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Should Your Company Have a Shareholder Agreement?

5 minute read

Why do shareholders in a private company need a shareholder agreement?

There are various good reasons. First, without a shareholder agreement which contains provisions dealing with share sales, any shareholder would be able to sell his shares to any third party outside the company, subject only to whatever transfer approval requirements are set out in the articles of the company. Prior case law has determined that those transfer approval requirements may not be able to be used to block a share sale to an outside party, so if the shareholders want to be able to protect against unwanted third party shareholders the agreement could include a right of first refusal under which the existing shareholders would have the option to match any third party offer made to one of their co-shareholders and instead purchase the shares of the selling shareholder themselves.

Another common share sale provision is designed to protect the minority shareholders if the majority shareholders are selling their shares to a third party in a transaction which could otherwise exclude the minority shareholders. The minority shareholders can be given a "piggyback" right to elect to sell some of their shares to the third party purchaser at the same price and on the same terms as the majority shareholders are selling. This protects the minority shareholders against being left in place without a market for their shares when control of the company is being sold by the majority shareholders and when this may be the only realistic way for the minority shareholders to realize on their investment.

The converse of the "piggyback" provision is a "dragalong" provision. This is a clause which provides that if a specified percentage of the shareholders (the "selling shareholders") want to sell to a third party, they can give a dragalong notice to the other shareholders requiring those shareholders to sell along with them. This is an important provision because often a purchaser of a private company will only want to pursue a transaction if it can acquire 100% of the company. This clause enables the selling shareholders to deliver 100% of the company. Sometimes this clause has a minimum price provision under which the dragalong can only be triggered if the offer price exceeds a specified minimum price - this would protect the other shareholders against being forced to sell at a price which, although acceptable to the selling shareholders, would be unacceptably low to them. An example of where this might be the case is where the original purchase price of some shareholders' interests is significantly higher than that of other shareholders.

Buy-sell provisions also commonly address what happens on the death of a particular shareholder, for instance, do the other shareholders or the company itself have an option or an obligation to purchase the shares of a shareholder on his or her death or do the heirs of the deceased simply take over ownership of his shares? The considerations here include the need for funds in the deceased's estate and the desire of the shareholders to control who their co-shareholders will be (that is, are the other shareholders willing to accommodate a new shareholder such as the deceased's estate or heirs or would they prefer to buy out the interest of a deceased shareholder to prevent that?).

Similar issues arise in connection with a shareholder who is also an employee of the company when that person leaves his or her employment. Is it agreed that that person can remain as a shareholder after leaving or will the other shareholders or the company have an option or an obligation to purchase his or her shares at that time?

In addition to buy-sell provisions, a shareholder agreement commonly deals with issues relating to management of the company. For instance, the shareholders may decide to specify that particular shareholders will have the right to appoint one or more directors of the company to, in effect, represent their interests. There may also be a clause providing that certain major decisions of the company cannot be taken without the approval of a specified high percentage of the shareholders. These actions typically include significant acquisitions and sales of property or business by the company, decisions to amalgamate with another company or to commence any bankruptcy or dissolution proceedings, to commence a significant lawsuit, etc. Other management type provisions sometimes found include provisions dealing with the amount and timing of dividends and other distributions by the company to its shareholders which, if not specified, would be in the discretion of the directors of the company.

Another common provision found in the agreement is a pre-emptive rights provision. This provision gives the existing shareholders of the company the pro rata right to subscribe for new shares which the company wants to issue to existing or new shareholders. This would permit the existing shareholders to protect their percentage ownership provisions and avoid being diluted on future share issuances by the company. This provision typically allows those shareholders who do subscribe for shares on future issuances to also increase their position by subscribing for the shares offered to other shareholders who choose not to preserve their ownership percentage, before any remaining unsubscribed shares are then offered to new third parties.

The above outlines some of the most common shareholder provisions. However, no two shareholder agreements should be the same. They need to be tailored to fit the fact situation which applies with respect to each individual company and its shareholders. When it is negotiated and signed, it will be contractually binding on the company and its shareholders and will provide a carefully considered structure to govern the operations of the company as long as it remains in place, which is usually until the number of shareholders is reduced to one or the company is dissolved. Experience has shown that it is much easier to negotiate fair provisions dealing with issues like those described above before the issues actually arise in practice without any agreement being in place.

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Greg Hatt

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