What you need in a shareholders agreement

How to protect your business interest, 4 issues you must address in your shareholders agreement.

By Jennifer Poon, January 3, 2023

A shareholder agreement is a legal contract between the shareholders of a company that outlines the rights, duties, and obligations of the shareholders with respect to the company and its management. Shareholder agreements typically cover issues such as the management of the company, the rights and responsibilities of shareholders, the transfer of shares, and the dissolution of the company. They may also specify how decisions will be made, how profits and losses will be shared, and what happens in the event of a shareholder's death or incapacitation. Note you should also consider a corporate power of attorney to take care of your business affairs, whom can be different from your personal power of attorney. We will address corporate estate planning in detail in a later post.

Shareholder agreements can be customized to fit the specific needs and goals of the shareholders and the company. They are often used in closely-held or family-owned businesses, where the shareholders have a more active role in the management of the company. Having a shareholder agreement in place can help to prevent disputes and misunderstandings among shareholders and can provide a clear roadmap for the management and operation of the company.

While each shareholders agreement should be tailored to your business arrangement, you should make sure you cover the 4 D's.

1. Death of a shareholder

You pick your business partner for a good reason and have a good relationship, would you work just as well with their spouse or children? The likely answer is no. A critical part of a shareholders agreement should address the transfer of ownership in the event of death. A common suggestion would be to have the surviving shareholders buy the deceased shareholder's interest and pay the proceeds to the estate. This ensure that there would not be a new, unplanned business partner and the deceased's estate is funded with proceeds of their share of the business. This is especially important in closely-held private corporations as there may not be a ready buyer for the business and the surviving shareholders may not be able to chose their replacement partner. It is key to ensure there is an agreed upon valuation methodology in the agreement. Note that we would prefer a valuation methodology and not a fixed price, business valuation would vary over time and with business results.

Generally speaking there are 2 ways to structure this:

1. Criss-cross buy-sell agreement - where each shareholder may have an agreement to buy each other out. This may require the use of personal funds and can be complicated if there are more than 2 or 3 shareholders. You want to have mirror agreements and ensure that the resulting shareholding does not change from your original (desired) shareholding.

2. Share redemption - a better way to structure a buy-sell would be to have the corporation redeem the deceased's shares and pay proceeds to the estate. This is often more desirable because it is less complicated and more cost effective. Your shareholders agreement would have one section describing the redemption of shares with an agreement upon valuation formula and a payment period. Most entrepreneurs have a significant portion of their net worth in their business, and as such liquidity for the estate can be a concern if there isn't a ready buyer or market. The estate may need funds to pay taxes on death. Corporately owned life insurance is the perfect tool to buy a share redemption.

Shareholders would agree to use corporate surplus to pay premiums on several

policies insuring the lives of each shareholder. Upon death, the insurance proceeds

would be paid to the corporation tax-free and the corporation would use the

proceeds to redeem the deceased's share and pay out a tax-free dividend to the

estate. Collectively, all shareholders ensure their business interest are protected and

there will be sufficient liquidity on their death by ensuring their corporation pays the

premiums.

2. Divorce

Often in a closely-held corporation, any big changes in your partners' lives can have a big impact on your business. In the event of a divorce, a shareholder's ex-spouse can end up holding shares of your company and become your new partner. A critical part of a shareholders agreement should address the transfer of ownership in the event of a divorce or a separation. While a shareholder may have a marriage contract in place, a common suggestion would have the other shareholders buy a portion of the divorcing shareholder's interest and use the proceeds to equalize the ex-spouse. You can also do this via a share redemption. In both options, the divorcing shareholder would likely have a reduced shareholding.

3. Dispute

In the event of irreconcilable dispute or tie-breaker situation, how would decisions be made? Your shareholders agreement should address protocols on how dispute should be resolved, and may include options such as mediation, veto rights, seeking external advice or tie-breaker rules. For example, you may seek the advice of your tax, financial or legal advisors on a particular issue and defer the veto to the expert.

4. Dissolution

A shareholder agreement should include provisions for the dissolution of the company. Dissolution refers to the process of bringing a company to an end and liquidating its assets. In the event of dissolution, the shareholder agreement may specify how the company's assets will be distributed among the shareholders and how any outstanding debts or liabilities will be settled. It may also specify the process for winding up the company's affairs, such as how to handle outstanding contracts and how to notify creditors.

The shareholder agreement may also outline the circumstances under which the company may be dissolved, such as the unanimous agreement of all shareholders or the death or incapacitation of a shareholder. Having clear provisions for the dissolution of the company in the shareholder agreement can help to ensure an orderly and fair process for winding up the company's affairs and can protect the interests of the shareholders.

Protect your business, think about the what-if's

You and your partners work hard at building your business, it would only make sense to protect it. Life can be unpredicable but the 4 D's (Death, Divorce, Dispute and Dissolution) are so common that the first D is even inevitable, please take care of your fruits of your labour and prevent great, lifelong relationships from going sour.