What does a shareholder agreement do for us? Are we required to have one? How much do they cost? These are among some of the top questions asked by business owners right before you hear those famous last words, “we don’t need a shareholder agreement.” Shareholders often let the cost of this legal document dictate how they will move forward. What many fail to realize is that without one, you don’t only put your bank account, but your entire business at risk.

A shareholder agreement is not mandatory and does not come in a specific form. It’s an agreement that is tailored made for your business and for the relationship between shareholders. The more detailed the shareholder agreement is, however, the less likely issues or disagreements between shareholders will arise. Having a shareholder agreement in place will prove to be a useful tool to resolve the issue in a timely and cost-effective manner.

Don’t think you need a shareholder agreement? We’ll go through a few examples and compare the results of not having a shareholder agreement versus having one:

Example 1 – Buying or Selling Shares to Other Shareholders

John and Christine are married and starting a business together. Together they own all of the shares of ABC Inc. being 50 shares each. Business is booming and the value of the corporate shares continues to rise every year. 5 years in, the marriage between John and Christine begins to deteriorate and they can’t stand to be in the same room, let alone run a business together. Christine wants to buy John out of the corporation and John does not want to sell. Christine would alternatively like John to buy her out, but John’s not cooperative on that point either.

Without a shareholder agreement:

There are no mechanisms in place with respect to selling shares other than the board of directors must consent to a transfer. If both John and Christine are on the board of directors, she’ll never get unanimous consent in this scenario. Christine would have to handle this situation in a family law context and could spend thousands in legal fees to come to an agreement with John to buy or sell.

With a shareholder agreement:

Christine is in luck! There is a shotgun provision in the shareholder agreement which allows Christine to provide John with an offer to buy his shares at a value that is calculated based on a method that was previously agreed upon. If John doesn’t agree to sell the shares at that price, he is required by the shareholder agreement to buy Christine’s shares at the same price.

Example 2 – Selling Shares to Third Party

Mike and Jeff have been friends for over 25 years. In the 25 years of friendship, they’ve never fought or been in a serious argument. They decide they are going to open a bar together and incorporate the business. Mike has more capital than Jeff and is able to put more money into the business. Mike owns 70% of the shares in the business and Jeff owns the remaining 30%. Turns out Mike does not have the flare for business quite like Jeff does. Jeff finds himself doing all of the work while Mike hangs out at the bar most nights. Jeff has put all his money into the business and feels that he should have more equity to show for it. Mike on the other hand is tired of the business and wants to sell his shares to the highest bidder. Mike finds someone who is willing to buy his shares and is planning to enter into a formal agreement the next day.

Without a shareholder agreement:

Mike has controlling power as a majority shareholder. Mike is free to enter into an agreement to sell his shares to the highest bidder while Jeff is stuck with his existing 30% of the company and new co-owner that he doesn’t even know. Not at all what he had in mind when he got into the business.

With a shareholder agreement:

Before Mike could finalize his agreement with the buyer, Jeff invoked the tag-along provision in the shareholder agreement. This right allowed Jeff to join the transaction and sell his shares to the buyer at the same price that Mike was getting for his shares. Once this provision is invoked, Mike would not be able to sell his shares to the buyer unless the buyer was willing to buy Jeff’s shares as well.

Example 3 – Hostile Takeover

Laura and Katrina were introduced by a mutual friend because they had the same aspirations when it came to business. Laura was great with people and Katrina was well versed in the back-office side of things. They agreed to be 50/50 partners and that Laura would go out and bring in the business while Katrina stayed in the office to finalize the service. It wasn’t long before Katrina started making her own connections and realized that she didn’t need Laura anymore. Laura isn’t very knowledgeable about the legal side of things and Katrina convinces her to appoint a friend to the board of directors to help with managing the business. While Laura was out and about, Katrina and her friend approved the issuance 100 more shares to Katrina and another 100 shares to Katrina’s friend, making Laura a minority shareholder and diluting the value of Laura’s shares.

Without a shareholder agreement:

Laura can try to negotiate a deal to be bought of the corporation, but Katrina and her friend are money hungry and are not willing to pay much. Laura could look to the court for help, but is she prepared to spend time and money fighting a battle that she may end up losing?

With a shareholder agreement:

The shareholder agreement stipulates that there must always be an equal number of directors elected to the board and that both Laura and Katrina must appoint themselves or they each get to choose one. The agreement also states that voting shares cannot be issued without the consent of ALL of the shareholders of the corporation, that would make any transfer without consent null and void.

Example 4 – Death & Disability

Jack and Paul are 50/50 shareholders in the corporation. They are 100% on the same page about business and they have never experienced problems in their business. A decision is never made unless both of them can agree on it. On their way to dinner after a hard day of work, Jack is in a car accident and passes. Jack’s Will leaves everything he owns to his 18-year-old son, Tim.

Without a shareholder agreement:

Tim becomes the owner of Jack’s shares in the corporation. Paul now has to figure out how he is going to conduct his business with 18-year-old Tim. After some time, Tim decides he wants out of the business, but unfortunately, Paul does not have the capital to buy the shares from Tim.

With a shareholder agreement:

The shareholder agreement states that in the case of death or disability, the shares of the deceased or disabled shareholder would be converted into non-voting shares allowing the other shareholder to remain in control of the corporation. There was also a provision that allowed the corporation to take out a life insurance policy on each of the shareholders for the purpose of buying and selling the shares at a price that was previously determined. Upon Jack’s death, the corporation collected on the life insurance policy and used those funds to pay Jack’s estate for the shares.

The above examples are simple versions of real-life scenarios. The protection you gain from a shareholder agreement can protect you from these scenarios and a variety of others.

A shareholder agreement should be viewed as the foundation of which your business is built. Among many other options, you can decide on different mechanisms to implement into your business, how prices for purchases and sales are to be calculated, or even what happens in the case of death or disability. It allows you to be confident that no matter what the scenario, your business will continue to operate the way you intended.

If you have any questions, please contact our firm today.