Shareholder Agreement FAQ - Canada

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A Shareholders' Agreement (also called a "Stockholder Agreement") is an agreement between all or some of the shareholders (or "stockholders") of a Corporation. This contract establishes the rights of shareholders and the duties and powers of the Board of Directors and management.

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Contents

What is a Shareholders' Agreement?

What is a Shareholders' Agreement?

A Shareholders' Agreement (also called a "Stockholder" Agreement) is an agreement between all or some of the shareholders (or "stockholders") of a Corporation. This contract establishes the rights of shareholders and the duties and powers of the Board of Directors and management. A Shareholders' Agreement is very beneficial when the Corporation is closely-held or there are only a few shareholders. A typical shareholders' agreement might do some or all of the following:

(1) determine rights related to the sale, issuance or subsequent distribution of shares (e.g. rights of first refusal, "piggyback" rights and pre-emptive rights);

(2) set out the rights and duties of the Officers and other management;

(3) create options to buy or sell the shares (e.g. a "shotgun" clause);

(4) determine what will happen in case of death, retirement, etc., of a shareholder (with the value of the shares to be calculated according to a certain formula);

(5) establish the number of Directors on the Board and their duties;

(6) provide existing shareholders with the right to approve future shareholders.

Who are the parties to the Shareholders' Agreement?

The parties to a Shareholders' Agreement are the shareholders of the corporation. Ideally, all shareholders will participate in the Shareholders' Agreement.

When should my Shareholders Agreement end?

The Shareholders' Agreement can end when all shareholders agree to end it, or on a specific date. The option to end it upon the agreement of all shareholders should only be used where there are a relatively small number of shareholders, the Corporation is not thinking of taking on new shareholders, and the shareholders have a good working relationship. Even one disgruntled shareholder could cause significant problems for the Corporation by refusing to terminate the agreement, even where it would in the best interests of the Corporation to do so. If there are a relatively large number of shareholders, or where the Corporation is trying to increase the number of shareholders, or if the potential exists for conflict among the shareholders, then the Shareholders' Agreement should probably be ended on a specific date.

Where do I file/register my Shareholders' Agreement?

You do not file a Shareholders' Agreement. To register a corporation you need to file your Articles of Incorporation and make regular annual filings as requested but that is all. Your Shareholders' Agreement is an agreement between parties just like any other business contract and is used for internal purposes only. It should be stored in your minute book.

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Warrants and Representations

Why would I want the Corporation to warrant its shares?

When a Corporation warrants its shares, it lists the shareholder names as well as the number and type of shares each shareholder owns at the time that the shareholders' agreement is signed. This warranty is beneficial when the shareholders may want some confidence as to how many shares of the Corporation are issued and who owns those shares.

Why do we need Shareholders to warrant that they are the beneficial owners of their shares?

Each shareholder may confirm that they are the beneficial owner of their shares. This means that that no other person has an interest in those shares nor are they held in trust for someone else. This warranty can provide some additional confidence to other shareholders and creditors regarding who "really" owns and controls the Corporation.


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Director and Officer Selection

Why would I want the shareholders' agreement to provide direction on Director selection?

In a small corporation where one person may own over 50% of the shares, a majority shareholder can be prevented from electing every Director, simply by virtue of their majority ownership. Depending upon your jurisdiction, you may have certain options in determining the Corporation's Directors. For example, the shareholders might each appoint one Director. This option will work better when there is a smaller number of shareholders and you want each shareholder to have equal power.

Alternatively, the shareholders may agree to elect a list of specified Directors. There might be ten shareholders, but all the shareholders might agree to have three specified Directors. This last option may be beneficial when the shareholders acknowledge that the majority shareholder should have greater representation but the minority shareholders each want a Director on the board to ensure their interests are protected.

It should be noted that all Directors have a duty to act in the best interest of the Corporation no matter how they were elected or which group of shareholders they are intended to represent.

Why would I want Alternative Directors specified?

In case there is a vacancy on the Board of Directors, the shareholders might want to identify alternate or new Directors. The vacancy could be temporary or permanent. This clause helps the shareholders to continue to control the appointment of Directors in the situation where one of the "specified" Directors is unable to continue to be on the Board of Directors.

Why would I want to specify the Officers of the company?

Specifying the Officers of the Corporation may prevents subsequent shareholders from firing the Officers even if they acquire a majority share or control of the Board of Directors. This may provides a level of managerial consistency to the company. However, for the same reason, specifying the Officers may also prevent the company from attracting sophisticated institutional investors who want to install their own management team to run the Corporation.

Why do I need to decide management issues in the Shareholders' Agreement?

Specifying management issues in the Shareholders' Agreement preserves the right of the existing shareholders to determine issues vital to the Corporation. If these issues are not specified in the Agreement, then the Board of Directors will be able to change and manage the Corporation as it sees fit. If you believe that the shareholders are in a better position to determine matters of importance to the Corporation than the Directors are, you should specify all the terms you deem important to the long term health of the Corporation.


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Share Transactions

How does a Corporation redeem stock?

A corporation can redeem stock by repurchasing it from existing shareholders and placing the stock back in the Corporation's name. This is done mostly by established Corporations. It is usually only done where the Corporation has enough cash to make the purchase while still covering operating expenses. Redeeming shares transfers equity back into the Corporation, increasing the company's future value.

When would a Corporation issue stock for non-money consideration?

Corporations will sometimes issue stock for non-money considerations when they are trying to attract top level professionals and skilled workers to the Corporation or when they are trying to purchase property but do not have the capital to do so.

What is the difference between a Shareholder Loan and purchase of shares?

When a shareholder purchases shares, the shareholder increases their equity in the company. When a shareholder makes a Shareholder Loan to the company, it is a personal debt owed to the shareholder by the company, as though both were private individuals. The debt must be repaid, but it does not increase the shareholder's equity in the company.

What are pre-emptive rights?

Pre-emptive rights give existing shareholders the right to buy any newly issued shares from the Corporation before it is sold to outside third parties. This protects existing shareholders by allowing them to retain their percentage of ownership in the company. Disadvantages of pre-emptive rights are that they may cause long delays in the sale of shares, and that they may discourage sophisticated institutional investors from investing because they may get a smaller proportionate share of the Corporation than they want when the pre-emptive rights are exercised.

What is a "shotgun" clause?

A "shotgun" clause provides an escape mechanism for shareholders if there is a serious dispute that cannot be resolved. One shareholder may offer to buy the other shareholder's shares for a certain price. A shotgun clause stipulates that the other shareholder may either sell his/her shares at that price, or buy the offering shareholder's shares at that same price. This process provides incentive for the offering shareholder to name a fair price.

However, if shareholders have unequal financial resources, one shareholder could specify an unfairly low price, knowing that the other shareholder cannot afford to buyout the offered shares. The offerer could then turn around and buy the shares of the weaker shareholder at the unnaturally low bid. The shotgun clause, therefore, might also require that a fair price be set for any buyout offer.

What is a right of first refusal?

A right of first refusal requires that when an existing shareholder wants to sell his shares, all shares must first be offered to existing shareholders on a pro rata basis, which enables the existing shareholders to retain their percentage stake in the Corporation, before being sold to an outside third party. It also protects existing shareholders from unwelcome new shareholders. However, if the existing shareholders cannot afford to buy the shares, the shares may still be sold to the third party and existing shareholders may end up with a new co-owner. One shortcoming of the right of first refusal is that it may cause long delays in the sale of shares.

What are "piggyback" rights?

A "tag-along" clause (also called "piggyback" rights) protects minority shareholders in the event of a third party buyout. If a majority shareholder sells his/her shares to a third party, the minority shareholder has the right to become part of the transaction and sell his/her shares to the same third party purchaser at the same price and on similar terms. Thus, the third party, if they wish to purchase the shares, must be prepared to purchase ALL of the outstanding shares. The benefit to the minority shareholder is that they can avoid being in business with an unwanted new co-owner. It also ensures that all shareholders will receive similar buyout offers and protects small shareholders from being forced to accept much less attractive offers. A shortcoming of tag along rights is that it may cause long delays in the sale of shares.

What is a valuation clause and why do I need it?

A valuation clause provides a method to determine the value of the Corporation's shares. Such a process is needed when shareholders want to sell their shares or when a shareholder dies and the other shareholders want to buy those shares. Since most small corporations are private (not traded on a stock exchange) the shares are hard to value without a predetermined method. Having this clause will reduce the disagreement and uncertainty that occurs when a shareholder wants to buy or sell shares.

Why would I need a professional valuator?

Shares that are not publicly traded on a stock market are hard to valuate because they are not easily convertible to cash. Valuating the shares yourself may lead to a large over- or under-valuation of the share price. Both mistakes can be detrimental to the company and to all affected shareholders. A professional will give a more accurate valuation that is fair to all shareholders. However, the valuation may be expensive so you must carefully consider whether or not to use a professional valuator.


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Miscellaneous

What is a dividend?

A dividend is a share of the Corporation's profits received by a shareholder at specific intervals during the year. Dividends are paid on a per share basis (e.g. $0.10 per share) and are used to give shareholders a positive return for holding onto shares. A corporation can pay out any percentage of its profits as dividends, but most pay out less than 100%, so the corporation has assets for capital expenditures, business growth, unexpected expenses, or business losses in subsequent years.

What is a non-compete clause?

A non-compete clause prohibits shareholders from competing with the Corporation while they are owners in the Corporation and for a short period after they have left the Corporation. In a small corporation, customers deal closely with the shareholders. A non-compete clause prevents an influential shareholder or former shareholder from attracting customers away from the Corporation. A shareholder that leaves the Corporation may also possess confidential information that can be used to advantage against the Corporation.

What is a non-solicitation clause?

A non-solicitation clause prevents shareholders or former shareholders from inducing other shareholders, Directors, Officers or employees of the Corporation to leave the Corporation or to compete against it. This clause prevents an influential shareholder from stealing key employees.

What is a capital expenditure and why would I want to have shareholder approval to buy or dispose of them?

A capital expenditure is money spent to acquire or upgrade physical assets such as buildings and machinery. Requiring shareholder approval of large capital expenditures protects the shareholders from the Corporation's employees or Officers putting too great of an investment into certain ventures without the shareholders' approval. It protects the shareholders' investment from the poor judgment of an Officer or employee. The amount of the limit will be dependent upon the size and resources of the Corporation as well as the shareholders' confidence in its management.

What is the difference between mediation and arbitration?

Mediation is a process by which a neutral third party, the mediator, assists the conflicting parties in negotiating an agreement regarding the issue in conflict. Arbitration is a process by which the conflicting parties present their conflict to an agreed upon neutral third party who, upon hearing from both parties, decides on how to resolve the issue.

When would the use of a mediator or arbitrator to settle disputes be beneficial?

A mediator or arbitrator should be used when the parties are at a deadlock over an issue. Mediation and arbitration are superior processes when there is a long term relationship involved and the survival of the business relationship is desirable. If the dispute is not resolved and goes to court, a judge may decide on a compromise that is not desirable to either party, possibly to dissolve the company. But, if both parties agree to choose a neutral third party mediator or arbitrator to resolve the dispute, the business relationship may be able to continue successfully.

Signing, witnesses and notaries

Who needs to sign the Shareholders' Agreement?

Each shareholder must sign the Shareholders' Agreement. In addition, a representative of the company should sign.

Do the shareholder signatures need to be witnessed?

This depends on whether the shareholders know and trust each other. If you suspect that one or more shareholders may deny ever having seen or signed the Shareholder Agreement then maybe all signatures should be witnessed.

Do the shareholder signatures need to be notarized?

Again, this depends on whether the shareholders know and trust each other. If there was ever a conflict in the future concerning the Agreement and you suspect that one or more shareholders may deny ever having seen or signed the Shareholder Agreement then maybe all signatures should be notarized.


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