Over half of the corporations we work with have a shareholder situation that is relatively straightforward — either a sole shareholder or jointly owned with their significant other.
For those corporations where we have shareholders that extend beyond one household, we encourage a group meeting (in-person or conference call) to ensure the appropriate level of planning is put in place.
Information gathering
Part of the Know Your Client (KYC) process is for us to gather information about our clients so that we can provide the most suitable recommendations for them. For clients that are a shareholder of a private corporation, we will also gather additional information.
One of the main questions is obtaining an understanding of the share structure of the company, including who the shareholders are, voting rights, and whether any shareholders agreement is currently in place.
Shareholder agreement
Simply put, a shareholders agreement is a binding contract between the shareholders of a corporation. It provides a method to address what happens if a significant life event (such as death or disability) or an important shareholder development (such as a liquidation of shares) arises.
This contract directly affects the rights and obligations of the shareholders with respect to each other and their relationship to the corporation.
While it is up to the shareholders to determine what provisions should be included in the contract, it generally addresses the most important business transition issues such as share ownership, transferability of those shares, and how to deal with significant management disputes that affect the viability of the business.
Unanimous shareholder agreement
In most provinces, including British Columbia, if the contract is agreed upon in writing by all the shareholders it can qualify as a unanimous shareholder agreement, which is legally binding for all shareholders.
This type of agreement is particularly useful in family-owned businesses as it can provide comfort to the founding shareholders that their vision for the business can continue when they are no longer involved.
Introduction of a shareholder agreement
The process of drafting a shareholder agreement takes time. If in discussions with our client we feel they should consider a shareholder agreement then we will have a meeting specifically for that purpose.
Many of the terms within a shareholders agreement may appear complicated and hard to understand. We encourage an initial meeting with the shareholders so that we can review the different terms. The following are some of the main terms we will cover.
Share restriction rights
Share restriction rights give shareholders the right to buy or maintain shareholdings in the corporation in proportion to their shareholder interest. Share restriction clauses can specifically impose restrictions on who may become a new shareholder when transferring existing shares of the corporation.
Share buyout rights
Having the right to buy out a company’s shares on the death, disability or bankruptcy of a shareholder is essential, particularly where there are significant family relationship issues that may impact the control of the company.
There may also be an immediate need for income or capital to address family financial obligations or to pay estate liabilities. An effective buyout clause that has both optional and mandatory event clauses can address such control and financial need issues in a manner that works for all shareholders.
Valuation rights
Purchase price or fair market value clauses establish how the share price is determined in a buyout situation. There are many different options for determining the valuation of a company.
Some of the options for setting the corporation’s share price can include: 1) An unanimously agreed upon business formula; 2) Having an independent value established by a third party, such as a professional valuator; 3) Setting an initial value and requiring the shareholders to update the value at agreed upon intervals.
The strengths and weaknesses of each approach should be explored thoroughly. It is also equally important to establish how the buyout would be financed.
Life insurance
The use of life insurance is one of the most common and cost-effective approaches. Insurance is often purchased on the life of the applicable shareholder and is either owned by the corporation or by the other shareholders in order to fund a buyout in the case of death. Our preferred approach is typically corporate-owned insurance.
The life insurance component involves important planning and tax considerations that should always be reviewed with a professional with the appropriate insurance licence. As a Portfolio Manager, I am also dually licensed to provide life insurance to our clients.
In order for this strategy to be effective, the individual shareholders must be insurable (i.e. no pre-existing health issues that would preclude them). The starting point is often doing a quote and going through the underwriting process with each shareholder if they are open to this component of the agreement. This stage alone can take a couple of months.
Rights of first refusal
Rights of first refusal clauses require that before selling to an outside third party, a shareholder must first offer the right to purchase his/her shares to the other shareholder(s). However, there is often a requirement to already possess a third party offer in hand.
This potential circumstance can be problematic depending on the relationship issues that can arise when an outside third party is introduced into a family-owned business setting.
At the very least, tag or drag along clauses should be considered; these set out options for the shareholders to voluntarily or by mandate accept such offers.
Dispute resolution rights — “shotgun clauses”
Some existing business partners may not get along due to personal reasons or strained relationships. If there is a dispute in the future, the classic shotgun clause is a common mechanism used to settle these matters. For example, one shareholder sets the price and terms where they would either buy or sell shares and the other shareholder has the option to accept or buy out the triggering shareholder.
Such clauses have the benefit of forcing shareholders to settle their internal disputes or be bought out. They are most effective in the case where each shareholder has reasonably similar financial circumstances.
Auction clauses
Where there are three or more shareholders, then there can also be auction clauses, where the shareholders must sell to the highest shareholder bidder.
Seeking legal advice
When we have clients with an existing shareholders agreement, this is factored into the financial and estate plans that we prepare. In some cases, we recommend updating the shareholder agreement. For clients who are mid-way into the process of a shareholders agreement (i.e. draft prepared and not signed) we will co-ordinate a conference meeting where we can review the agreement with our client to make sure that they understand the structure of the agreement.
If, during our KYC discovery, we note a situation where a client does not have a shareholders agreement, and we feel that it may be applicable, then it is added to the agenda for discussion. There are lawyers that specialize in commercial or corporate law, with extensive experience with drafting shareholder agreements.
Failure to have an agreement
The failure to address shareholder rights can often result in tragic circumstances for shareholders, their companies, and their family members. In the absence of an updated shareholders agreement, such conflicts may not be resolved without resorting to costly litigation.
Kevin Greenard CPA CA FMA CFP CIM is a Portfolio Manager and Director, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at timescolonist.com. Call 250-389-2138, email greenard.group@scotiawealth.com or visit greenardgroup.com/secondopinion
