My name is Mark Goodfield. Welcome to The Blunt Bean Counter ™, a blog that shares my thoughts on income taxes, finance and the psychology of money. I am a Chartered Professional Accountant and a partner with a National Accounting Firm in Toronto. This blog is meant for everyone, but in particular for high net worth individuals and owners of private corporations. The views and opinions expressed in this blog are written solely in my personal capacity and cannot be attributed to the accounting firm with which I am affiliated. My posts are blunt, opinionated and even have a twist of humor/sarcasm. You've been warned.

Monday, April 11, 2016

What Small Business Owners Need to Know - Shareholder Agreements

If you are starting in business with another individual, your accountants and lawyers will likely suggest that you draft a shareholder agreement. However, since many small businesses are started by family and/or friends with limited funds, the idea of paying a lawyer to draft a shareholder agreement is usually not at the top of the priority list for two reasons:

123RF Stock Photo Copyright: Andrew Grossman

1. The cost of drafting the agreement.

2. Why Worry? Since the shareholders are family or friends, everything will work out because - well, we are family and/or friends, so what could go wrong? 

Consequently, shareholders of many small businesses may go several years before they decide it is time to engage a lawyer to draft a shareholder agreement. Typically the two catalysts to action are:

1. The business has become profitable enough that the shareholders want to ensure if something were to happen to them, their family is well provided for.

2. There is some shareholder friction.

In today’s post, I will discuss two key areas that should be considered/included in any shareholder agreement, whether drafted at the outset of the establishment of the business or years after the business has begun. As many agreements are over 25 pages, please keep in mind I am touching on maybe 30-50% of what is required in a typical shareholder agreement and providing an accountants take on a legal document. I am not a lawyer. If you need an agreement, you must obtain proper legal advice and should get moving on the project, as most agreements take many months to be hammered out.

Key Considerations in a Shareholder Agreement


The two issues I am going to discuss in this post are:

1. Share Transfer Provisions

2. Death Provisions

Share Transfer Provisions


Share transfer provisions in a shareholder agreement provide some order to the often “unorderly” process of third party share sales, unsolicited share offers, shareholder exits and shareholder power struggles.

The most common provisions included in a shareholder agreement are:

1. Right of First Refusal

2. Shotgun

3. Piggyback

4. Drag-along

Right of First Refusal


In order to protect one shareholder from selling to an unwanted or undesirable third party, shareholder agreements typically contain a Right of First Refusal provision.

These provisions typically state that the existing shareholders have the option to match a third party offer made to any of the other shareholders and to purchase the shares of the selling shareholder themselves, on the same terms and conditions as offered by the third party. Minority shareholders, depending upon their financial situations, may be somewhat prejudiced by these provisions.

A related shareholder agreement provision is a Right of First Offer. Under this provision, a shareholder does not need a hard third party offer and can just state the terms on which they wish to leave the company and if the other shareholders do not take them up on the offer, they can sell to a third party on those terms.

Shotgun


A shotgun provision allows one of the shareholders to offer the other shareholders a price and the terms under which they are prepared to either purchase the other shareholder’s shares or sell their shares to the other shareholders. In theory, this will result in a fair price, since the shareholder triggering the shotgun, does not know if they will be selling or buying.

Once the offer is made, the other shareholders must decide whether they wish to buy the offered shares or sell their own shares on the same terms and conditions presented.

While this provision is often useful in shareholder disputes, where one shareholder has more resources than another, they may be dictating the end result of the shotgun, since the shareholder with less finances will not have the resources to fund the purchase of the shares and will be forced to sell.

Piggyback


A common share provision used to protect minority shareholders is a “piggyback” right. This provision protects a minority shareholder from being excluded by the majority shareholders, where they wish to sell their shares to a third party, but have not included the minority shareholder as part of the deal for one of many possible reasons.

A “piggyback” right typically allows a minority shareholder to sell some of their shares to the third party purchaser under the same terms as the majority shareholders.

Drag-along


As noted above, a “piggyback” provision protects minority shareholders where they are excluded from a sale by the majority shareholders. A drag-along provision is a clause that allows the majority shareholder to drag-along the minority shareholder whether they like it or not, where the majority shareholders want to sell and the purchaser wants 100% ownership with no minority owners.

These provisions will often have a minimum price to protect the minority shareholders from selling at a price they consider too low and/or apply only after they had the opportunity to purchase the departing shareholders shares (which in many cases is not practical given their resources).

Death Provisions


It is very important that any shareholders' agreement consider the death and disability of any of the shareholders. I briefly want to discuss one issue that can arise upon the death of a shareholder; that being the flow-through of the capital dividend account to the spouse or estate of the deceased shareholder.

Typically shareholder agreements require all shareholders to obtain life insurance with the corporation being the beneficiary. The idea is that if one shareholder were to die, the insurance is sufficient to allow the corporation to redeem the deceased shareholders shares at their fair market value, subject to a valuation. It should be noted, that life insurance proceeds generally are added to the corporations capital dividend account and can be paid as a tax-free dividend.

The requirement to redeem the deceased shareholder’s shares generally allows the surviving spouse to receive most of the redemption funds tax-free (via the capital dividend) and the remaining shareholders to obtain control of the corporation, with minimal cash outflow, since typically the insurance covers most if not all of the redemption price payable to the spouse or estate.

The reason I have mentioned all this is; that while most agreements have a clause regarding the redemption of the deceased shareholder’s shares and the requirement for the shareholders to obtain life insurance, I have seen on several occasions no mention that the funds used to redeem the shares must be paid from the capital dividend account ("CDA") caused by the insurance (Nowadays, many lawyers do not specifically reference the CDA, but have a clause requiring the redemption to be made in the most tax efficient manner for the vendor). 

Without this clause, the corporation can use the life insurance proceeds to redeem the shares, but keep the capital dividend for itself and its remaining shareholders. While most people would not try and take advantage of such a missing provision, where the shareholders and their families have not got along, the surviving shareholder could try and “stick-it” to the estate of the deceased shareholder without a clear provision.

Marital Breakdown


Many shareholders do not consider that a marriage breakdown by one shareholder can significantly impact the other shareholders. As this post is too long as it is, I will quickly point you to an interesting article published by Jordan Dolgin Do Family Law Clauses in Shareholder Agreements Really Matter? that discusses this topic.

My post today just touches on just a couple points you need to consider in drafting a shareholder agreement. If you have a corporation and do not have such an agreement, I suggest you contact your lawyer and get to work promptly on drafting such.

Bloggers Note: I have disabled the ability to comment on this or any prior blog post. I apologize, but I am too busy during tax season to answer the various questions and comments I receive.

The above blog post is for general information purposes only and does not constitute legal or other professional advice or an opinion of any kind. Readers are advised to seek specific legal advice regarding any specific legal issues.

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation.

Small Business Owners - Get on my Mailing List


If you are an owner-manager and/or a shareholder in a corporation and have not signed up for my corporate mailing list, please email me at bluntbeancounter@gmail.com.

I will be sending out specific mailings on matters of importance to small business owners and I am considering, depending upon the interest, holding a roundtable for small business owners who are in the Toronto area. I will start the mailings in May.

Thanks to the many readers who have already signed up.