Starting a business is an exciting venture, filled with possibilities and potential. However, as businesses grow and evolve, the relationships between their ‘owners’, better referred to as shareholders—can become complex and challenging to manage. This is where shareholder agreements come into play.
A shareholder agreement is a vital document that sets out the rights, responsibilities, and obligations of shareholders within a company. It acts as a blueprint for how the company will be managed and how major decisions will be made, helping to prevent disputes and ensure smooth operations.
A shareholder agreement serves multiple critical functions that are essential for the operation and stability of a company. Firstly, it provides protection against disputes by clearly outlining the rights and responsibilities of shareholders, which helps set expectations and reduce misunderstandings that could lead to costly and prolonged litigation, potentially harming the company's reputation and financial stability.
Secondly, it offers clarity on roles and decision-making authority by defining the powers of directors, voting rights of shareholders, and procedures for making significant business decisions, ensuring a clear process for handling major decisions such as mergers, acquisitions, or large capital expenditures.
Additionally, shareholder agreements are crucial for ensuring business continuity by including provisions for situations where a shareholder wants to sell their shares, passes away, or becomes incapacitated, often incorporating buy-sell provisions, rights of first refusal, or drag-along and tag-along rights to manage such transitions effectively. They also play a vital role in attracting investors and raising capital by demonstrating robust corporate governance, reducing perceived risks, and clearly outlining shareholder rights and the process for issuing new shares, thereby facilitating smoother negotiations during fundraising or acquisitions.
Finally, these agreements are particularly valuable for closely-held companies like family businesses or startups, allowing for customized governance structures that cater to specific needs and concerns not adequately addressed by general corporate laws or articles of incorporation.In this first part of our series, we will explore the importance of shareholder agreements, provide a brief history of their development, and highlight key case law that has shaped their use in Canada.
A brief history
Shareholder agreements have been around for centuries, evolving alongside the concept of corporations and the development of company law. The need for agreements between shareholders became apparent as early joint-stock companies emerged in the 17th and 18th centuries, primarily in England.
The growth of the British Empire and international trade necessitated the formation of corporations, leading to the creation of legal frameworks governing how these entities operated.Initially, company governance was governed solely by common law principles and corporate charters, which often left gaps in terms of shareholder rights and obligations. The development of the Companies Act in England in 1844 marked a turning point, providing a statutory basis for the creation and regulation of companies, including provisions related to shareholder rights. Over time, the complexities of business relationships and corporate management highlighted the need for agreements specifically tailored to address the rights, responsibilities, and disputes between shareholders.
In Canada, company law evolved similarly, influenced by English law but with unique features tailored to Canadian business practices. Shareholder agreements became a common practice to fill in the gaps that statutes and bylaws could not adequately address, especially concerning closely-held companies and startups. These agreements are now an essential part of corporate governance in both jurisdictions.
Reasons for Having a Shareholders' Agreement
There are several compelling reasons to formalize agreements in writing. One of the most important is to prevent misunderstandings. Another is to ensure that all parties are clear that what has been discussed has now become a binding contractual term with corresponding legal consequences.
(Austin v. Warner, 2008 BCSC 1076 at para. 89)A shareholders’ agreement defines the overall business arrangement between the shareholders and the company. At its core, it serves as a mechanism to "fill in the gaps" between the stipulations of the Business Corporations Act, S.B.C. 2002, c. 57 (the “BCA” or the "Act") and the company's articles.
Shareholders' agreements are often essential or highly beneficial for companies that are closely held or "private" (i.e., not publicly traded) and involve multiple shareholders who participate in the company’s financing and daily management.
Typically, one of the primary objectives of a shareholders’ agreement is to protect minority interests. Additionally, it can safeguard majority shareholders against potential future claims of oppression or other allegations from minority shareholders who may contend that the majority has acted unfairly. Essentially, a shareholders’ agreement clearly defines the relationship between all parties involved.
Under the BCA, a special resolution may require approval by a majority ranging from two-thirds to three-quarters of the votes cast, depending on the specific terms of the company's articles. If the articles do not specify, a special resolution can be passed with a two-thirds majority of votes cast or, in the case of a pre-existing company subject to the Pre-existing Company Provisions, with a three-quarters majority. As a result, shareholders holding less than one-quarter to one-third of the voting shares, depending on the scenario, may be outvoted on significant corporate decisions if they do not have protections beyond those provided by statutory and common law.
The process of creating a shareholders' agreement necessitates discussions between the shareholders and their professional advisors, enabling them to articulate, in writing, their mutual understanding of the business relationship regarding the company’s operations. Professional advisors can identify critical issues that should be covered in a shareholders' agreement, which shareholders might not have considered independently. This discussion phase also helps clarify the shareholders’ goals and expectations for the business and, importantly, determine whether these objectives are shared.Although drafting a comprehensive shareholders’ agreement can involve considerable costs, it may prove to be a minor expense when weighed against the potential costs associated with disputes about shareholder relations or litigation involving the company.
Statutory Protections
Shareholders of companies incorporated under the BCA are entitled to certain statutory protections. For instance, some actions undertaken by the company require a "special resolution" from the shareholders or special separate resolutions from a class or series of shareholders. A special resolution typically involves the approval of a majority ranging between two-thirds and three-quarters of the votes cast, depending on the specific provisions outlined in the company’s articles. Examples of situations where a special resolution is necessary include:
When the company intends to sell all or substantially all of its assets or business operations (s. 301).
When the company seeks to amalgamate with another entity through a long-form amalgamation (s. 271).
The BCA also allows for the articles of a company to mandate that certain matters be approved by an "exceptional resolution," which requires an even higher majority than that needed for a special resolution.It is essential to consider these statutory provisions when drafting a shareholders’ agreement to determine which additional protections might be necessary. For example, depending on the terms set out in the articles, if a shareholder controls more than one-third of the voting shares, it may prevent the other shareholders from passing a special resolution. This statutory limitation might already provide adequate protection for that shareholder without needing further safeguards through a shareholders' agreement. However, shareholders' agreements often expand upon the limited protections available under the BCA by addressing a broader range of issues, explicitly protecting minority shareholders, and setting higher thresholds for shareholder approval on critical decisions.For companies that were incorporated before the enactment of the BCA and that remain governed by the Pre-existing Company Provisions, there are additional statutory protections available for shareholders. The most notable protections include:
Companies must proportionately offer any new allotment of shares to existing shareholders.
Before a company can purchase or redeem its shares, it must make an offer to purchase or redeem proportionately to each shareholder within the specific class or series of shares being considered for purchase.
Notice of Articles and Articles
The Notice of Articles provides essential details about a company, including its name, the location of its registered and records offices, the names of its directors, the authorized share structure, and any special rights or restrictions associated with its shares.
Shareholders’ Agreement vs Articles
When deciding what provisions to include in the articles of a company versus a shareholders’ agreement, several considerations must be taken into account. Some matters are more appropriately included in the articles, while others might be better suited for a shareholders' agreement, or in some cases, both. You should keep the following points in mind:
Parties to the Shareholders’ Agreement
It is common practice to include the company as a party to a shareholders’ agreement because these agreements often contain provisions that impose obligations on both the shareholders and the company. For example, the agreement may require the company to purchase shares from any of its shareholders under certain conditions.
Tax Considerations
One of the primary concerns when drafting a shareholders’ agreement is the potential income tax implications for both the shareholders and the company. These implications arise from the investment in the company and the provisions of the agreement related to the sale of shares and additional investments. The tax consequences can be substantial, complex, and subject to continuous changes. Significant tax considerations should be made regarding the buy-out of a shareholder’s shares, whether during their lifetime or upon death. It is essential to consult with a qualified tax expert when preparing a shareholders’ agreement to ensure compliance with the latest tax laws and regulations.
Conflicts
Lawyers must remain mindful of the potential conflicts of interest that can arise between a company and its shareholders, as well as among different shareholders. When acting as a lawyer for the company, the duty is to the company as an independent legal entity. Conversely, when representing a shareholder, the duty is to that specific shareholder. The interests of the company may not always align with those of the shareholders, and disagreements may arise between individual shareholders or between shareholders and the company.
Conclusion
Shareholder agreements are indispensable tools for managing relationships and protecting the interests of all parties involved in a business. They provide clarity, prevent disputes, and ensure smooth operations by setting out the rules and expectations for all shareholders. In the next part of this series, we will dive deeper into the key provisions that every shareholder agreement should include and how they help manage potential conflicts and business challenges.
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