It is common to suggest shareholders enter into a shareholders’ agreement, where each shareholder assumes certain rights and obligations relating to the business of the corporation. The shareholders’ agreement typically includes provisions dealing with the management of the business and future transfers of shares upon death or other circumstances. Unfortunately, once the shareholders’ agreement is signed, it is often filed in the corporate minute book and never reviewed by the signatories.
There are several reasons to review the shareholders’ agreement every 3 to 5 years. This article will highlight some provisions that should be reviewed and understood.
Death of a Shareholder
All shareholders’ agreements have a provision anticipating the death or incapacity of a shareholder. The provision incentivizes a smooth transition by protecting the interest of the remaining shareholders while ensuring the estate of a deceased shareholder will be treated fairly. For estate planning purposes, understanding the terms of the shareholders’ agreement and the rights of the shareholders in the eventuality of death is important.
However, ask a client about the terms of the shareholders’ agreement on their death or incapacity and often, a blank stare follows. Professional advisors must review the provision dealing with the death or incapacity of a shareholder and ensure the client and their family understands their rights and the process that will follow.
Preparing for an Exit Strategy
Whether you are considering a future sale of the corporation or leaving the corporation (on your terms or otherwise), it is important to familiarize yourself with certain key provisions of the shareholders’ agreement.
Value of Shares
There is a clause stipulating the methodology determining the fair market value of the shares in a buy-sell context and it is one of the most important clauses in a shareholders’ agreement. This clause determines whether the surviving shareholders will exercise an option; it regulates the funds that a signatory must plan to have available to satisfy an obligation to purchase; and it may materially affect the tax liability on a shareholder’s death.
Shareholders must understand the provision of the agreement that dictates the formula establishing the price of their shares and whether adjustments can be made if new circumstances arise. Otherwise, an outdated formula will establish an inaccurate price for the shares, which will be detrimental to the estate or the surviving shareholders.
Life Insurance
It is common to fund the purchase price of the buy-sell provision (especially in the case of death) with a corporately-owned life insurance. Shareholders must understand the treatment of life insurance death benefit proceeds to the corporation and whether the buy-sell structure on death will be done through tax-free capital dividends.
This often depends on the buy-sell structure; if it is a cross-purchase structure or corporate share redemption structure (or a combination of both). This must be understood by the shareholders.
Non-Disclosure Agreement & Confidential Information
It is typical that a shareholders’ agreement has a section protecting the corporation’s information. Shareholders are entrusted with confidential and privileged information that constitutes a proprietary right of the corporation that must be protected at all times.
The non-disclosure agreement and confidential information sections are particularly relevant and ought to be reviewed when one contemplates selling their shares to a third-party; where information can be disclosed.
Non-Compete Clause
Every shareholders’ agreement has a section imposing a restriction on competition to a shareholder who ceases to be a shareholder of the corporation. The clause will prevent, for an appropriate amount of time, a shareholder from carrying on or engaging in any business or other activities that are deemed to compete with the corporation.
A shareholder that leaves the corporation (by their decision or not) may be restricted in future business activities for a specific period of time.
Conclusion
A shareholders’ agreement is an important document to shareholders and businesses. It is important to ensure it is up to date and accurate. It may be time for clients to dust off their shareholders’ agreement to understand the rights and provisions afforded to them as shareholders and if needed, amend the document so it remains accurate and relevant.
