Most provinces have passed legislation approving the concept of a unanimous shareholder agreement. This occurs when all shareholders, and the corporation, agree upon the terms of the agreement. Subject to legislative requirements, this will bind both current and future shareholders. This is particularly important for closely held corporations, essentially family businesses where the founder(s) want to address potential risks and opportunities when building a legacy for future generations.
The importance of a shareholder agreement in transition and corporate estate planning for family business owners
A shareholder agreement provides a key governance roadmap for the family business and significant planning opportunities. A Corporate Estate Specialist (CES) takes a unique and highly tailored planning approach, as seen in the process Chart 1, relating to:
- Ensuring alignment of corporate and estate objectives,
- Identifying and mitigating legal contingencies, and
- Addressing business continuity and transition
Chart 1. A tailored planning approach
Examples of the corporate estate planning approach are highlighted when addressing management and ownership succession issues and when developing a “Plan B” – in the case of death, disability, or other unplanned exits of a shareholder. It also addresses the impact of existing or proposed governance structures and other important estate and tax planning options.
Family business case study
To illustrate the application of our tailored approach, we provide a case study based on a review of sample shareholder agreement rights that should form the foundation for closely held family business arrangements.
We are highlighting such rights through the example of the J and M Corporation, a family-run business with long-time equal sibling shareholders, John and Marcia.
Both are currently officers and directors of the corporation. In addition, each has children who work in the business. However, John and Marcia have different visions for the future of the business.
They are also concerned that their children are not ready to take over the day-to-day operations. John is ready to retire; however, both shareholders need to ensure that the business they have built, and their legacy, are protected by an effective shareholder agreement.
Share restriction and fundamental voting rights
Share restriction rights give shareholders the right to buy, sell or pre-emptively maintain shareholdings in the corporation. Share restriction clauses can also specifically impose qualifications regarding who may become a shareholder in terms of new issuances and when transferring existing shares of the corporation. Fundamental voting clauses can also require either unanimous or super-majority voting requirements to be passed when facing a corporation’s most important business issues.
In our example, John knows his sister, Marcia, is a major risk-taker. Marcia wants to go global and bring in a new external shareholder who could provide much-needed financing. Both recognize that, for the business to survive, it must expand. Yet John would prefer to take a slower and more conservative approach. His fundamental voting rights protect against taking unnecessary risks.
In addition, John will be evolving into a stewardship role soon. As part of his successorship plan, he will no longer be an officer and director of the corporation but will still have a significant ownership interest. Such voting rights help maintain a reasonable level of control over fundamental future business decisions and potential buyouts by both shareholders.
Voluntary event buyout rights
The right of first refusal and certain other voluntary transfer clauses require that before selling to an external party, a shareholder first offers the shares to the other shareholder. If the right is not exercised, the triggering shareholder can sell to an external party. There can also be a requirement to already possess a legally binding third-party offer.
In the case of John and Marcia, this potential circumstance is problematic given the numerous family relationship issues that can arise when an external third party is introduced. At the very least, tag along or drag along clauses should be considered. Tag along clauses give the other shareholder a right to also sell. Drag along clauses require the other shareholder to sell if certain terms are satisfied. Depending on negotiations amongst the siblings, these can be set out in advance to provide certainty and an acceptable procedure for a third-party share purchase.
Finally, if the two sibling partners cannot resolve their differences, they could include either a shotgun or final auction clause in the agreement, allowing for a concluding bidding process. However, it can detrimentally impact the family-shareholder relationship. Nevertheless, this is a better option than potential litigation within the family. The family should also consider dispute resolution procedures, including a binding arbitration clause that can address any other differences that may arise regarding the terms of the agreement or other disputes not covered.
Involuntary event buyout rights
Clauses that trigger optional or mandatory buyout rights of a shareholder — on a death, disability, or insolvency, in the event of a family law claim and other shareholder disputes — are essential, particularly where there are significant family relationship issues.
This is a sensitive topic for John and Marcia, who each represent their specific family shareholder interests. For example, Marcia has voiced major concerns regarding John’s new spouse being in control of his shares should a significant capacity event occur. John is also worried about his children and new spouse if an unexpected event happens to him. There may be an immediate need for income or capital to address family financial obligations or pay estate liabilities.
An effective and flexible buyout clause with optional and mandatory clauses, including effective valuation procedures, can address such circumstances in a manner that works for all shareholders in good standing.
Valuation rights
Purchase price or fair market value clauses establish the procedure for assigning an appropriate value to an exiting shareholder’s interest when an involuntary buy-sell provision is triggered.
This is often the most contentious shareholder issue, and John and Marcia must establish the valuation method to be used before the event.
Options for determining value include:
- Unanimously agreed upon formula,
- Determination by an independent third party such as the corporation’s accountant or independent professional valuator; or,
- Establishing an initial value and requiring the shareholders to update the value at agreed-upon intervals or upon an agreed-upon triggering event.
John and Marcia, in consultation with their outside professional advisors, should thoroughly review the strengths and weaknesses of each valuation method and address the terms, conditions, and funding of the buy-out, particularly when purchasing a deceased shareholder’s shares.
Tax planning and insurance planning considerations
Addressing how the mandatory and optional buy-sell arrangements will be set up and funded in the event of a shareholder’s death is paramount. The shareholders will need to explore all potential funding options, including term and permanent life insurance. In addition, John and Marcia will have to address key insurance issues, including ownership, beneficiaries, amount of insurance, and the necessary policy terms and conditions to ensure an effective buy-out.
For example, insurance may be purchased on the life of both John and Marcia. J&M Corporation or the shareholders can own the insurance. John and Marcia will have to consider not only the current value of J&M Corporation but also the future growth and valuation of the business to ensure the death benefit is adequate to fund a purchase of the deceased’s interest. In addition, the insurance policies should be revisited periodically to ensure they are still appropriate in their circumstances. By taking these steps, life insurance can generally be paid out tax-free, subject to certain conditions, to provide a cost-efficient means of funding a buy-sell arrangement.
There may be other significant tax implications regarding certain clauses and options commonly found in shareholder agreements. For example, shareholder agreement clauses that affect company control, such as voting rights and appointments to the board of directors, as well as options to buy or sell shareholders’ shares, may impact the taxation of the corporation and other corporations that may become associated with it.
Before executing any shareholder agreement, it is imperative to consult your tax and legal advisors to discuss and analyze any potential tax, legal, and business implications of the clauses to be included in the shareholder agreement.
Conclusion
The Advanced Planning and Services team will help you identify the risks and opportunities associated with your shareholder agreement and ensure that your corporate and estate objectives are aligned in a manner that addresses legal contingencies, business continuity and transition issues.
