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. Please note the blog post is time sensitive and subject to changes in legislation or law.

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.

Corporate Divorces and Butterflies

Over the last couple months I have received a few private emails enquiring about the services provided by my firm Cunningham LLP. I have never directly marketed my firm on this blog; however, today will be the exception.

Cunningham LLP is a mid-market CA firm that deals almost exclusively with owner/managed corporations. We prepare financial statements (Notice to Readers, Reviews and Audits) and provide advisory services on acquisitions, divestitures, financing and succession planning to name a few. In addition, we provide business valuations, bookkeeping, wealth management services and, the service area most dear to my heart, income tax services. The income tax services range from corporate reorganizations and remuneration strategies, to estate planning, estate freezes and the introduction of family trusts amongst a plethora of other services. Today, I have decided to show off some of our income tax expertise; at least that is what I told my tax partner Aaron Schechter (I really needed a break from writing) when I convinced him to write today's guest post.

Corporate Divorces and Butterflies

In the ordinary sense of the word, a butterfly (noun) is defined as a nectar-feeding insect, characterized by two pairs of large, typically colorful wings and clubbed or dilated antennae. However, the term “butterfly” when used in an income tax context is often the most tax efficient solution for shareholders who often can no longer stand each other and want to part ways, while each taking their pro rata share of the business with them. In other words, a “butterfly” transaction is used to divvy up the business on a tax-free basis.

The transaction is referred to as a “butterfly” by tax practitioners because when diagrammed, the series of steps resemble the wing(s) of a butterfly.

A butterfly transaction is one of the more complicated transactions to carry out for Canadian income tax purposes. Butterfly transactions are typically used where there are arm’s length parties. It should be noted that when the shareholders are related (siblings are deemed not to be related for purposes of the butterfly rules) there are usually simpler ways to achieve the intended divorce than a butterfly.

The complexities lie in the provisions and rules found in the Income Tax Act that make the transaction tax-free. These provisions contain several income tax minefields and should the parties misstep they can quickly find themselves outside the tax-free provisions. Since the dollar amounts involved in a butterfly transaction are generally fairly large (if the dollar amounts were small, the parties would more than likely opt to create a taxable divisive transaction rather than dealing with the administration e.g. obtaining a tax ruling and incurring the professional fees associated with a tax-free butterfly transaction), a misstep can result in significant taxes owing.

While the specifics of the tax-free butterfly provisions are beyond the scope of this blog, in general a tax-free divisive reorganization of private corporations can be accomplished if:

1. Each type of corporate property is distributed pro rata to all shareholders. Corporate property is divided into three types – cash and near cash, investment property and business property;

2. A shareholder’s proportionate share of each type of corporate property is determined immediately before the transfer and is equal to the proportion of the fair market value of the shares of the distributing corporation owned by the shareholder relative to the total fair market value of all the issued shares of the distributing corporation.

3. The recipient(s) of the corporate property is(are) a corporate shareholder(s).

4. The recipient(s)’s shares of the distributing corporation is cancelled or redeemed at the end of the transaction.

The tax-free butterfly transaction is best illustrated with an example. Say Mr. Sheen and Mr. Lorre each own 50% of a company that specializes in organizing children’s birthday parties called Children Birthday Surprises Ltd. or CBS for short. Mr. Lorre believes that Mr. Sheen has not been devoting himself to the business and his recent behaviour has been negative for CBS. On the other hand, Mr. Sheen believes that he has not been properly remunerated by CBS for his contributions to the business. In other words, Mr. Sheen and Mr. Lorre want to part ways and each take a part of the business with them. They wish to undertake a tax-free butterfly transaction.

Prior to separating, the company owns $1,000,000 of cash, $2,500,000 of marketable securities (cost $1,000,000) and $5,000,000 of inventory (cost $4,000,000) and the ownership structure looks like this:

The first step of the butterfly is to have Mr. Sheen incorporate a new company, SheenCo. He then transfers his 50% ownership of CBS to SheenCo. The transfer takes place on a tax-free basis under the rollover provisions in the Income Tax Act.

Next, CBS transfers 50% of the cash, 50% of the marketable securities (investment property) and 50% of the inventory (business property) to SheenCo. in exchange for shares of SheenCo. Again, the transfer takes place on a tax free basis under the rollover provisions in the Income Tax Act.

Immediately thereafter, SheenCo, has its 50% share ownership in CBS redeemed for $4,250,000 and CBS has its shares of SheenCo. redeemed for $4,250,000. The redemption proceeds for each redemption are satisfied by promissory notes worth $4,250,000.

The promissory notes are then offset by each other and cancelled. Each of SheenCo. and CBS now own 50% of the original assets and can carry on business separately.

The transaction discussed above is commonly referred to a “single wing” butterfly since only one additional corporation is incorporated. However, “multi-winged” butterfly transactions are also possible.

Butterfly divisive reorganizations are generally much more complicated and involved than the example provided, so it is often recommended that the parties obtain an advanced tax ruling from the Canada Revenue Agency to confirm that the transactions proposed will indeed be tax-free. When undertaken properly, the tax-free butterfly transaction can be as beautiful as the real thing, just remember to tread carefully, otherwise the process could metamorphosize into something a whole lot uglier.

Finally, I hope it goes without saying, but today's discussion has been general in nature and the specific nuances related to a divisive reorganization are vitally important. Thus, do not act without first seeking professional advice.

Aaron Schechter CA, is a partner with Cunningham LLP, who specializes in income tax planning and income tax reorganizations.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs. Please note the blog post is time sensitive and subject to changes in legislation or law.