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What you need to know about shareholder agreements
Protect your business by updating your shareholder agreement. Here are some things that may help you.
Every business that has more than one owner should have an up-to-date shareholder agreement. It makes good sense to protect the assets you have worked so hard to build.
"If you haven't looked at the agreement for a long time, now is a good time to blow the dust off," says Dean Gallimore, Enterprise Leader in KPMG's Lethbridge, Alberta office. "Business owners ought to make the time."
Making the time to update your shareholder agreement now may save you plenty of headaches later. As proof, Gallimore says that there are far more stories of messy shareholder break-ups than there are of long-term successful relationships. "I had a client with a successful business owned by two shareholders. One of the partners had a drinking problem that was so severe, it was impacting the business and the working relationship. However, the partner with the drinking problem argument almost put their company out of business and cost a small fortune in legal fees," says Gallimore.
"Acrimonious breakups are stressful, hard on the business and can actually reduce the value you may get for it if you want to sell," adds Gallimore.
If your business partners are family members, you are not immune. "In fact, it's even worse. Even if you win, you lose," explains Hank Kroeker, KPMG Enterprise Leader in Fraser Valley, B.C. Business disagreements with family are extremely stressful and can destroy family relationships. A good agreement provides for what happens "when" or "if." It provides an "escape hatch" so both you and your partner(s) have a way out."
Sometimes, merely the exercise of developing the agreement provides valuable insight into differing attitudes on important business issues among shareholders," says Kroeker. "It all starts with shared values and how you use the agreement to drive behaviour. There are many options that involve tax planning, financing, legal advice and insurance. Make sure you make informed decisions that are right for you," says Kroeker.
Overview of some suggested clauses for shareholder agreements
This is not an exhaustive list, but here are some basic concepts you might want to consider:
Right of first refusal (if there is an offer to purchase)
Give yourself some time to come up with the money, or to consider the deal. A 30-day period is good.
A "Shotgun" clause
This sounds extreme—what is it? Put simply, a "Shotgun" is an escape hatch mechanism. In a "Shotgun" arrangement, when one shareholder makes an offer, the shareholder receiving the offer can either accept or not. If the offer is not accepted, then the shareholder who turns down the offer, in turn, must buy the other partner's interest for the same terms as the original offer. It is harsh, but it provides protection for both parties and a mechanism to exit as well as to determine price and terms.
"It can give an advantage to the party with the deeper pockets," says Bob Holden, Enterprise Leader for Okanagan-South Thompson, British Columbia. Your shareholder agreement should give you time to finance and respond to a "Shotgun." Between 30 to 60 days is reasonable. Consider taking back a note to finance the purchase, with reasonable payback terms and rate of interest. You need to think about whether you want the "Shotgun" to take place inside the company or between the shareholders. These have very different financial and income tax implications.
A "Shotgun" arrangement where the company buys the shares is usually attractive to the buyer and not to the seller. It's attractive to the buyer as the company finances the purchase and does so with pre-personal tax dollars. A redemption occurs when the company buys the shares. This results, in most cases, in a deemed dividend, but the proceeds are not eligible for the capital gains exemption. In addition, there may be safe income that can be taken out of the business with little (or even no) tax before the transaction is completed. If the purchase is between the shareholders, the buyer needs to arrange the financing and pays for the shares out of tax paid income. If there is a capital gain to the vendor, it may be eligible for the $500,000 capital gains exemption.
Sound complicated? "Shotgun" clauses are. They are also frequently unpredictable. And that's precisely why they are so powerful. So, never exercise a shotgun unless you are prepared to have it turned on you with the same terms.
How key decisions will be made:
Whoever controls the Board, controls the business. Often, agreements provide for the need for unanimous approval for certain decisions in spite of unequal shareholdings. This is fine, as long as there is agreement and protection for minority shareholders, but it can be a stumbling block for decision-making. On the other hand, if everyone agrees, you can keep the shareholder agreement in the drawer and do as you like.
Other financing arrangements.
One of the more complex and creative financing vehicles is to use a Retirement Compensation Arrangement (RCA) to provide a loan to the company to finance the share purchase. The RCA is initially funded by the company and a financial institution would generally advance funds based on the assets in the RCA.
Shareholder loans
When you are starting out, this isn't usually a problem, but as the business succeeds and evolves shareholder loans can become unequal to share ownership. Generally, these loans should be secured and a fair rate of interest should be charged to compensate the investing party for leaving the money in.
Pre-1995 agreements
If your shareholder agreement was established before 1995, there are favourable grand-fathering provisions regarding determination of taxable gains from insured buy-sell arrangements. Check with your income tax advisor.
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