Shareholder’s Agreement: What It Is and Why You Need to Review Your Own

This article is a reprint of Wise Bread's contribution to OPEN Forum from American Express -- where small business owners can get advice from experts and share tips with each other.

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When you get into business with a partner or partners (be they a friend, family member, or simply a business acquaintance), you do so with the best of intentions. As such, in many cases, the apparent need for a Shareholder’s Agreement goes unnoticed. In fact, you may be embarrassed to bring up the idea since it seems like a complicated legal mess that screams of a business version of a “pre-nup”: something that protects your interests if the business relationship goes belly up for some reason.

But a Shareholder’s Agreement is so much more than just something to deal with the breakdown of a business relationship. Life happens while we are busy making plans, and sometimes life’s happenings can throw us curve balls that will affect not only our relationships, but the business. Disabilities, untimely deaths, marriage breakdown, and simple falling-out between partners can mean disaster if these scenarios (and others) have not been given due consideration.

Also known as a Buy-Sell Agreement, a Shareholder’s Agreement is designed to help you and your business navigate life’s tricky twists and turns. Although the reference to “shares” implies it is limited to corporate ventures, similar partnership agreements can be drawn up for other business structures.

Among other things, a Shareholder’s Agreement will contain terms that come into play when a partner:

1. Wants to sell their share of the business.
2. Becomes disabled.
3. Dies.
4. Has life changes that affect their personal estate plan.

Advantages of having a well-drafted Shareholder’s Agreement include:

1. Having a road map to follow when an unexpected change happens.
2. The value of the business is preserved.
3. Taxes are minimized.
4. Surviving (or remaining) owners are protected, as is the business.
5. Elimination of miscommunications and discord between surviving family members (of a deceased or disabled partner) and the other business partners.

10 common clauses found in a Shareholder’s Agreement

1. Valuation

How will the company be valued in the event of a sale (be it the outright sale of the company, or the sale of a partner’s shares back to the company)? Will you use a professional valuator? Or will you use the adjusted book value of the shares, capitalized earnings, or a combination of these factors? The best valuation method will depend on your business and industry. A conversation with your accountant could shed some light on this matter.

2. Restrictions

This will illustrate how an owner can sell, give, or bequeath their share of the business to somebody outside of the group of owners. As you can imagine, having a partner give or sell their share of the company to a complete stranger - without permission - could wreak havoc in the flow of business, so these restrictions lay out the ground rules.

3. First Right of Refusal

If a partner wants to sell their share of the business, under the terms of this clause they must first offer the shares to the other partners. Should the partners refuse this “first right” to buy, then the selling partner can then find a third-party buyer at the same (or higher) asking price.

4. Shot-Gun Clause

This clause is optional, and can get ugly so it must be used carefully. If you enact this clause, you will offer your share of the business to the other partners at a price specified either by you or the valuation clause. If the partners refuse to buy you out, then you have the right to buy the other partners out at the same price. This clause often comes into play when the owners have a falling-out, since it automatically escalates to one of the partners being bought-out.

(True disaster story: Two owners of a company could not see eye to eye. One partner was the financial backer of the company, the other partner was the brains and manpower. Once the business was well-established and earning good revenue, the financial partner enacted the shot-gun clause and set an asking price that was well under the company’s true value. The brainy partner, however, did not have the money to meet this asking price, and in having to refuse the offer, the financial partner then bought out the brainy partner’s share for this deeply discounted price. So beware of how this clause is structured, as a financial inequality between partners could be exploited with a shot-gun clause.)

5. Disability

If a partner becomes disabled either permanently or long-term, the business may well suffer since their active role in operations will be affected. In this scenario, it is often best that the disabled person’s share of the business is bought out by the other partners.

Issues to consider with a disability clause include:

1. How long the disability is in effect before the buyout procedures begin (typically, the partner needs to be disabled for 2 years).
2. The criteria of the disability. Depending on the business and the partner’s role in it, some disabilities will be more destructive than others. This clause will reflect your business’s individual needs.
3. How the buyout is funded. The company will not likely have the cash on hand to pay out the disabled owner, so buy-sell disability insurance is an option. More on this shortly.

6. Death

Similar to the disability clause, this clause is a road map in case of the death of a partner.

Here are some things to consider:

a) Without this clause, the deceased’s shares would be bequeathed to their next of kin, or according to the terms of their personal estate plan. This may be terribly inappropriate, depending on the deceased partner’s family involvement in the business and with the other partners.

b) How is it funded? (As in the case of a disability, money will most likely not be sitting around in the company to fund an unexpected buy-out). Life insurance is a common solution, but there are many options and tax consequences any insurance buy-out. Is it personally owned by the owners, or does the company own the policy? How are the premiums funded – by the company or the individual owners? The answers may not seem as simple as you think.

c) Within this clause, special terms can be written depending on each partner’s situation. If one partner has a child or spouse active in the business, then they can bequeath their shares to the child or spouse until their own death, at which time the shares are sold back to the company (or to the remaining owners).

7. Retirement

Contrary to popular opinion, most businesses will not take care of their owners in retirement. Once not actively running the business, a retired owner becomes a liability and not an asset. Continuing to keep an inactive partner on the books could adversely affect cash flow, depending on your business. This clause can dictate how a retiring partner is provided for. Will they receive an income? Or will their shares be bought out – and if so, how will this be funded? This is an essential component of the Shareholder’s Agreement and any partner’s personal business succession plan.

8. Marriage Breakdown

Without attention to this clause, a partner’s share of the business may be subject to property division along with their other personal assets. If an inactive (and soon to be former) spouse becomes part-owner due to this division of assets, the business could be in trouble, especially if one of the parties is feeling vindictive.

The Marriage Breakdown clause can prevent this from happening by stating that the shares are not to be included in a partner’s personal assets, and (as with the Restrictions clause) the other partners need to give express approval before a new partner is introduced to the mix.

9. Funding

As mentioned earlier, funding of a buy-sell procedure is tricky business. Between ensuring the cash is on hand (through insurance or other methods) and effectively avoiding double taxation, it is recommended that your accountant and financial planner become an active part of structuring your funding methods.

10. Payment

This specifies exactly how the payments are to be made in the buy-sell process. Options include lump sums and installments, and this clause also addresses matters like interest charges on unpaid balances.

As with any legal agreement, a Shareholder’s Agreement is something that requires a lot of conversation and thought prior to walking into your lawyer’s office. This is not conversation that will likely come easily or naturally to you and your partners, and so your financial planner or accountant may be able to help you discern the issues that are of importance.

Life’s curve balls do not have to have tragic consequences. Review your current Shareholder’s Agreement for viability, and if you don’t have one – well then, you know what to do.