What is a Shareholder Agreement?
A shareholder agreement is a document signed by two or more shareholders of a corporation that sets out many of the rules applicable to the shareholders (owners) of the company. These rules cover things like:
- dividend payments (return on investment paid to shareholders/owners),
- voting rights of shareholders for various business decisions,
- appointment of individuals to manage the corporation (directors and officers),
- termination of rights of shareholders or directors,
- restrictions on how shares can be transferred to new shareholders who may or may not be known to the corporation, and
- how share prices/values are established, amongst other things.
Without a valid shareholder agreement, the rules will fall to the legislation, such as the Canada Business Corporations Act, which is very restrictive and does not leave much room to accommodate the unique needs of your business. As a result, you may not be able to manage your corporation effectively and could face many costly obstacles, or even lose control of your company in some cases.
What if I don’t have a Shareholder Agreement for my company?
CASE STUDY:
Bill and Clark are the shareholders and directors of an auto repair business named ABC Inc. There are also 3 additional directors, but they are not shareholders. Bill and Clark do not have a shareholder agreement, as they do not see any need since Bill and Clark are good friends.
Bill owns 70% of the company and Clark owns 30%. While Bill is the majority shareholder, Clark is more active in the management and administration of the business and Bill focuses on the vehicle repairs.
Scenario #1: Death of Shareholder
Bill dies and leaves no will. What happens to Bill’s shares and who is entitled to vote on behalf of Bill?
If there was a shareholder agreement, the agreement would say what happens to Bill’s shares. For example, the company, or Clark, may have an automatic right to purchase the shares for a pre-defined price. However, if there is no shareholder agreement, the shares in the corporation will be subject to estate law, go through probate and can even be sold by Bill’s estate to anyone for any price, even if the other shareholders disagree with the sale. This could result in months or years of uncertainty while waiting for the shares to be sold and, ultimately, could leave Clark with a partner he doesn’t want.
By having a clear shareholder agreement, Bill and Clark can rest comfortably knowing what will happen to their company in the event of their untimely death, or the death of their fellow shareholder.
Scenario #2: Decision Making Power
Bill decides he wants to enter a new and expensive agreement on behalf of the company, but Clark is opposed to this. Clark is more aware of the company’s management and administrative needs and thinks the new agreement is a waste of money.
Without a shareholder agreement, Bill could use his position as the majority shareholder to execute a special resolution approving the agreement against Clark’s will. However, if they had a shareholder agreement, they could agree in advance that all major decisions require agreement by all shareholders. This would give Clark the right to veto Bill’s expensive agreement and help protect the company.
Scenario #3: Obligations and non-competition
Bill and Clark have verbally agreed that they will both devote an equal amount of time towards the company and will not work for a competing business, but Clark has recently started a new business venture doing auto repairs and hasn’t been to the ABC Inc. garage in weeks. Several of Clark’s clients have been calling and some have left negative reviews on Google.
Without a shareholder agreement, Bill would have very little recourse against Clark, as there is no general obligation on shareholders to devote themselves to a company, nor is their any general non-competition provision in the legislation.
If there was a shareholder agreement, it would include restrictions stating what Bill and Clark are required to do as shareholders and could even restrict their ability to work with, or invest in, competing companies. Additionally, it would state what happens if a shareholder fails to do what they agreed to do. For example, the shareholder agreement could restrict investment income to shareholders in breach of the agreement, or permit the directors to employ a 3rd party to perform Clark’s duties and deduct any costs/losses from Clark’s future investment income.
Scenario #4: Director Restrictions
The 3 non-shareholder directors wish to enter into a new agreement on behalf of the company, but Bill and Clark are opposed to this, as they believe it will increase financial burden with no benefit.
If there was a shareholder agreement, it would detail the authority of the directors and could restrict what the directors are capable of doing on behalf of the company. These restrictions create additional powers for the shareholders, as the powers that are removed from the directors are automatically given in the shareholders. Additionally, a shareholder agreement could specify that certain types of decisions must also have the approval of the founding directors, Bill and Clark. This would ensure that the directors do not use the 3/5 majority to make decisions that Bill and Clark would oppose.
Additionally, if the directors do something that is beyond their power, the act will be illegal and the director may be held responsible for any damages. If there was no shareholder agreement restricting the director’s powers, the directors could enter into an agreement on behalf of the corporation and the shareholders couldn’t hold the directors personally responsible. Sure, Bill and Clark could remove and replace the directors, as they own the company, but they would still be bound to the unwanted agreement and wouldn’t have the ability to hold the directors personally responsible in most situations.
Having a clear agreement would not only provide a method to hold the directors responsible, it would provide clarity that would discourage the director from exceeding their authority.
Scenario #5: Sale of Shares
Bill decides to sell his shares to a new person Clark doesn’t know. Clark is worried the new shareholder, as the majority shareholder, will unilaterally make decisions for the company without Clark’s agreement. What if the new shareholder decides to turn the auto business into a storage business instead?
If there was a shareholder agreement, the new purchaser would be automatically bound to the terms of the agreement. Moreover, the agreement could allow Clark to buy out Bill, thus preventing him from selling his shares to a 3rd party, who would be a stranger to the corporation, and Clark.
Without a shareholder agreement, Bill would be free to sell his shares to anyone he wants, and Clark would have no power to stop the sale.
Scenario #6: Shareholder Investments
Bill and Clark have expanded the business by buying new equipment. Unfortunately, revenue hasn’t increased as expected and the company requires additional resources to continue operating until business increases. While Clark is happy to invest in the company, Bill is reluctant and wants to cut costs and sell some of the new equipment, which would result in a loss for the company.
If there was a shareholder agreement, it could specify that the shareholders are responsible for extending credit to the company or making direct investments to the company. However, without any agreement, Bill could refuse any financial assistance, which could lead to the company’s bankruptcy.
Take Away
A well-drafted shareholder agreement can provide certainty and predictability for shareholders, prospective shareholders and directors. Failure to have a shareholder agreement can cause uncertainty and conflict that could result in massive consequences, such as interpersonal conflict, losses in business activity, expensive litigation and even a halt to your business operations.
How can Varity Law Professional Corporation help?
We have drafted countless shareholder agreements for our clients, which have allowed them to customize their corporate rules to match their needs. With our wealth of experience, we can anticipate common problems – such as those described above – and pre-emptively think of solutions to address them, without leaving you in desperate position of litigating against your own partner.
If you have a corporation that has more than one shareholder, but do not have a shareholder agreement, we strongly encourage you to schedule a consultation so we can discuss how Varity Law Professional Corporation can help protect you and your business. To book a consultation, please go to: https://calendly.com/sabrina-668/1stfreeconsult
Author: Jonathan Thibert is an experienced lawyer at Varity Law Prof. Corp.
Kindly note that this article is only meant to provide general information, not specific legal advice on what you should do in your situation. To receive legal advice, please book a first free consultation with us.
