Practical Considerations for Entering into a Shareholders’ AgreementTuesday, April 24, 2018
Read online or download the full update here.
Notwithstanding the size or stage of your business, if your company has more than one shareholder, it is wise to consider entering into a shareholders’ agreement. A shareholders’ agreement is a contract between some or all of the shareholders of a company, and in some instances, the company itself. The contract governs the relationship between the parties and can control how the business and affairs of the company are managed. While there is no legal requirement for shareholders to enter into this type of agreement, there are a number of benefits gained from having a shareholders’ agreement in place. In general, a well-drafted and considered shareholders’ agreement anticipates reasonably likely future events and provides for methods of dealing with them, which can help avoid or resolve future disputes among shareholders, and ultimately save time, money and the stresses associated with conflict resolution. However, shareholders’ agreements can also result in burdensome conditions, making it more difficult to effect decisions and run a business. For example, a shareholders’ agreement that requires unanimous consent for certain corporate actions, or provides certain shareholders with veto rights over certain company activities, can result in deadlocks and lost business opportunities.
The following is a high-level summary of the material covered in Chapter 4 Shareholders’ Agreements of a new book Startup Law 101: A Practical Guide edited by Catherine Lovrics, a partner of Bereskin & Parr LLP. Chapter 4 of Startup Law 101: A Practical Guide was contributed by Wildeboer Dellelce LLP lawyers Rory Cattanach and Carlye Bellavia. Startup Law 101: A Practical Guide was published by LexisNexis Canada.
What is the Purpose of a Shareholders’ Agreement?
Shareholders’ agreements can be used for a variety of purposes depending on the parties involved. For example, a shareholders’ agreement can address procedural matters pertaining to a company, such as the frequency of board meetings and how a meeting is called. Alternatively, a shareholders’ agreement can be used to deal more substantively with shareholder voting rights. In this type of agreement, often referred to as a voting or pooling agreement, the parties agree to vote their shares in a particular manner with respect to certain items of business or the election of directors.
Shareholders’ agreements can also confer rights, restrictions and obligations on shareholders. Examples of shareholder rights and restrictions include: (i) how shareholders can transfer, dispose of or encumber their shares; (ii) a priority right to purchase newly issued shares from the company; (iii) rights over the approval of the sale of the company or its assets; (iv) a right to receive additional information about the company beyond the regulated corporate disclosure requirements; (v) financing obligations; and (vi) non-competition and non-solicitation clauses prohibiting shareholders from competing with or taking clients from the company.
In addition to governing the relationship and permitted and prohibited activities of shareholders and the company, certain types of shareholders’ agreements are used to restrict the powers of the board of directors and transfer some or all of these powers from the directors to the shareholders.
Types of Shareholders’ Agreements
There are two main types of shareholders’ agreements:
(i) a general shareholders’ agreement is a contract between two or more shareholders and
is treated as a traditional commercial contract. This type of agreement is subject to a
company’s constating documents and should be carefully drafted to be consistent with
its articles and by-laws as well as provisions of applicable corporate statutes; and
(ii) a unanimous shareholders’ agreement (a “USA”) is a contract involving and signed by all
of the shareholders of a company. A USA can address matters that are typically dealt
with in a general shareholders’ agreement. Additionally, the Business Corporations Act
(Ontario) (“OBCA”) and the Canada Business Corporations Act (“CBCA”) provide that a
USA can restrict the powers of the board of directors to manage or supervise the
management of a company. Under these conditions, shareholders inherit the rights,
powers and duties, as well as the liabilities, of the directors.
Considerations for Drafting a Shareholders’ Agreement
In Ontario, shareholders’ agreements are regulated by ordinary common law principles of contract law, as well as by the OBCAor the CBCA, as applicable. The OBCA and CBCA permit certain shareholders’ agreements to override a number of statutory provisions. As such, in addition to consulting a company’s articles and by-laws, it is important to consider the effect of applicable corporate statutes when drafting a shareholders’ agreement.
Although each shareholders’ agreement will be tailored for the type of business and circumstances of the company, there are a number of standard provisions that are commonly included in most shareholders’ agreements. A shareholders’ agreement is often used to control the transfer of shares of the company by its shareholders. For example, if a company is privately held, share transfer restrictions can be put in place to ensure that any one shareholder does not transfer its shares to an unknown or unwanted third party without prior approval of the other shareholders or the board of directors. A shareholders’ agreement can include a general prohibition on transferring shares, or alternatively, can outline limited scenarios where transfers are permitted. In the case of a permitted transfer, the transferee should be required to agree to be bound by the shareholders’ agreement.
There are also a number of provisions in a shareholders’ agreement that can be used to control share issuances and dispositions, including pre-emptive rights and rights of first refusal/first offer. A pre-emptive right provision gives existing shareholders the right to purchase any new securities that a company proposes to issue; this gives existing shareholders the opportunity to prevent their ownership from being diluted when new shares are issued. Similarly, a right of first refusal clause gives shareholders a right to purchase shares from another existing shareholder that wishes to dispose of its shares to a third party. Before the selling shareholder can dispose of its shares, it must first offer to sell such shares to the other shareholders of the company, who will have the right to buy their pro rata portion of the shares on the same terms and conditions as the selling shareholder received from the third party for a limited time period. A shotgun clause can be used to facilitate the exit of a shareholder from the company by allowing a shareholder to either sell its shares to or acquire shares from one or more existing shareholders on identical terms.
Tag-along rights and drag-along rights are especially important for start-ups with upside potential. Tag-along rights provide minority shareholders with greater liquidity and protection if one or more shareholders are selling their shares, while drag-along rights prevent a minority shareholder from blocking the sale of the company that is supported by the majority of shareholders.
Other provisions commonly included in shareholders’ agreements (i) set out voting thresholds, in excess of those prescribed by corporate statutes, or require special shareholder approval in order for certain corporate actions to be undertaken; (ii) dictate the approvals required for permitted debt arrangements; (iii) deal with events pertaining to the death, disability, loss of capacity or divorce of an existing shareholder; (iv) provide for one or more mechanisms for dispute resolution; and (v) confirm that each party to the agreement has obtained independent legal advice.
This update is intended as a summary only and should not be regarded or relied upon as advice to any specific client or regarding any specific situation.