Aug 07
Minority Shareholders - The Shareholder Agreement - rplawyers.ca

Minority Shareholders: The Shareholder Agreement

Read time: 5-6 minutes

Closely-held corporations tend to be premised on relationships between a group of friends, colleagues, or family, and are often more informal in terms of business organization. As such, there is less likely to be separation of roles between managers and investors. In a small corporation an individual may be a shareholder as well as a director, manager or employee, whilst someone else may only be involved as a passive investor. This blurs the line between what duties are owed to the corporation or the participants.

As the company grows, so does the value of the shareholder’s investment. However, disputes often arise over time over such things as the direction a company is taking, the sale or distribution of assets, or a communication breakdown among the shareholders, directors or managers. This can lead to forced sale of shares, shares sold to other parties, or, as a worst-case scenario, litigation to request that the corporation be wound-up if the differences are irreconcilable.

A unanimous shareholder agreement (“USA”) can help manage and mitigate risk and may prevent future disputes between shareholders. This is particularly important for minority shareholders who may feel that they lack the voice or ability to protect their investment.

Unanimous Shareholder Agreement

Every corporation is governed by corporate legislation, the articles of incorporation and its by-laws. These documents set out the basic rules and procedures by which a corporation is governed. However, shareholders will often want to set out rights and procedures on matters beyond the scope of the legislation and constating documents. The USA allows the shareholders to do this; it is an agreement where the shareholders define their obligations to each other and provides procedures for certain shareholder situations.

A USA is a specific type of agreement that is signed by all shareholders at the time it is entered and it binds future shareholders whether or not they sign it and can, if required, transfer powers and duties from the directors of the corporation to the shareholders. A USA can, amongst other things, set out procedures for dispute resolution, the process by which shares are sold, or the procedures to be followed if a shareholder dies or two shareholders divorce.

A USA should be tailored to the unique needs of the corporation and the particular risks and objectives the shareholders face. It should anticipate reasonably likely future events and provide flexibility for dealing with unforeseen matters.  The following sets out some of the key areas a USA should cover in order to protect a minority shareholder’s interest.

Governance, Management & Control

A director owes a fiduciary duty to the corporation, not the shareholders. When some individuals are both directors and shareholders, other shareholders may feel that their interests are not being protected and that the other shareholders/directors are taking the company in a direction that suits their interests over the minority shareholder’s interests.

The USA can set out specific guidelines for the selection of the board of directors as well as the removal of individual directors. A minority shareholder may want a board seat in order to invest; this can be agreed upon by all shareholders in a USA. Alternatively, shareholders can negotiate for additional protections such as unanimous voting on certain significant matters or set out a prescribed list of actions that require shareholder consent.

Capital Expenditure Approval

Capital expenditures lock up large sums of money. In a small business, minority shareholders may require that they approve any significant expenditure of capital to protect their investment in the business.

Financing

This can set out how the corporation’s annual budget is to be determined and funded particularly in its start-up phase. If all shareholders are expected to participate in early funding, the ability of shareholders to weigh-in on such decisions should be considered.

Know the Outstanding Shares

When a shareholders agreement includes a breakdown of share ownership, it specifically lists who owns what number of shares. As a minority shareholder, it’s useful to know the total number of shares outstanding, and the percentage of ownership held by other shareholders.

Shares may be classified as voting shares or non-voting shares. If you own the latter, you should seek clarity on whether those shares are assigned a lesser value in the company. Often, if a corporation is being sold, the potential buyer may assign a higher monetary value to voting shares particularly if those shareholders are also integral to the operations of the corporation.

Specific Management Issues

If you have particular insight into the business, use the shareholder’s agreement to list specific issues you foresee occurring for the business. For example, you can require that all suppliers be ISO-compliant, meaning they have set in place processes to ensure the quality of what they supply.

Pre-Emptive Rights

With pre-emptive rights, a minority shareholder is guaranteed the right to purchase any new shares issued. This mechanism protects a minority shareholder’s percentage of ownership by avoiding dilution. However, it can also cause delays in stock sales and turn away institutional investors.

“Shotgun” Clause

This is an exit provision and gives you the right to buy or sell your shares to another shareholder if you cannot resolve an issue regarding the company’s operations or sale. If you include this clause, don’t set a value for the shares. Instead, specify that the shares are to be sold at a fair market value and that an independent business evaluator will be used to determine the price.

These can work well between shareholders of relatively equal bargaining power but can disadvantage a financially weaker shareholder. If the share price is high the weaker shareholder may not be able to raise the purchase price and might be forced to sell their shares.

Right of First Refusal

Right of first refusal is similar to pre-emptive rights. Selling shareholders are required to sell their shares to other existing shareholders after receiving a bona fide offer from a third party, and on the same terms as that third-party offer.

Similar issues exist with this clause as with pre-emptive rights – it may slow down the process of selling stock and is not attractive when institutional buyers consider investing in the business.

Piggyback/Tag-Along Rights Upon Sale of Shares

These rights are designed to protect minority shareholders. Typically, when a majority shareholder sells all or a portion of their shares, the other shareholders have the right to be included in the sale on a pro-rata basis and on the same terms as the majority shareholder. This is called “piggybacking.” It protects a shareholder’s investment should the company be sold.

Piggybacking requires that any party considering the purchase of the business be able to buy 100 percent of the outstanding shares.

Valuation of Shares

When it comes time to sell the stock, a fair valuation is critical to a transfer of the shares to minimize disagreement. Specify the valuation method in the shareholder agreement to protect your rights when you or your heirs are ready to sell, or include provisions for the share price to be determined by a qualified third party.

Confidentiality of Information

This protects against unauthorized disclosures of confidential information by shareholders. It is particularly useful when shareholders are also key employees of the corporation and have access to sensitive information.

Non-Compete & Non-Solicitation

When you invest in a corporation, the corporation has the right to specify that you can’t compete with its product or service, or solicit employees away from the corporation for a fixed period. Typical clauses would prevent this competition for the entire period you own shares, and for a defined period after you have sold the stock.

Dispute Resolution

These provisions provide mechanisms for resolving various disputes, it may include negotiation, mediation, arbitration, and buy-sell/shotgun clauses.

If you are setting up a new corporation or have been asked to invest in a startup, a USA can be invaluable in protecting your investment and establishing your rights as a minority shareholder. While negotiating such an agreement may be challenging, it is often easier to negotiate fair provisions at the outset rather than after an issue has arose.

Please contact Michael Paiva at 416.800.1733 or at 519.729.5038 for more information or if you require assistance with drafting or enforcing a shareholder agreement.