THE HONEYMOON: Everything started out great. The shareholders were optimistic and the business plan was unfolding as it should. During the initial start-up, somebody suggested they should get a shareholder’s agreement. Everybody felt it was a good idea, but it wasn’t a priority – why spend extra money on legalities and lawyers when the money could be spent on needed business expenses like marketing, equipment and staff?
THEN LIFE HAPPENS: It didn’t take long, however, for “reality shock” to set in. One shareholder didn’t live up to his promises (or the other shareholder’s expectations). An expected account didn’t materialize. Another shareholder’s outside interests proved more demanding and difficult to deal with, taking too much away from the new venture. The actual implementation of the business plan involved a surprising number of very important decisions; and the parties couldn’t agree on them all.
LIVING WITH THE CONSEQUENCES: Without the shareholder’s agreement there were no clear, objective and legally binding guidelines for the business and its shareholders to rely upon. Expensive and time consuming work (and possibly litigation) would now be needed.
LET'S MAKE THINGS RIGHT
The above scenario is more common than you might imagine. Effective communication, adequate capitalization and a certain amount of patience will go a long way to make business co-ownership successful. Although easily overlooked, a shareholder’s agreement can also make a profound contribution both to the survival of the relationship and to the orderliness of problem solving and succession planning.
A shareholder’s agreement (more commonly called a unanimous shareholder agreement) can have many functions.
Expectations: It can, for example, set out expectations and obligations and create mechanisms for dispute resolution.
Excluding New Shareholders: It can also control, govern and even fund the entrance and departure of shareholders. In the event of the death, disability or insolvency of a shareholder, share options, coat-tail provisions, and rights of first refusal can all limit the risk of having a second cousin, trustee in bankruptcy or some other unknown party becoming a co-owner in your business. Such provisions enable a smooth transition of ownership in a way the parties have pre-arranged. Unwanted shareholders are avoided and, through the holding of proper insurance products, the funding for the transaction may even be available, which minimizes both business and personal disruptions.
Eliminating Existing Shareholders: In a dispute, the agreement is like a “velvet covered brick”. If a disagreement between shareholders remains unaddressed or unresolved then one of the buy/sell mechanisms could be triggered by any one of the parties. The mere possibility of this option provides a strong incentive to find a reasonable solution. In a buy-sell arrangement, the party who triggers the provision offers to sell (usually). The other shareholder(s) then have the option to either accept the offer (buying the initiating party’s shares) or can shot-gun it back requiring the initiating party to buy instead. As you can see, the initial offer had better be for a ‘fair’ selling price since that would be the price that the initiating shareholder would need to pay if forced to buy.
The impact of having such a written agreement is like an insurance policy – you gain a certain peace-of-mind when mechanisms exist to handle a variety of contingencies.
The absence of an agreement means that there are no rules to enable shareholders to remove one or several members, or themselves, from the relationship in an orderly fashion.
Once a dispute is apparent, the business can quickly become paralyzed and countless hours are usually wasted. The shareholders quickly become entrenched in adversarial positions as each obtains legal advice regarding their position. Each focuses on their defensive positions –
“Can I force him off the board?”
“Can I force an audit?”
“Can I threaten dissolution?”
“Can I force him to agree to a share valuation?”
“Can I buy him out”?
“Can I start a new company and when?”
“Should I resign as director?”
If questions like these cannot be addressed through a pre-existing shareholder’s agreement, then the answers will be unpredictable, uncertain and likely undesirable. Shareholders are forced into negotiations with few ground rules. The outcome will often depend on who has the upper hand in terms of aggression, financial backing and better advice. This can result in the unfair treatment of a minority shareholder or the forcing out of the one with the least money. An uncooperative shareholder can also hold the business at ransom through unreasonable negotiating positions. Ultimately, the parties are often forced to dissolve the corporation or commence very expensive and time consuming litigation.
As you can imagine, it doesn’t take long before a shareholder sees the value in a written agreement. Adding this step to the early stages of the business set up takes advantage of the optimism and goodwill usually in good supply at that stage. An agreement can truly be an ounce of prevention in the face of immense potential costs and lost opportunities.