares to a third party for the same price and conditions as an offer to the majority shareholders. A reverse-piggyback clause may allow a majority shareholder to force minority shareholders to sell their shares to a third party with the added condition that the purchaser has to acquire all of the company’s shares.
This is a quick and efficient method for resolving situations where shareholders are no longer able to work together. Typically, one shareholder submits an offer to purchase all outstanding shares held by the other shareholder; the shareholder receiving the offer will then have a choice to either sell her shares or purchase the shares of the shareholder making the offer at the identical price and conditions offered.
This provides an incentive for the triggering shareholder to make a fair offer because he may be forced to sell at that price and on the same terms. On the other hand, it could also enable a wealthier shareholder to take advantage of a shareholder with less financial firepower.
A shotgun provision is usually the last resort for resolving disputes.
Fair Market Value versus discounted price
Including the method to be used to value the departing shareholder’s shares in various circumstances (death, disability, retirement, etc.) can provide a shareholder (and his or her estate) peace of mind.
Without an agreement, there can be costly disputes or an undue cash flow burden for the business. In some instances, fair market value should be used to determine how much the departing shareholder receives.
Other times, a discounted price may be more appropriate (such as an earlier than expected departure of a shareholder). There are different methods for valuing shares so make sure clients consult and utilize a qualified professional when drawing up this provision and for valuing the business.
In most cases shareholders want to ensure that when one of them dies, the surviving shareholders are able to purchase the deceased’s shares from his estate and carry on the business without interruption. The use of corporate-owned life insurance can facilitate a smooth transition and provide liquidity to enable the company to acquire the deceased’s shares.
There are generally two types of buy-sell agreements:
- Share-purchase arrangement whereby the surviving shareholders use insurance to purchase the shares from the deceased’s estate.
- Share-redemption arrangement whereby the company redeems the deceased’s shares.
Note that these two options provide very different after-tax proceeds to the estate so professional tax advice should be used to ensure your estate maximizes its value.
When relying on life insurance, shareholders should review their coverage on a regular basis to ensure sufficient funds are available when needed. Provisions should also be included in the shareholders’ agreement to address the situation where the insurance is insufficient at the time of the buyout. This may include a buyout over a period of time to reduce the cash flow burden to the remaining shareholders or the business.
Where shareholder involvement is extensive, include provisions to deal with a shareholder becoming disabled.
Shareholders’ agreements often set out dispute resolution methods designed to reduce or avoid litigation. This can be useful in settling disputes regarding matters such as share value or the application of the shareholders’ agreement. An arbitration process is often included in shareholders’ agreements to minimize costs to the shareholders and the business.
Structuring an effective agreement requires independent advice and participation by all shareholders. As no two businesses are exactly alike, relying on a generic agreement is not recommended. Any closely held company with more than one shareholder is subject to shareholder disputes and the best way to avoid the resulting complications is to have a comprehensive shareholders’ agreement drawn up and regularly reviewed.
To find out how to end your partnership peacefully, read “When good partners go bad,” by Katie Keir.