May 11, 2021

The Importance of a Shareholders’ Agreement

Entering into a shareholders’ agreement is an essential step if you are thinking of starting a business with partners or if you are already a shareholder in a company with several shareholders.

Even if you go into a partnership with close friends or relatives, shareholder conflicts can arise. It is therefore important to enter into the shareholders’ agreement as early as possible, when everything is going well, in order to prevent conflicts and to plan in advance for how certain events will be handled.

The shareholders’ agreement is a contract between all the shareholders of the corporation and governs, among other things, the operation and management of the affairs of the corporation, the issuing of new shares and the transfer of outstanding shares. The shareholders’ agreement may also limit or remove powers of the board of directors.

Without being exhaustive, the purpose of this article is to present you with certain essential clauses that should be included in a shareholders’ agreement. It is important to consult your legal advisors to ensure that your shareholders’ agreement is adapted to your needs and the needs of the corporation.

Provisions governing the issue and transfer of shares

Right of pre-emption

The right of pre‑emption, which applies when the company issues shares, allows existing shareholders to subscribe in priority to the new shares issued. In other words, the company has an obligation to offer the new shares to its shareholders before offering them to third parties. It is possible to provide for this right to be exercised in favour of certain specific shareholders or in favour of all shareholders, in proportion to the number of participating shares they hold. In the latter case, the right of pre‑emption not only prevents a third party from becoming involved in the company by giving priority to the existing shareholders, but can also avoid a dilution of the latter’s participation.

Right of first refusal, tag-along right and drag-along right

In order to prevent third-party interference, a shareholders’ agreement should also provide for a right of first refusal. The purpose of the right of first refusal is to oblige a shareholder who wishes to dispose of their shares to offer them to the other shareholders of the corporation before selling them to third parties. As with the right of pre‑emption, it is possible to provide that the right of first refusal be applied in priority to certain shareholders or in proportion to the number of participating shares that they hold, all in order to maintain the distribution of shares within the corporation.

If certain shareholders do not exercise their right of first refusal, a third party may become a majority shareholder of the corporation. In such a case, it is important to provide an exit route for shareholders who do not wish to continue operating the business with this third party. Thus, if, after the right of first refusal has been exercised, more than 50% of the voting shares of the corporation are sold to a third party, the shareholders’ agreement may provide for a tag-along right pursuant to which the remaining shareholders may require the acquiring third party to acquire, in addition to the shares of the selling shareholder(s), their own shares. It is also possible to provide for the opposite, i.e. a drag-along right, which allows the selling shareholders to require the remaining shareholders to sell their shares to the third-party purchaser.

 

Death and withdrawal from business

Unlike buy-sell clauses, the death clause and the buy-out clause apply in situations where a shareholder does not necessarily wish to dispose of their shares, but is obligated to do so due to the occurrence of specific triggering events.

In order to prevent the estate of a deceased shareholder from taking possession of the shareholder's shares, the death clause provides that the shareholder, immediately prior to his or her death, offers to the corporation or the other shareholders all of the shares he or she holds in the corporation, and that this offer is automatically accepted by the corporation or the other shareholders, whichever is applicable.

As for the buy-out clause, it obliges the shareholder to sell all of their shares to the corporation or to the other shareholders upon the occurrence of certain events, for example, in the event of the bankruptcy or disability of a shareholder, the dismissal for cause of a shareholder who is also an employee, or the failure of a shareholder to comply with undertakings set out in the shareholders’ agreement. Such a clause makes it possible to settle certain conflict situations in advance by providing for the withdrawal of a shareholder who acts contrary to the interests of the corporation.

It is also important to provide in the shareholders’ agreement for the manner in which the fair market value of the corporation’s shares will be determined. A properly drafted shareholders’ agreement with buy-out and death clauses will therefore allow shareholders to facilitate and accelerate the share buy-out process, notably by avoiding debates and conflicts over the determination of the purchase price and the terms of payment.

Clauses governing the administration of the corporation

A shareholders’ agreement can set out the process of appointing directors and provide for the terms of meetings of the board of directors, the procedure to be followed in the event of a vacancy in one or more positions on the board, and a deadlock mechanism in the event of an even number of directors.

The shareholders may also remove or limit the powers of the directors. For example, the agreement may grant more powers to the shareholders by providing that certain decisions that are normally the sole responsibility of the board of directors must be approved by a majority or unanimous vote of the shareholders. Certain powers could also be completely withdrawn from the directors.

This is particularly important where there are minority shareholders in the corporation. Requiring a decision to be made by a unanimous vote of the shareholders allows these minority shareholders to retain control over certain aspects of the company.

Clauses to protect the company’s interests

In order to protect the interests of the company, the shareholders’ agreement may contain undertakings on the part of the shareholders, such as confidentiality, non-competition and non-solicitation undertakings. In the event of a shareholder’s departure, the shareholder may not compete with the company during the period and in the territory provided for in the agreement, nor solicit the company’s clients or employees.

Dispute resolution clause

Where a dispute arises between shareholders with respect to the application of the shareholders’ agreement, the shareholders’ agreement may provide that the shareholders shall, before resorting to litigation, use private dispute avoidance and resolution procedures such as mediation or arbitration. This saves the corporation and its shareholders the significant costs associated with litigation.

The CaLex Legal team is available to answer your questions, prepare your shareholders’ agreement, or review and update an existing shareholders’ agreement.

This note contains general legal information and should not be used as a substitute for legal advice from a lawyer who will consider your specific needs.