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The Importance of a Shareholder Agreement for a Private Corporation

April 02, 2013

It is not uncommon for entrepreneurs to overlook the importance of a shareholder agreement when establishing a new business. However, failure to overlook this critical agreement can cause considerable headache in the future. Simply put, a shareholder agreement is a contract to structure the relationship amongst the shareholders of a corporation. A well drafted shareholder agreement should define each party’s expectations with clear rules that describe the relationship amongst the shareholders and outline how the business should be managed.

It is common for corporate statutes such as the Business Corporations Act (Ontario) (the “OBCA”) or the CanadaBusiness Corporations Act (the “CBCA”) to provide the directors of a corporation (rather than the shareholders) with the requisite power to manage the business of the corporation. This situation can be reversed through the use of a unanimous shareholder agreement which restricts the power of the directors to manage the corporation and instead transfers the authority to the shareholders. Both the OBCA and the CBCA provide that where a unanimous shareholder agreement exists, a shareholder who is a party has all the rights, powers, duties and liabilities of the directors to the extent that the agreement restricts the powers of the directors to manage the business of the corporation. In contrast, a shareholder agreement may be entered into among all shareholders without constituting a unanimous shareholder agreement if the agreement does not restrict the powers of the directors to manage the business of the corporation.

Regardless of which type of shareholder agreement is used, the agreement can be useful for numerous purposes, best demonstrated through the use of an illustration. Consider the case of a minority shareholder wishing to exit the business and sell his or her stake in the private corporation. Shares of a private corporation are often illiquid especially in the case of a minority shareholding interest. At times, the only plausible purchaser may be the majority shareholder however, the majority shareholder may place an unrealistically low value on the interest. A shareholder agreement is able to address this problem by prescribing a fair method of valuation and a course of action to be followed upon the sale of the shares.

Furthermore, a shareholder agreement can include the following additional measures to ensure a fair outcome for all parties involved:

1.Dispute Resolution: Consideration can be given as to how deadlocks amongst shareholders can be resolved. A common mechanism in a shareholder agreement is to limit the dispute resolution process to mediation or binding arbitration which is a considerably less expensive alternative than seeking restitution through the courts.

2. Unanimous Shareholder Approval: In the case where one shareholder owns the majority of shares, it is important to consider whether any issues exist that should not be decided by a majority vote. A shareholder agreement can set out a class of material decisions which require unanimous shareholder approval to ensure that the majority stakeholder is not able to make unilateral decisions without first obtaining the consent of all stakeholders involved.

3. Share Transfer: A shareholder’s agreement typically contains a primary rule that no shares be transferred without prior approval of the directors. This can be supplemented with a number of additional mechanisms to promote liquidity of the shares:

• Right of First Refusal: A shareholder who receives an offer from a third party to purchase his or her shares must first allow the existing shareholders the right to match such offer prior to selling to any third party. This mechanism allows the existing shareholders the option to prevent a third party purchaser from becoming a shareholder and exercising control over the corporation in the future. 
• Buy/Sell or “Shot Gun” Provision: This provision allows one shareholder to offer the other shareholders a price and establish the terms under which he or she is prepared to either purchase the other shareholder’s interests or sell his or her interest to the other shareholders. It is then up to the other shareholders to decide whether they wish to either buy the offered shares or sell their own shares on the same terms and conditions presented. This provision can be very useful in the event of a shareholder dispute where the relationship between the shareholders has broken down and one party wishes to exit.

4. Funding Considerations: A corporation requires access to capital both upon incorporation and during operation. A shareholder agreement can prescribe how such capital be obtained and ensure that each shareholder contribute the requisite amount in conjunction with his or her interest in the corporation or face a penalty for failure to do so. In the case of debt financing, a shareholder agreement can prescribe how guarantees are to be signed and provide for the sharing of liability amongst shareholders.

The abovementioned provisions are merely intended to provide a brief overview of the content which a shareholder agreement can include whereas the agreement can be expanded to incorporate several additional areas which may be of issue in the future. Regardless of the breadth of the agreement, it is important to remember that corporations are creatures of statute which offer little guidance in the event of a dispute or protection for a minority shareholder. A well drafted shareholder agreement is particularly useful in a closely held corporation to supplement the statutory framework and avoid the exorbitant costs and aggravation of resolving future disputes without guidance.

Tags: Private Company