The purpose of a shareholders’ agreement is to govern the relationship between shareholders and determine the rights and obligations of the shareholders. The scope of a shareholders’ agreement can vary considerably. Some only set out a method of having one shareholder buy out another in the event of a dispute. Others deal with the consequences of the death of a shareholder. Others set out rules for determining company policy and management. Yet others give certain shareholders rights to acquire or dispose of shares in certain circumstances. Often agreements combine all or several of these aspects.
Shareholder agreements are discussed under the following headings:
Where a dispute arises between shareholders, it may, unfortunately, get to the stage where the shareholders cannot continue doing business together. However, decisions as to who should leave and the price of that person’s departure may be very difficult and time-consuming. In addition, conflict between shareholders can cause the business itself to lose value.
This can lead to unwanted attention given to the business because of the dispute, or because customers have become aware of the dispute and decided to find a replacement for the sake of more stability. Resolving the dispute between shareholders is likely to require either extended negotiations or litigation – or both. This usually means large bills incurred for lawyers, business valuators and tax specialists. It also involves a lot of time and stress for the principals.
A shareholders’ agreement can minimize both the time frame and the costs involved of a potential dispute. Typically a shareholders’ agreement deals resolves disputes by adopting one of several possible methods of enforced share sales. These entail the following points:
- Who buys and who sells?
- What is the price?
- When does the sale take effect?
A standard method used is known as the “shot-gun” provision, which works as follows:
- The first dissatisfied shareholder gives a notice to the other shareholders, naming a price per share.
- The others must either buy the first shareholder’s shares at the price or sell his/her shares to the first shareholder at the same price.
- A time period is pre-set for a response to the notice, and the time until the sale takes effect is also pre-set.
Other methods may involve one shareholder having either the right or the obligation to acquire the shares of other shareholder’s at a price based on a formula, or by a third party. A formula could include a percentage of gross (or net) revenues in previous financial periods or perhaps a percentage of book value of assets. A third party might be the company accountant, charged with determining value according to pre-set criteria. Alternately, it might be an outside person charged with making a fair market value determination.
In a publicly-traded company, neither the management of the company nor the shareholders are too concerned with who owns shares at any given time (except where one shareholder or a group has a control block of shares). After all, being a shareholder in a public company does not involve you in management decisions.
However, in a small private company, the identity and involvement of shareholders is a very important issue. In effect, to the principals, the company is almost like a partnership – and you want to pick your partners, not have them imposed on you. As such, a shareholders agreement should contain provisions to appropriately deal with this. A widely used provision is the right of first refusal. This means that if a shareholder obtains a commitment from an outsider to purchase shares, the shares have to first be offered under the same terms to the existing shareholders for a specified period. The other shareholders have the opportunity to match the price and purchase the shares, thereby preventing any unwanted third party from acquiring shares in the Company.
Another option is a complete prohibition on the sale of shares to any third party; however this is a very restrictive measure which can be quite unattractive to minority shareholders.
When the Parties are looking for the middle ground between the above two scenarios, the preemptive offer is typically used. Here, a shareholder intending to sell shares is required to send a notice to the other shareholders specifying the offer to sell and the offer must be kept open for a fixed period of time. If all the shares offered for sale are not purchased by the other shareholders, the selling shareholder then has the right to offer the remaining shares for sale to third parties for a further pre-determined fixed period – but only on terms no more favourable than those offered to the other shareholders.
Third Party Offer
Sometimes, a third party will offer to buy 100% of a company but not all the existing shareholders want to accept the offer. A provision may be included in the shareholders agreement which provides that those who do not want to accept the third party offer must then purchase the shares of those who do want to accept the offer, on the same terms as the third party offer.
Typically, the death of a shareholder actively involved in a business creates problems on two fronts. Firstly, the surviving shareholders no longer have the benefit of the deceased contributing to the business, and may need to replace that person with a new shareholder. Secondly, the family of the deceased will want to be compensated for the deceased’s interest in the business. The obvious solution is to provide a mechanism for the shares of the deceased to be sold to either the company, the other shareholders or a new shareholder.
The weakness with the concept of a simple sale of shares from the deceased is finding the money. Usually, after having just lost an active shareholder, neither the surviving shareholders nor the company itself have sufficient cash flow to pay for the shares. If the family of the deceased does not need the funds right away, the problem may be dealt with by providing for a series of payments over a period of perhaps several years. In this case, there should be restrictions on the surviving shareholders to ensure that the payments are duly made.
If the family of the deceased is not able to wait for payments, it may be that life insurance provides the best solution. Two methods are commonly used:
- criss-cross insurance – where each shareholder owns coverage on the other shareholder(s), and the proceeds are earmarked for the surviving shareholder(s) to buy the shares of the deceased.
- insurance owned by the company itself on the lives of each of the shareholders, so that the company will use the proceeds to re-purchase the shares of the deceased. Where shares are repurchased by the company, they are in effect eliminated, leaving the surviving shareholders with proportionately larger interests.
The tax consequences of the two schemes differ. In the past, the second method provided a valuable tax saving opportunity for the deceased, but not as favorable a treatment for the surviving shareholders. Now, the situation is less clear because of the 1995 updates to the Income Tax Act with regards to dealing with tax treatment of losses.
Generally, the amount to be paid for the shares of a deceased shareholder is determined by:
- the amount of life insurance proceeds available;
- reference to a value determined between the shareholders by agreement every year; or
- a formula based on recent financial statements.
Short Term Disability
Usually, shareholders’ agreements dealing with short term disability will provide for shareholders who are employed by the company to receive full salary for a number of months, even if unable to work. This provides some financial stability for the disabled shareholder, but imposes a burden on the working shareholder(s).
For this reason, many shareholders purchase disability insurance so that a certain number of days after the disability strikes, the disabled shareholder will receive monthly payments from the insurer. The company’s obligation to continue paying the disabled shareholder’s salary will normally cease on the same date the disability insurance commences payments. An alternative in the event that there is no disability insurance is to pay a reduced salary.
Disability provisions should be structured to ensure that a disabled shareholder cannot remain indefinitely under short-term disability coverage by returning to work for brief periods between bouts of absence from work.
Long Term Disability
It is unusual for a shareholders’ agreement to provide for continuing salary payments to a shareholder who is disabled for a long period.
Instead, shareholders’ agreements may provide for a forced sale of the disabled shareholder’s shares. This may benefit that shareholder by turning shares for which a ready market may not exist, into cash. It benefits the working shareholder(s) by ensuring that profits do not have to be split with a shareholder who is, in effect, no longer contributing to the company’s success.
Particularly where there are more than two shareholders, or where there is a minority shareholder, provisions restricting management may be an important protection mechanism for those who can be out-voted. Typically, the shareholders agreement will provide that certain decisions require unanimous approval and others a specified percentage in excess of 50%. An example might be:
- Unanimous Decisions
- Elections of directors
- Issuance of new shares
- Sale of the entire business
- Changes to share rights
- Executive salaries and bonuses
- 70% Majority Decisions
- Expenditure on capital items in excess of $20,000 per item
- Decisions to call on shareholders to lend to the company
A “put” is defined as the option of selling shares at a fixed price on a given date. In a shareholders’ agreement, one shareholder may be granted a put which allows that shareholder to require one or more of the other shareholders to buy part or all of his/her shares at either a fixed price or a price determined by a formula. The Put may have a period of time before it can be exercised, or it may expire if not exercised before a specified date, or it may remain in effect virtually indefinitely.
A “call” is more or less the reverse. It confers an option to buy shares at a fixed price on a given date. This means that one shareholder may be granted the right to buy a certain quantity of shares from one or more of the other shareholders by notice, at a price that is either fixed or determined by a formula. The same comments about time made in relation to puts apply.
Typically, shareholders’ agreements provide that the primary source of borrowing funds for the company will be institutional lenders (banks, trust companies, credit unions, and so on). However, if funds are required and cannot reasonably be obtained from conventional sources, the shareholders may each agree to personally lend the company a proportionate share of the amount required.
Where one or more shareholders are unable or unwilling to contribute the required amount, the shareholders’ agreement may provide that that shareholder is in default. This may allow the other shareholders to force the defaulter to sell his/her shares, often at a discounted value. Alternatively, the shareholders’ agreement may provide that one of the other shareholders make the loan that the defaulter should have made and charge a high interest rate to the defaulter for doing so.
When loans are made to the company by institutional lenders, shareholders may be required to sign “joint and several” unlimited guarantees. This means that each shareholder is personally liable for 100% of the amount owed by the company to the lender. Where one shareholder is virtually without assets, this may mean very little – you can’t get blood from a stone, and the other shareholder(s) should be concerned. The reason for concern is that if one shareholder does not cover a proportionate share of the guarantee, the other(s) will be forced to pay more than a fair share. It may be possible to negotiate with the lender to either “cap” the guarantees at an amount less than the entire indebtedness, or to make several guarantees that are not joint so that each shareholder is only responsible for a proportionate share.
Normally, a shareholders’ agreement provides that certain acts or omissions by a shareholder be considered as a breach of the agreement and result in special rights being conferred on the other shareholders.
As noted above, financial defaults can result in interest being charged against the defaulter at a high rate. There are two reasons for the high rate. The first is to make it more attractive for the defaulter to meet the financial obligations, even if that means borrowing the funds to do so. The second is to compensate the other shareholder(s) for having to step in and put in more than a proportionate share of the money.
Another common consequence of default is an option for the other shareholder(s) to buy the defaulter’s shares. Usually the price is determined by a formula designed to approximate fair market value, but is then reduced by a percentage portion. The reduction is justified on the basis that it is the defaulter who created the situation, not the other shareholder(s) and the timing of a buy-out may well not suit the other shareholder(s).
Events of default usually include:
- not carrying out obligations under the shareholders agreement
- bankruptcy or insolvency
- permitting any creditors to attempt to seize one’s shares
Other events of default might include:
- having one’s spouse apply under the Family Relations Act for a portion of one’s shares;
- ceasing to be a Singapore resident (under some circumstances, this could adversely affect the company’s tax treatment)
In most small companies, the shareholders (or at least some of them) are also active employees. While written employment contracts for key employees are prudent (for reasons ranging from limiting exposure on wrongful dismissal suits, to protection of confidential information, to income tax), shareholders’ agreements are often used to establish the ground rules for the terms of the employment contract, particularly in relation to salaries and benefits. Furthermore, there may be advantages to including non-competition provisions in a shareholders’ agreement rather than in the employment contract.
In some small companies, the principals do not own any shares in the company. Instead, they control personal (or family) holding companies which own shares that are crucial to the running of the business. The reasons for doing this may range from tax implications to estate planning. Tax advice (as always) will be important.
From a corporate point of view, management companies add a layer of complexity to the shareholders’ agreement. The holding companies will be parties to the agreement, as they are the shareholders. The principals must also be parties and, for example, all references to the death or disability of a shareholder have to be changed to death or disability of a principal.
Furthermore, a number of additional provisions come into play. Foremost of which is a restriction on the shareholdings of each holding company as without such a restriction, the shares of a holding company could be sold by a principal to a third party. The result of which would then defeat the purpose of the holding company and that no change in players in the company should occur without the existing players having a first option to take over the position of the player leaving the company.
There are a number of people who are or should be involved in the creation of a shareholders agreement. These include:
Generally, all shareholders should be party to an agreement, although it is possible to omit, for example, non-voting shareholders.
Obviously, if spouses are shareholders, they should be included in the shareholders’ agreement. Like the other shareholders, spouses should each receive independent advice. This ensures that they have an opportunity to protect their interests in the agreement. It also reduces the likelihood of a spouse later challenging the enforceability of the agreement on the basis that the spouse did not sign voluntarily or failed to understand the contents of the agreement.
Most shareholders’ agreements that deal with the consequences of death or disability rely on insurance policies covering such events. It is essential to involve the insurance agent in the preparation of those parts of the agreement to ensure that the insurance policies and the agreement correlate.
LAWYERS AND LEGAL CONSULTANTS
The complexities of shareholders’ agreements are such that they should not be drafted by the shareholders but only by professionals with experience in drafting such agreements.
An accountant with tax expertise should be involved in the preparation of the shareholders’ agreement to ensure that the tax implications are dealt with correctly. This has a further advantage as the accountant will be familiar with the agreement and can raise an alarm when changes to tax laws create a need to change the agreement.
As mentioned above, changes to tax laws may result in necessary changes being made. Adding new shareholders usually requires at least the signing of a document by which the new shareholder formally becomes a party to the agreement. Changes in the size of the company, its business, the financial circumstances of the shareholders, and other internal matters may justify at least a review of a shareholders agreement.
Where shareholders are required to decide annually on an agreed valuation of the company (usually to provide for a sale price where a shareholder dies or becomes disabled within the following year), a diary system may be critical to ensuring that the task is performed regularly.
Timing and Conclusion
Though most business people starting up new companies agree that a shareholders’ agreement is important, two reasons are often put forward for not putting the agreement in place at the beginning:
- we are too busy getting the business up and running (and anyway, we all get along really well)
- we don’t have the cash yet.
The first reason really doesn’t hold water. Running a small business means you are always busy. So, if you don’t have time to get around to a shareholders’ agreement at the beginning, face it: you won’t later on. As far as getting along really well, that is the way almost all businesses start. Yet, like marriages, a significant number of small companies encounter disputes between shareholders and unfortunately by then, the goodwill between shareholders has usually dissipated, and it is not possible to sign a shareholders’ agreement.
In response to the second reason, the value of a shareholders’ agreement far exceeds the initial cost and as such it is worth the investment. You can not afford to NOT have one. Shareholders’ agreements serve a wide range of purposes. Every small company with more than one shareholder should have one.
A shareholders’ agreement can be a cost-effective and efficient way to minimize disputes between shareholders. Once all your company’s shareholders have agreed on the material terms to govern their relationship, Rikvin can provide you with a shareholders’ agreement drafted to the suit your needs at an affordable price.
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