Spotlight On: Shareholders’ Agreements


We’re all in this together: The importance of shareholders’ agreements


“Why do I need a shareholders’ agreement?”

It’s a great question.  Negotiating and implementing a shareholders’ agreement can be resource-intensive, and can require founders to challenge their assumptions about each other and their business.  It may also feel counterintuitive to require shareholders to think about their individual rights when everything else about the operation feels like you’re all in this together.

Here are some reasons why putting a shareholders’ agreement in place can be well worth the work.

Starting Off on the Right Foot

A shareholders’ agreement requires advance planning for aspects of a business that founders may not have initially considered, and so the process of preparing one sets a company up for an organized approach to growth, which can appeal to both present and future investors.

It’s also a great opportunity to consider unlikely or worst-case scenarios while the parties are all still getting along.  Because they require shareholders to consider their individual interests vis-à-vis each other, shareholders’ agreements can reveal stark differences in expectations and priorities.

Asking the difficult questions up front can also save you from expensive disputes later on.  A little while ago, in preparing for a Law Society presentation about tips on shareholders’ agreements, we reached out to a litigator friend of the firm to ask for the top reasons that people sue each other in relation to a shareholders’ agreement.  His number one reason (“by a mile”) was when there was no shareholders’ agreement at all.  Regardless of the quality of drafting, the mere existence of a shareholders’ agreement is likely to reduce your litigation risk.

And finally – you’re probably already halfway there!  Many of the topics a shareholders’ agreement can cover are likely things you and your co-founders have already considered when it comes to working together.  Putting it all in writing makes those joint intentions clear and enduring.

The Big Four

A shareholders’ agreement typically addresses four major considerations:

  • How decisions get made;
  • How money comes in;
  • How money goes out; and
  • How shareholders exit (or transfer their shares).

Because these questions are certain to come up at some point in your company’s life cycle, dealing with them up front can help your business respond more efficiently when they arise.

How Decisions Get Made

Without a shareholder agreement, the board would manage or supervise the management of the business and affairs of the corporation and make most of its decisions, including about such matters as issuing new securities, entering into material contracts, hiring new executives, and creating new subsidiaries.

Shareholders would approve only those fundamental matters as required by law, such as amending the corporation’s articles, entering into an amalgamation or plan of arrangement, a sale or transfer of all or substantially all of the property of the corporation, continuing the company into a different jurisdiction, and winding up the company.

A shareholders’ agreement can provide shareholders with additional approval rights – common examples are:

  • a material change to the nature of the business,
  • issuing shares or other securities,
  • a material acquisition or the purchase or sale of real estate,
  • entering into a non-arm’s-length contract,
  • changing the fiscal year end,
  • adopting or changing a share option plan, and
  • the formation of subsidiaries or taking an interest in another company.

“Shareholder approval” doesn’t have to mean that all shareholders need to approve the action – indeed, as a company grows, this kind of approval can be increasingly difficult to achieve.  Consider instead whether just certain founding shareholders, or major shareholders holding at least a certain percentage of shares, should be specified.  There can be different approval requirements for different types of decisions.

A shareholders’ agreement can also be a great place to plan for the governance of your company.  For example, you can specify who gets a seat on the board – which may perhaps feel redundant when the founders initially hold controlling equity interests in the company, but can become very valuable after the dilutive effect of subsequent financings.

Shareholders can agree in a shareholder agreement to vote their shares in a certain way in order to provide certainty going forward – one such example is the exemption of the corporation from the annual audit requirement imposed by corporate statutes, unless the board determines otherwise.  Shareholders can also assign their voting power to others.

And finally, a shareholders’ agreement can provide for information rights, such as regular access to budgets, interim financial statements, and other important information, to which shareholders would not otherwise be entitled by law.

How Money Comes In

A shareholders’ agreement can clearly set out stakeholders’ expectations about how funds will be raised for the company’s business.  Should shareholders be compelled to contribute capital, or to personally guarantee debts of the corporation if a lender requests that?  Should shareholders be able to participate in future issuances of shares and other securities (often known as a pre-emptive right), to allow them to avoid being diluted and to help keep the circle of shareholders small?

How Money Goes Out

A company’s articles will confirm which classes of shares permit dividends to be declared, and the board is responsible for declaring dividends, but a shareholders’ agreement could provide for shareholders to approve a dividend policy or approve each dividend before it is paid.

Customized approvals can be required for corporate budgets, major acquisitions, and contracts involving more than a certain amount per year.  Profit-sharing arrangements can be baked in, as can arrangements for the repayment of shareholder loans.

How Shareholders Exit

Going into business together can be profoundly personal.  A principal objective of many founding shareholders is to control who gets to be part of their company – both by way of managing issuances of shares from treasury, and also by providing for how existing shareholders may sell or transfer their interests.

The articles of any private company will require that all share transfers be approved by the board or as set out in a shareholder agreement.  It is common for shareholders’ agreements to set out how a shareholder can sell, transfer or encumber their shares in the corporation.

Some other key provisions that can affect how shareholders exit the company or transfer their shares include:

  • Tax planning transfers, and transfers to competitors – certain transfers that are common in tax planning, such as from an individual shareholder to her holding company, can be deemed to be approved in advance such that they aren’t held up at the time. Other transfers, such as transfers to competitors, can face higher approval thresholds to discourage them from occurring.
  • Rights of first refusal – these permit other shareholders (all or only some of them) or the corporation to purchase the shares of an exiting shareholder before the shares can be sold to a third party, which can help prevent unfamiliar parties from becoming shareholders in the company. Rights of second refusal can also be added if the parties who have first right of refusal pass on the purchase.
  • “Shotgun” (or “buy-sell”) provisions – these permit one or more shareholders to force the remaining shareholder(s) to either buy or sell their shares, which can be helpful in breaking a deadlock among shareholders about how to run the company going forward (but can also put shareholders with fewer liquid assets at a disadvantage if they can’t quickly raise the necessary funding).
  • Drag-along clauses – these can allow larger shareholders, or a group of shareholders meeting a certain threshold, to compel smaller shareholders to sell their shares to permit a buyer to purchase 100% of the company, even if those smaller shareholders don’t like the price or terms of the purchase.
  • Tag-along provisions – these allow shareholders to require that a purchaser of someone else’s shares acquire their own shares as well on the same terms. These provisions can provide a chance at liquidity to certain shareholders but can also make it more difficult for a larger shareholder to sell their shares.

Such provisions, especially the shotgun, can be a potent remedy, and the timelines and processes they involve should be carefully modelled out.  Once triggered, a shotgun provision can be difficult to halt and can result in adverse outcomes.  As the Court of Queen’s Bench of Alberta put it in Trimac Ltd. v. C-I-L Inc., “A shotgun buy-sell is strong medicine. One takes it strictly and in accordance with the prescription or not at all.”

A shareholders’ agreement may also provide the corporation or other shareholders with a right to purchase the shares of a shareholder in the event of their disability, death, bankruptcy, divorce, or other circumstances which affect a shareholder or their property.  Often, these mechanisms can benefit both the corporation (by preventing an unfamiliar third party from becoming a shareholder) and the bought-out shareholder (by providing cash at a time of need).  In other cases, such as where the shareholder has breached the shareholder agreement, such provisions can provide for a discount on the repurchase price as a penalty to the exiting shareholder.

Reverse vesting provisions can also be included in a shareholders’ agreement if the parties are comfortable with those provisions being visible to all future parties to the agreement.  Read more about reverse vesting in SkyLaw’s blog post here.

Does it Need to be Unanimous?

A shareholders’ agreement doesn’t need to be unanimous in order to be enforceable against the shareholders who are parties to it.  However, a non-unanimous agreement should carefully distinguish between the entire shareholder body and those who are party to the agreement.  Proceed cautiously around approval thresholds and special shareholder rights to make sure only the right shareholders are taken into account.

When a shareholders’ agreement is unanimous, it takes on the additional quality of being able to restrict the powers of the directors of a corporation to manage the business and affairs of the corporation (such powers, along with their related liabilities, can be transferred to the shareholders).  It will also apply automatically to newly issued securities (a characteristic not shared by the non-unanimous agreement).

For companies which have only one shareholder, such as wholly-owned subsidiaries, a form of shareholder agreement called a “unanimous shareholder declaration” can transfer all powers of the directors to the shareholder, ensuring that the shareholder retains complete control and that the directors are not able to make any decisions for the company.

Public companies cannot, by their nature, have unanimous shareholders’ agreements, but their shareholders can still have agreements between themselves about matters such as how to vote.

Who Can be a Party?

A shareholders’ agreement can include not just the shareholders of the corporation, but also the individual principals of corporate shareholders and trusts, to ensure that an individual is ultimately accountable for the conduct of each shareholder.

Third party stakeholders can also become parties to a shareholders’ agreement, which may make sense if the agreement contains rights that they would like to be able to directly enforce.

Restrictive Covenants

Non-Competition

An additional reason to enter into a shareholders’ agreement is to put in place restrictive covenants that apply to all of your shareholders.  A non-competition clause is a great example: “non-competes” can help ensure that your shareholders do not start up, or work with, a competing business.  Like other “restraint of trade” provisions, non-competition provisions must ultimately be reasonable in their scope, and must meet specific requirements in order to be enforceable, so it’s important to consider the actual needs of your business when structuring this kind of provision.

Non-Solicitation

Generally speaking, a non-solicitation clause prohibits a person departing from a company from soliciting away that company’s employees or clients. In the context of a shareholders’ agreement, a non-solicit can help prevent existing and former shareholders from drawing away the company’s employees, contractors, and clients or customers.

Confidentiality and Non-Disparagement

Often, shareholders can be recipients of sensitive corporate information such as pitch decks, financial statements, and investor correspondence and presentations (including at shareholder meetings).  A confidentiality clause in a shareholders’ agreement can be a great way to impose an obligation on all shareholders to keep such materials confidential.

A non-disparagement clause can prohibit stakeholders from making written or oral comments about the business and its stakeholders that could reasonably be understood as negative or disparaging – an obligation that can help preserve the company’s goodwill and reputation.

Dispute Resolution

Without a shareholders’ agreement, most disputes will land in court, where proceedings and decisions are public.  A shareholders’ agreement can provide that disputes will be handled by arbitration, to keep matters confidential.

Key Take-Aways

If you’re considering whether to put a shareholders’ agreement in place, keep these take-aways in mind:

  • An ounce of shareholders’ agreement can be worth a pound of problem-solving later on. Shareholders’ agreements can set your company up for success and help reduce the risk of costly and distracting litigation later on.
  • Consider whether your agreement should be unanimous. Sometimes, multiple agreements can be in place at once – for example, one agreement to manage the transfer of voting rights among certain shareholders, and a separate, broad agreement to govern all shareholders of the company.
  • Challenge assumptions and consider unlikely scenarios. Consider using illustrative examples to work through how mechanisms such as approval rights, pre-emptive rights, rights of first refusal, and drag-along and tag-along provisions will play out.  Understand your company’s cap table and how it is likely to change over time.
  • Not everything needs to be planned out in advance. Provisions can be worded permissively – for example, an agreement can give the board the discretion to approve budgets from time to time, without creating an obligation for a formal budget to always be in place.
  • Each shareholder and the company should consult their tax advisors to understand any tax-specific requirements that may be relevant. Shareholders’ agreements often deal with the movement of money, so ensure that you understand how that may affect you.  Also consider whether any governance or voting provisions in the shareholders’ agreement may affect the company’s “Canadian Controlled Private Corporation” status for tax purposes.
  • Generally, the earlier any agreement is documented, the better. In particular, consider putting a shareholders’ agreement in place before bringing on third-party investors, such that the agreement binds them from the start.  If it is thoughtfully drafted, it may even impress them!

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