Many shareholders come to a point where they want to buy out their co-shareholders in a private corporation. This is best accomplished in one of two ways:
- All shareholders come to a mutually acceptable agreement on the terms for a purchase and sale transaction, whether or not a Shareholders’ Agreement is in place, or
- A transaction is completed under the terms set out in a previously negotiated Shareholders’ Agreement. Typically, this would be entered into at the commencement of the enterprise although it could be entered into at any time.
It can be difficult to negotiate a transaction without a Shareholders’ Agreement being in place since there is no default mechanism to force a transaction to take place if the parties don’t agree on terms. Often one party will want to complete a transaction for some reason but the timing or terms offered are such that the other shareholders do not want to proceed with a transaction. In order to avoid this result, a Shareholders’ Agreement is advisable.
The key purchase and sale provisions of a Shareholders’ Agreement are a shotgun provision and a dragalong clause.
A shotgun provision is structured so that any shareholder can initiate a transaction by delivering a notice to the other shareholder or shareholders naming a price per share for the transaction. The other shareholders have a specified period in which to elect to buy the shares of the initiating shareholder or sell their shares to the initiating shareholder. The advantages of this mechanism are that (a) the price selected should be a fair price since the initiator does not know whether he/she will be the buyer or the seller and (b) there is a guarantee that a transaction will occur, i.e. there is a guaranteed market.
The agreement will also specify the other terms of the shotgun transaction. Two important terms are:
(a) including an agreed non-competition covenant on the part of the seller; without this, the value of the business acquired by the buyer could be substantially impacted
(b) addressing whether any indebtedness owing among the purchaser, seller and corporation will be paid out in full on closing (in order to make a clean break) or will be left outstanding due to liquidity or other considerations.
If the parties do not wish to include a shotgun clause, or do not want to trigger it, the other useful purchase and sale mechanism is a dragalong clause. This permits a shareholder or shareholders with some agreed threshold of ownership to negotiate a sale transaction with a third party purchaser and force all other shareholders to join in that sale transaction. This is useful since a third party purchaser may only be interested in buying an interest in a private company if it can acquire 100% of the company.
In the case of this clause, it is not necessary to deal with price, non-competition covenants or other terms since those will be determined by the third party’s offer.
The ownership threshold to trigger a dragalong transaction is typically in the 60 -75% range although it can be whatever the parties agree upon in the Shareholders’ Agreement.
Either of the above types of transaction could provide better tax treatment for the seller than a buyback of the seller’s shares by the corporation itself.
If none of the above are applicable, then the shareholders may end up stuck with each other in an increasingly dysfunctional situation or, in some cases, may end up in litigation as an attempt to force a transaction. That is usually a difficult objective to achieve through litigation and is also expensive and time-consuming for all concerned.