What You Need to Know About Shareholder Agreements

Building your startup team is essential. Building a company without the right people can hinder your success. But it is a challenge to find and keep the right people on your side. A strong shareholder agreement can help.

What is the Purpose of the Shareholders Agreement?

A Shareholder’s Agreement governs the relationship among the shareholders. It provides for the management of the corporation as well as in certain situations, creates liquidity for otherwise unmarketable shares within a private corporation. It is difficult to sell the shares that you might own in a start-up company before it has really taken off, so previsions can help control that. A shareholders agreement also anticipates future events such as death, disability and divorce. Lastly, it supplements the statutory framework that applies to corporations, whether they be federal and or provincial.

Why is a Shareholders Agreement so Important?

Control

There is a common misconception that a majority shareholder can control a minority shareholder and what a minority shareholder can do with its shares.

  • Drag Provision – In the case that a larger corporation wants to buy out your business and one of your minority shareholders refuses, the agreement gives the majority shareholders the right to drag that one person along and tell them they have to sell their shares along with them. In favour of the shareholders that hold the majority share.
  • Piggy-Back Provision – It gives the minority shareholder the control to not be put in the situation where the majority shareholders all sell their shares and leaves one or two minority shareholders stuck with a new majority shareholder in a business when they might have liked to sell at the same time.
  • Allows certain shareholders the right to have one or more nominees sit on the board of directors. Sometimes a majority shareholder will want to have more than one nominee so this is a way in which certain shareholders can control who ends up on the board.
  • Quorum Requirements – Typically default on most decisions having a majority (slightly more than 50% of the shareholders/directors in a shareholder situation/director situation) You can actually increase that threshold by way of previsions within the shareholders agreement for certain types of decision making.
  • Approval Requirements – Stipulating a certain level of approval for very important decisions. In this way certain shareholders can control what is going on within a company.

Restrictions

  • Cannot transfer the shares (only holding company or family trust).
  • Right of First Refusal (ROFR) – If a shareholder has received an offer from a third party to have their shares bought out, that they go back to the group of other shareholders (providing them the details of the offer) and see if they want to buy them out before they can go to a third party.
  • Right of First Offer – A shareholder who wants to sell their shares goes first to the group of shareholders, sets out a bunch of terms, and if they don’t want to buy the shares, they have the ability to go out into the market and find somebody who will (on the same set of terms given to the other shareholders).
  • Cannot encumber the shares – can’t use them as collateral for a bank loan, etc.
  • Pre-Emptive Rights/ Anti-Dilution – Restriction on the corporation so the corporation can’t issue more shares without taking into consideration what shares are already owned by current shareholders, and seeing if they want to participate. A way of restricting issuances and or transfers of shares.

Protection

  • Confidentiality – Shareholders cannot disclose confidential company information to outsiders.
  • Non-Competition – Shareholders cannot turn around and create a different company that competes with their corporation.
  • Non-Solicitation –  Not allowing shareholders to steal the employees and or customers of their corporation.
  • Assignment of Intellectual Property (IP)
  • Arbitration – Protecting the corporation by not allowing shareholders to take their disputes to the court system.

Issues that arise with no signed shareholders agreement:

  • Cannot force a shareholder to sign an agreement after the shares are in their hands (many start-ups discover this too late)
  • Rogue shareholder (one of these devalues a corporation)
  • Investors may not want to invest if there is a possibility of a rogue shareholder or the lack of protection in favour of the corporation

Equity Compensation

  • Outright issuance of shares (upfront)
  • Stock Options/ESOP (to be earned)
  • Reverse Vesting (can take them back)
  • Phantom Stock Options (no actual shares)

Other Considerations with Equity Compensation

  • Simple time frames is not the best
  • Can you set milestones?
  • Need a way to get the shares back

It is important for businesses to keep the right people and having a shareholders agreement is a crucial step to having the necessary control, restrictions and protection for your growing business.

This article is based off an original presentation done by Andrea Brinston from Pallett Valo LLP. Check out our events calendar to see what is happening at Altitude Accelerator.


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