Shareholders' Agreement: What is it and why do you need it?

For corporations with more than one shareholder, a Shareholders’ Agreement is often a prudent and beneficial agreement. A Shareholders’ agreement is a contract addressing, first and foremost, how the shareholders of a corporation are related to one another. A Shareholders’ Agreement typically governs the voting rights attributable to shares held by the shareholders of the business, and matters relating to the management and affairs of the corporation by the directors of the business, whose powers can be restricted by such an agreement.

It should be noted that there is no standard Shareholders’ Agreement. Rather, each Shareholders’ Agreement should be tailored according to the specific facts of the situation and the needs of the corporation and its shareholders. A major benefit of having a Shareholders’ Agreement is that it gives the shareholders the opportunity to put their mind towards various scenarios that may occur during the lifetime of the corporation, and such a process can unveil many unspoken assumptions on important issues.

The following provides a summary of some of the many reasons to consider a Shareholders’ Agreement:

1. Establish How Shareholders Exercise Their Voting Rights

A corporation will list each of the shareholder names as well as the number and type of shares each shareholder owns at the time the Shareholders’ Agreement is signed. This ensures clarity and confidence among the shareholders. A Shareholders’ Agreement dealing with voting rights is typically an agreement by which the parties have agreed to vote their shares in a particular manner and/or provide for proxies or powers of attorney that would result in their shares being voted in a particular manner (i.e. to elect as a director a nominee of a particular shareholder).

2. Reduce Family Law Concerns

Many shareholders are concerned that matrimonial conflict may destabilize the shareholdings of a corporation. Under Ontario’s Family Law Act (the “FLA”), shares in a private corporation can sometimes be employed to satisfy equalization or support obligations upon matrimonial breakdown. Therefore, in order to satisfy equalization or support obligations, a court could order a spouse to transfer shares in a corporation to the other spouse. This may lead to concerns for the other, remaining shareholders. Care should be taken at the time a Shareholders’ Agreement is prepared to ensure that the spouse of each participating shareholder provides a waiver of any claims to the shares of the shareholder. An alternative would be to require the sale of the shares of any shareholder in the event an application or proceeding is brought by or against that shareholder under the FLA.

3. Restrict the Transfer of Shares

Preventing shares from being transferred to unknown or undesirable shareholders is a key feature of a Shareholders’ Agreement. This objective must be reconciled with the desire of shareholders to maintain liquidity in their shares. A private company Shareholders’ Agreement will often prohibit any transfer of its shares, unless either (a) the board or shareholder approval is obtained, or (b) certain procedural steps designed to protect the interests of the seller or other shareholders are complied with. This can be achieved by the following clauses, either alone, or in combinations:

• Right of First Offer;
• Right of First Refusal;
• Piggyback (Tag-Along) Rights; and
• Drag-along Rights

Consider the following scenario. Allan and Bill are shareholders of corporation. Allan’s friend, Charles, has made Allan an offer to purchase Allan’s shares. If a right of first refusal were in place, Allan may be required to first offer Allan’s shares (on the same terms and conditions as Charles’ offer) to Bill before completing a transaction with Charles. In other words, Charles’ likelihood of purchasing Allan’s shares will depend upon whether Bill is willing and able to acquire such shares.

4. Restrict Directors’ Powers to Manage the Affairs of the Corporation

A Unanimous Shareholders’ Agreement (“USA”) is a type of Shareholders’ Agreement which includes all of the corporation’s shareholders. A USA will stipulate how the management of the business and affairs of the corporation by the directors is to be restricted, and the agreement therefore may mandate certain matters and may require that certain actions only be taken with the consent of the shareholders or a particular majority of the shareholders (i.e. the issuance of additional securities, the incurring of debt by the corporation, and/or any agreement outside of its normal course of business or any change to the corporation’s articles and by-laws). A USA is the only contractual mechanism by which shareholders can curtail directors’ powers to manage the affairs of a corporation.

5. Dispute Resolution

Disputes among shareholders are inevitable and can range from minor disagreement on day-to-day matters to deadlock at the board or shareholder level that render it impossible for the corporation to conduct business. A comprehensive Shareholders’ Agreement should provide mechanism for the resolution of disputes. The appropriateness of any particular mechanism may depend on the disagreement it is intended to resolve. Examples range from discussion/negotiation, to mediation and binding arbitration, to the most drastic of remedy, the sale of the business.