WHAT IS A SHAREHOLDER AGREEMENT?

A shareholder agreement is a legal document that outlines the rights and obligations of the shareholders of a corporation. In Ontario, there is no requirement for a corporation to have its shareholders enter into a shareholder agreement. Depending on the industry of the corporation, a shareholder agreement may be short and simple or lengthy and complex. In our experience, a detailed shareholder agreement that addresses how shareholder disputes are to be settled and that provides sufficient exit strategies can save the corporation and its shareholders a lot of time and money by mitigating the chance of extensive conflict or litigation. Below you will find terms that are included in a detailed shareholder agreement:

  • Identification of the parties (i.e. the corporation and its shareholders);
  • Identification of the directors at the time of signing the shareholder agreement;
  • Procedures for conducting shareholder meetings and voting rights of shareholders;
  • Identification of matters requiring unanimous shareholder approval;
  • Identification of various share classes including the number of shares from each class issued to shareholders;
  • Determination of procedures for paying out dividends to shareholders;
  • Determination of procedures for obtaining future financing;
  • Identification of requirements for shareholders to provide financial contributions to the corporation, if any;
  • Pre-emptive rights which offer existing shareholders the right to have first option to purchase new shares issued by the corporation;
  • Implementation of restrictions on the transfer of shares to third parties;
  • Identification of procedures upon the death, disability, or divorce of a shareholder from his or her spouse;
  • Identification of procedures for amendments to the shareholder agreement;
  • Non-competition, non-solicitation, and confidentiality clauses, as applicable;
  • Identification of procedures for dispute resolution between shareholders;
  • Remedies for breach of the shareholder agreement; and
  • Identification of exit strategies for shareholders wishing to leave the enterprise.

Below you will find further information regarding some of the most commonly used clauses in a shareholder agreement.

RESTRICTIONS ON THE TRANSFER OF SHARES

Implementation of the restrictions on the transfer of shares to third parties may be one of the most important functions of a well-drafted shareholder agreement. Typically, when you start conducting business with another individual, you do not wish for them to have the ability to sell their shares to a third party without your consent or without following proper procedures. Share transfer restrictions in a shareholder agreement may prevent a shareholder from selling their shares to a third party without the consent of the board of directors or without the consent of the majority of shareholders. A shareholder agreement may install specific procedures that must be followed if a shareholder wishes to transfer their interest in the corporation to a third party.

RIGHT OF FIRST REFUSAL

A right of first refusal clause requires shareholders who receive a valid purchase offer for their shares to first offer existing shareholders the opportunity to purchase the shares on the same terms and conditions as offered by the third-party purchaser. In the event that existing shareholders do not want to purchase the shares, the shareholder is then able to sell their shares within a specified period of time. A right of first refusal may make the purchase of shares unappealing to third-party buyers if they have to wait lengthy periods of time before a shareholder can accept their offer.

PRE-EMPTIVE RIGHTS

A pre-emptive rights clause is a mechanism designed to prevent the dilution of one’s interest in the issued and outstanding shares of a corporation. A pre-emptive rights clause entitles existing shareholders to purchase additional shares issued by the corporation proportionate to their existing ownership percentage in priority to individuals or entities who are currently not a shareholder of the corporation. Pre-emptive rights grant shareholders the opportunity to maintain voting rights as well as a fixed percentage of ownership on the issued and outstanding shares of the corporation.

DRAG-ALONG

A drag-along clause entitles shareholders who receive a valid purchase offer for all or a portion of their shares to force other shareholders to join in the sale and sell their shares to a buyer under the same terms and conditions offered by the buyer. Drag-along rights may be beneficial to protect majority shareholder rights by enabling them to offer all outstanding shares of a corporation to a potential buyer.

TAG-ALONG RIGHTS

A tag-along clause, or “piggyback clause”, entitles shareholders to join in on the sale of shares if a third party makes a valid offer for the purchase of a portion or all of an existing shareholder’s shares. This type of clause is typically used by minority shareholders when a majority shareholder receives an offer from a third party to buy all or a portion of their shares. A tag-along clause may protect shareholder rights by providing an exit strategy in the event that an unwanted stranger purchases a majority shareholding in the corporation.

DISPUTE RESOLUTION

A well-drafted shareholder agreement will set out provisions that will be used by the shareholders to resolve shareholder disputes. Typically, shareholders will consult the shareholder agreement only after they have failed to resolve the dispute through discussions and negotiations during shareholder meetings. Examples of dispute resolution procedures commonly used in shareholder agreements are set out below.

Mediation – A shareholder agreement may set out that in the event of a fundamental dispute between the parties, decisions shall be made by an independent third-party mediator chosen by the parties. The purpose of the mediator is to encourage discussion from both parties by setting out the perspective of both parties to amicably resolve the dispute. In the event that a mediator is unable to yield the desired result of resolving the dispute, the shareholder agreement may further set out that the parties submit to arbitration for the resolution of disputes.

Arbitration – An arbitrator is a neutral third party, sometimes appointed by the shareholders or the courts, who will listen to the case of both parties and render a binding decision that the parties must follow. A shareholder agreement will generally set out the procedure for the election of an arbitrator by the shareholders. In Ontario, arbitrators are governed by the Arbitration Act, which imposes a duty of equality and fairness upon the arbitrator. One benefit of arbitration is that the decision rendered by the arbitrator is legally binding, effectively resolving the dispute among the shareholders. For this same reason, arbitration may leave certain parties dissatisfied that they are now bound to follow a decision they may not agree with. In instances like these, shareholder agreements may contain certain exit strategies like a shotgun clause, which enables a shareholder to force the sale of their shares effectively leaving the corporation.

Shotgun Clause – Certain shareholder agreements will set out exit strategies that may be exercised by a discontent shareholder if disputes are not resolved. Examples of this include a shotgun clause, in which one party offers to purchase the shares of another party for a specified price. The party receiving the offer can elect either to sell their shares to the offering party or purchase the offering party’s shares at the same price. This mechanism ensures that the offering party does not provide a “lowball” offer to other shareholders. While a shotgun clause has its own disadvantages, it may be an effective tool for dealing with a dispute that can only be resolved by the departure of a shareholder. You should always consult an experienced business lawyer prior to exercising shotgun rights set out in your shareholder agreement.

DEATH, DISABILITY, AND DIVORCE OF A SHAREHOLDER

Shareholder agreements generally include clauses that deal with the death, disability, or divorce of a shareholder. For example, in the case of death, the shareholder agreement may stipulate that the estate of the deceased shareholder must sell his shares to the remaining shareholders at fair market value. Similarly, after carefully defining what constitutes a disability, a shareholder agreement may stipulate that shares of a disabled shareholder are to be sold to the remaining shareholders at fair market value. In the case of divorce, a shareholder agreement may require a shareholder served with an application for divorce to provide evidence within a specified time that the divorce application will not affect the issued shares of the corporation, failing which may require the shareholder who is getting divorced to sell their shares at fair market value to the remaining shareholders.

If you are in the process of forming a corporation with other shareholders, we highly recommend that you enter into a well-drafted shareholder agreement prepared by an experienced business lawyer. If you require legal assistance with reviewing, drafting or negotiating a shareholder agreement, contact us our business law team today to set up an initial consultation.

Disclaimer: The information contained in this article is not to be construed as legal advice. The content is drafted and published only for the purpose of providing the public with general information regarding various real estate and business law topics. For legal advice, please contact us.

About the Author:

Shahriar Jahanshahi is the founder and principal lawyer at Jahanshahi Law Firm with a practice focus on representing business star-ups and investors in the province of Ontario. For further information about Shahriar Jahanshahi, click here.

 

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