Shareholder Agreement – what is it and why it matters
A shareholder agreement is an essential tool to protect business owners and their partners. Here are some key elements to keep in mind.
A shareholder agreement is an arrangement among shareholders that describes how a company should be operated and outlines shareholders’ rights and obligations. It also includes information on the management of the company and privileges and protections of shareholders.
A shareholder agreement can go a long way in protecting business owners from unwanted and unnecessary conflicts as the business grows and circumstances change. Not having a shareholder agreement is a primary cause of inter-company shareholder conflict and can turn close friends and even family into bitter adversaries.
Here we will talk about my top three (3) provisions in a good shareholders’ agreement:
A buy-sell provision is often the main reason why a shareholder agreement is prepared. A Forced Sale (Shotgun) Clause are primarily designed to protect minority shareholders. They allow a shareholder who receives an offer to buy him out to turn around and buy out the other shareholder. Let us look at an example of how it works. You and a college friend Mat own a successful business. You are the minority shareholder with 40% while Mat owns the other 60%. Mat decides he wants to buy you out and do things 100% his own way. So, he makes you an offer of $4M for your 40%. The shotgun clause would then kick in once Mat makes his offer, allowing you, within a certain time period, to buy him out for the same cost per share that he offered you. Thus, in this case you are permitted to buy Mat’s 60% for $6M. This forces majority shareholders to give you a reasonable offer for your minority position because if they do not, you could get a really good deal on their shares and keep 100% of the business.
Another situation that should be addressed with the buy-sell provision is what happens if one of the owners dies. Often there are insurance clauses as part of the buy-sell provisions for such a case that work together with company owned life insurance policies. The agreement can limit the use of life insurance policies for buy-sell funding only. A good shareholders agreement will describe the flow of funds that follows the payment of the life insurance proceeds to help ensure operational and tax efficiency.
Right of First Refusal
Similar to a shotgun clause, a right of first refusal is to protect the existing shareholders. Here’s a situation where it would become handy. Tom a fellow shareholder decided to sell his shares to a third party, someone who you do not know and never worked with, leaving you with a lot of risk. To avoid Tom being able to do this without consent of current shareholders you would depend on the Right of First Refusal Clause in the shareholder agreement. This ensures that the shares will be offered to the existing shareholder(s) first before being able to be sold to a third party.
Valuation of the Company’s Shares
The shareholder agreement must include a clause identifying the valuation method to be used in determining the value of the company’s shares in the event of a forced share sale. There are two methods commonly used to determine share value. First, an agreed value approach. This method has the advantage of being inexpensive and simple to apply but may not be very accurate and requires an implied agreement. At the opposite end is having the requirement of determining the value by a professional, such as an accredited appraiser or Certified Business Valuator (CBV). This has the benefit of being more exact but is also the more expensive alternative. Closing Thoughts
There are many other provisions that should be considered when creating a shareholder agreement. It is essential to consult your legal, tax, and financial advisors to discuss the pros and cons of including some of the clauses mentioned above.
Jared Burns CPA, CA is the Director of Estate and Tax Planning with Louisbourg Investments. Submit your comments to firstname.lastname@example.org.
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This writing is for general information purposes only. It is not intended to provide legal, accounting, tax or financial advice. For complex matter you should always seek help from a professional. Any opinions expressed are my own and may not reflect those of Louisbourg Investments.