Examining Shareholders' Agreements
Starting, growing, and managing your business takes a lot of work. Take a look at any successful company out there and you’ll see that no one really was able to do it on their own!
A lot of people have to come together to make something worth having. Oh, and working together isn’t all sunshine and rainbows either– we’re all human, sometimes personalities get in the way and we all make mistakes. That’s why in business, having mechanisms in place to smooth out these relationships is all the more important.
Shareholders’ Agreements are legally binding documents that set out, among other things, what the individuals that have a stake in your business can and cannot do, are allowed and not allowed to do, and in addition to their responsibilities towards each other. It’s the central document that the company will reference when dealing with conflicts or major events. Pretty important stuff if you ask me!
In this blog post, we will go over the various kinds of terms you can have in a Shareholders’ Agreement and how they can have a huge impact on your business.
Why Have A Shareholder’s Agreement?
Investor and Shareholder Protection
If your business is starting to go through the motions and you realize that you’ll need outside financing to continue your expansion, there is a strong chance that anyone who has the cash to invest will want to look at your Shareholders’ Agreement. If you don’t have one, and you’re looking to get external financing, they’ll make sure to impose one to protect their investment.
Unanimous Shareholders' Agreements
What are they, and should I get one? Well, it's a little up in the air.
Essentially, a Unanimous Shareholders' Agreement (USA) is a specific type of Shareholders’ Agreement that is signed by every single shareholder at the time of inception and will bind future shareholders to the agreement whether or not they choose to sign. USA’s have the effect of removing much of the power from directors and officers that is normally given through legislation, onto the shareholders.
It effectively removes any separation that shareholders can be “passive” investors, taking up a controlling mantle in the business.
Normally, this would be bad for start-ups. USA’s make decision making a lot more rigid, and the document itself is hard to get rid of. Shareholders end up obtaining a fiduciary duty to the company and have very limited ways to escape that situation — shareholders cannot simply resign just like a director. Efficient decision-making will grind to a halt with a lot of shareholders and newcomers are automatically included in the pool, but new investors may not want to be a party to it.
Terms You May See
A majority of legal documents — Shareholders’ Agreements included — can be customized and tailored to the specifics of your business. Not every Shareholders’ Agreement will contain the terms we go over below, and not every term below may be in yours!
Companies can issue new shares at any point so long as the appropriate parties vote in favour of the issue. Shares are typically issued when a corporation has to do another round of financing, and instead of going down the debt road, they decide to get other parties to buy stakes of the company. As a shareholder of said company, you may be wary that your investment might get diluted or otherwise unsavoury individuals may be sharing the same meetings as you.
Often, Shareholders’ Agreements will contain provisions that dictate the process in which new shares will be issued. Typically, if included in the Agreement, the existing shareholders may be able to exercise all kinds of rights like vetoes or pre-emptive rights to take up the financing round themselves instead of bringing in outside parties (eligible transferees).
Escrow provisions can be used to delay the issuance of shares, subject to a variety of conditions.
Shares are often used in place of compensation for many of the directors, officers, and senior employees of a corporation. To prevent a huge chunk of a company’s shares from vesting at one time upon vague benchmarks, a schedule will be set out as to what performance standards need to be met and to tranche the issuance of shares.
Usually, these terms will contain what you can do with shares that are in escrow (i.e., that haven’t been released to the individual yet), whether you can use it for loans, whether you can trade it, what rights (voting, dividends) you have attached to them, etc.
Rights, Duties, and Powers of Directors and Officers
Explicit provisions limiting the overall power of a director or officer will be more prevalent in Unanimous Shareholders’ Agreements, but regular Shareholders’ Agreements can also speak on the issue.
The spectrum can be quite extreme, ranging from a simple nod to the typical powers that Directors and Officers will have that is already laid out in Canadian law, to completely stripping their powers and issue them to shareholders. They can also affect the individual shareholders that may be entitled to vote on director and officer election protocols.
These covenants are promises to do or refrain from doing something without shareholder consent. If you’re making decisions that require the approval of a certain percentage of shareholders that a Board of Directors can typically make on their own, it increases the chance of hold-up risks in decision-making.
Ideally, start-ups need to be as dynamic and flexible as possible, and control provisions go against that requirement. As a result, keeping the covenants to a minimum will free up a lot of capacity for pivots and crucial decision-making when it’s needed most. However, that isn’t to say they don’t belong at all in a Shareholders’ Agreement; confining them to certain areas like financing and raising debt is recommended. Additionally, a sunset provision in which the control provisions will expire while the rest of the agreement continues can be implemented as well.
Pre-emptive rights allow current shareholders to participate in future financing on a pro-rate basis with the number of shares they currently own. If new shares are being issued to a third party, that has the effect of diluting the percentage stake existing shareholders will have. Pre-emptive rights are a benefit to the existing shareholder and will likely be a key term to negotiate. These rights may be encompassed in the first topic covered, the issuance of new shares, or vice-versa.
When separating the founders of a business from the business itself, it is typically in the business's best interest to talk the founders out of holding such pre-emptive rights. Key investors that are necessary to grow and scale a business past the fledgeling stage may baulk when they see the amount of power that founders have. If as a founder, you are insisting on such clauses, having sunset provisions past a certain period of time, and preventing the use of third party money (banks) is often a solid middle ground.
Rights of First Refusal
These rights come into play when an existing shareholder who is a party to the Shareholders’ Agreement wants to sell their shares. ROFRs mandate that the selling shareholder has to first offer them to the other shareholders of the business before offering them to external parties. This has a similar effect of pre-emptive rights, in the way that protecting existing shareholders’ interests are the crux of most Shareholders’ Agreements.
While Rights of First Refusals make it difficult for the person to sell their shares, there are two types that you can consider in your agreement — a soft ROFR and a hard ROFR.
- Hard: These mandate that the selling shareholder must first find a buyer at an ascertainable price, then offer the shares to the existing shareholders at that same price. This process takes a lot of time and money to value as start-ups are notoriously difficult to value, and no one is going to make a legitimate offer if it’s going to get snapped up by the other shareholders anyways.
- Soft: These have a different process. First, the selling shareholder will inform the others that they intend to sell their shares to the open market and that the ROFR is triggered. The other shareholders have a few weeks (depending on the Agreement) to decide if they want to buy at a pre-determined price. If not, the selling shareholder is free to take their offer to external parties.
The problems with ROFRs are that they cause hold-up risks in the decision-making process, and depending on the type of ROFR you have, can effectively consolidate voting power to a small handful of individuals, and can cause shareholders to be trapped in situations in which exiting may not yield them a good return.
To mitigate the problem, some shareholders’ agreements allow shareholders to sell up until a particular threshold before a Right of First Refusal kicks in, allowing for freer transactions with smaller percentages of shares. Another mitigation tactic is similar to pre-emptive rights -don’t allow any third-party money to snap up any shares.
Piggyback / Tag-Along Rights
Piggyback or Tag-Along Rights are used in scenarios where if one shareholder wishes to sell their shares, the other shareholders can sell their shares to the same buyer on a pro-rata basis. This is done so that investors can have the opportunity to exit at the same time as other shareholders, particularly key players who may believe it is a good time to recoup their investment, or if the company isn’t doing as well as they want.
Obviously, this can cause major delays where shares are in a weird offering-limbo period where they may be purchased by an external party or not. Doubly so, depending on which shareholders would exercise their Piggyback Right, that could end up seeing an external party with a massive stake in the company. The provision can also cause delays if an investor is trying to recoup their investment as it is much more difficult to sell large portions of shares than a simple stake.
As a result, many shareholders’ agreements limit the individuals to who these Piggyback Rights will ay. Only key employees and individuals who are crucial to the success of the company should be able to trigger a Piggyback Right, as it is likely that investors bought into the company on the premise that there was a special talent, or the CEO was securing major financing. If that major financing didn’t work out, and the CEO is wanting to liquidate their shares, other shareholders should be able to do the same.
These rights have come into effect upon the sale or dissolution of a company. Drag-Along rights create investor exits even when there is < 90% approval of the sale – normally that is the threshold required for shareholder votes to approve the decision. If there is a particular begrudged individual who just happens to own a large chunk of the company’s outstanding stock and to cross the 90% threshold, you need their vote, Drag-Along rights will allow for the sale to happen even if the individual holds out.
The other side of the coin is that if you happen to be in the minority of the votes that get “dragged along”, and you don’t want to be a part of the sale or merger, it is important to note that protections can be included in the drag-along provisions. “Dissenter Valuation Rights” afford large protection to the existing shareholders that are in the voting minority. It allows shareholders to exit the company if they don’t want to be part of the merger at a fair market price for their shares.
However, like with most rights discussed in this post, the problem of these drag-along rights has the ability to potentially blow up deals if the shareholders who are being dragged along are warranted to be paid in cash. Often, the company may not have the reserves to finance such a transaction.