Unread, Out-dated, Unsigned, Misunderstood and Incomplete Shareholders’ Agreements

October 17, 2016

It is more common than not for a business owner to discover that their shareholders' agreement is unread, outdated, unsigned, misunderstood or incomplete. Even worse – it may not exist! Common examples of where a shareholders' agreement is incomplete include

  • Dated agreement not reflective of the current business situation and dynamics of shareholders
  • No policy or process for managing conflict
  • No compensation policy
  • No way to hold management accountable
  • No rules around distributions to shareholders
  • No way in – and even worse – no way out!

And the timing of this discovery is inevitably when the shareholders' agreement is urgently required – typically in circumstances of one or more of the “6 Ds”: death, disability, divorce, disenchantment, disposal or a dispute.

Let's put this into a practical setting to show why having a comprehensive, updated shareholders' agreement makes good sense.

What is the concern?

The ability to transition a business in the event of the 6 Ds is crucial. One or more of these events WILL occur to each shareholder and will impact their spouse and family members.

Consider the following scenario: Two siblings – Bob and Sarah – are equal shareholders in the family business. The shareholders' agreement was crafted by dad 20 years ago when he transferred ownership of the business to the children. Fast-forward to today. Bob's wife files for divorce and under family law is entitled to 50% of Bob's shares in the business. Dad never contemplated this situation when Bob and Sarah became shareholders. Now Sarah and Bob have another shareholder to consider – Bob's ex-wife. This is unlikely to be a desirable outcome on many levels. A properly constructed shareholders' agreement will anticipate this situation and incorporate mechanisms to protect the business and the siblings' interests.

What you need to know

It is incumbent on all shareholders in a business to engage in an open, transparent and inclusive process of creating and building a shareholders' agreement - and reviewing it on a regular basis. While your lawyer and other advisors will help you navigate the nitty-gritty details, here are some overarching key concepts for the shareholders to come to agreement on:

  • Begin with the end in mind: What is the exit strategy? Think in terms of both voluntary and involuntary exits.
  • Who can become an owner? Family members only? In-laws? Third parties?
  • How do new shareholders buy in? What price and terms are affordable while being fair to any shareholders who are exiting? Will this buy-in / buy-out process provide the business with the best chance to remain strong and stable?
  • Determine expectations for return on investment, reinvestment in the business and distributions to shareholders by way of dividends.
  • Communication is critical to your success! Put governance systems in place that promote functional relationships and will encourage positive communication and good decision making. Governance systems to consider include an advisory board with independent board members, an owners' council and a family council.
  • Decide upfront on key policies, such as how to compensate family members and key managers for the role they fulfil in the business operation. Note that employee compensation is separate and distinct from any dividends received as shareholders in circumstances where shareholders are also actively involved in day-to-day business operations.
  • Plan for involuntary exits due to death, disability, divorce, disenchantment, dispute and disposal.

What can I take away?

In business with others? You NEED an up-to-date shareholders' agreement that is comprehensive, transparent and understood by ALL shareholders. This requires that the agreement is created with input from all current and prospective owners and that it reflects not only present circumstances but also anticipates the future. A shareholders' agreement is essential for protecting your family's assets and securing the value of your business through inevitable life events. It is critical to the success and continuity of your family enterprise.

To learn more:

Cindy Radu
Partner, Business Transition Services for Western Canada

Jeff Noble
Director & Practice Leader, Business Transitions

Brent VanParys
Partner, Business Transition Services for Central Ontario

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