What is a Shareholders’ Agreement and how might it benefit your business? In this article, we’ll explain the purpose of a Shareholders’ Agreement and why many businesses choose to have one prepared early on. We’ll also provide you with a rundown of all the jargon you’ll find in a Shareholders’ Agreement—from piggyback rights to shotgun clauses!
What is a Shareholders’ Agreement?
A Shareholders’ Agreement is first and foremost a contract between the owners of a company. It’s often called the business prenuptial agreement as it lets the owners of a company map out a process to resolve disputes and add rules for managing the company and ownership structure. Important provisions within a Shareholders’ Agreement include the decision-making powers of directors and shareholders, restrictions on the sale and transfer of shares, and the process for resolving disputes.
If you’re the only owner of your business, then you won’t need to worry about a Shareholders’ Agreement.
Why does your business need a Shareholders’ Agreement?
1) Decision making and disputes
When you start your business, you and your partners may expect smooth sailing going forward. But conflicts are inevitable in business, and shareholder disputes can contribute to the failure of small businesses all too easily. With a Shareholders’ Agreement in place, you can proactively decide how you plan to resolve specific issues productively, including specifying dispute resolution mechanisms that are agreed to in advance.
Also, the laws governing corporations in Canada give extensive powers to a company’s directors. In some companies, this legal default situation is satisfactory and the directors can make all important decisions for the company. In other companies, particularly small and growing companies, the shareholders want to directly make important decisions without relying upon the directors. A Shareholders’ Agreement can be used to transfer these decision making functions from directors to the shareholders.
2) Controlling the transfer of shares to new owners
You and your partners probably have a good understanding of your relationship with each other as you start your company. But over time, as your business grows and as you consider adding new owners, things can change. Removing or adding any team member can have a huge impact on your entire company.
Think about the effect on your business if your partners can transfer their shares freely to anybody they choose. Suddenly, someone whom you don’t know could be making decisions for your company alongside you.
That’s why a Shareholders’ Agreement will often impose restrictions on the transfer of shares. Restrictions can include requiring all shareholders to agree before any one of them can sell shares as well as providing existing shareholders the first opportunity to buy shares of a departing shareholder.
What happens if one of your partners wants to leave the company. Can one partner buy another out?
To this end, one option in a shareholders agreement is to include a shotgun clause or a “buy-sell provision.” This simple mechanism provides the structure under which one partner can buy the shares of a partner who wishes to leave the company, with all terms pre-negotiated to prevent disputes. Without a shotgun clause, this type of dispute may lead to litigation or even the dissolution of the company.
Relationship building with your partners
Even the process of building a Shareholders’ Agreement benefits your business, as it puts you and your business partners in a position where you are required to have an open and honest dialogue about subjects that might otherwise go unspoken for years. Your team is likely to come out feeling stronger thanks to the realization that you’re all on the same page and if a conflict arises, you’ve already done the hard work to come to a fair and equitable resolutions.
Legal jargon and terms you’ll find in a Shareholders’ Agreement
There’s a lot of terminology that’s unique to a Shareholders’ Agreement. We explained the most common terms below:
Drag Along Right requires minority shareholders to sell their shares once the majority shareholders have agreed to sell the company.
Piggyback Right the opposite of a drag along right, it’s intended to protect minority shareholders by requiring any offer to purchase shares from the majority shareholders to also make the same offer to all minority shareholders. The minority shareholder would then have the option to sell their shares to the buyer. This is also referred to as a tag-along right.
Put Clause gives the shareholders the right to require the company to purchase their shares back from them at any time. It’s also referred to as a ‘Buy-Back’ clause.
Non-Competition Clause prevents a shareholder from becoming involved with one of the business’s direct competitors for a specified time period and location.
Non-Solicitation Clause prevents a shareholder from trying to solicit the business’s clients or employees for another company.
Right of First Refusal provides that if one shareholder has received an offer to sell their shares, all other existing shareholders have the first opportunity to match that offer to purchase the shares.
Right of First Offer slightly different than a Right of First Refusal clause, a Right of First Offer clause sets out that a shareholder who wishes to sell their shares must first offer those shares to existing shareholders at a specific price. It’s only after no other existing shareholders choose to purchase the shares that the shareholder is free to sell to anyone, so long as the price of the shares is equal to or higher than the original offer.
Shotgun Clause outlines a process for one shareholder to sell their shares and leave the company or require the remaining shareholders to purchase their shares. One shareholder can set a price for the company’s shares and the other shareholder(s) must then either sell their shares at that price or purchase the shares belonging to the shareholder who set the price.
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