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8 Dangers of Using Free Shareholder Agreements from the Internet
We encourage our clients to use a shareholder agreement in companies they own with one or more other people in order to protect themselves and the company’s business. Most of the time, people are on the same page as we are—believing in the value of a shareholder agreement. However, sometimes that belief is only to the extent that they can find a free shareholder agreement form on the internet. This article looks at the most common problems we see with using an internet-sourced, generic, and suspiciously-inexpensive or free shareholder agreement (called an “FSA” in this article).
1. Lack of protection for the company’s business.
FSAs might miss out on critical business protection policies. In the course of owning shares in the company, a shareholder will often have access to information about the company not otherwise available to outsiders. Frequently, shareholders might also be an employee, consultant, director, or officer of the company where they learn intimate details about the company’s business and clientele. FSAs often don’t address how a shareholder has to deal with the Company’s information while they’re a shareholder, and after they cease being a shareholder. If a shareholder sells his shares, can he go out and start another company with a substantially similar business model and targeting the same clients as those of his now-previous company?
2. Fails to plan for the addition of new shareholders.
When a FSA fails to contemplate new shareholders in the company, the entire agreement can become stale or otherwise unnecessarily difficult to amend when a new person joins the company. You can’t always plan for new shareholders and the commercial reality is that it’s not uncommon to need an entirely new shareholder agreement when a new shareholder joins a company that hadn’t previously believed it would need to bring on other shareholders. But when the founders of a company at the outset know they want to raise money by selling shares in that company, it’s important to account for that plan in the shareholder agreement. Making room for new shareholders in a shareholder agreement can involve—among other things—implementing mechanisms that give existing shareholders the ability to prevent dilution of their shareholdings, prohibiting new shareholders from getting any shareholder benefits until they have agreed to be bound by the shareholder agreement, and altering defined terms to reflect an evolving reality.
3. Overly-simplistic mechanism regulating a shareholder’s departure.
Disputes can arise if a FSA fails to provide adequate exit strategies for shareholders. If a shareholder gets to the point where she wants to sell her shares in a company so that she can cut ties with the company, there are a number of different types of mechanisms that can achieve this. We’ll often see FSAs include some sort of simplistic right of first refusal (where a withdrawing shareholder is permitted to sell her shares to a third party so long as she has first given the other shareholders the opportunity to buy those shares on substantially identical terms) but the agreement will fail to take into consideration the practical implementation of that mechanism, and will often fail to include any other mechanism relating to a shareholder withdrawing from a company. While a right of first refusal can be effective in certain circumstances, it relies on the existence of a third party buyer and there often isn’t a market for shares in a closely held company. How can a shareholder withdraw from the company if there’s no third party that wants to buy the shares? Can the withdrawing shareholder force the other shareholders or the company to buy her shares? If so, how is the purchase price determined?
4. Misses the opportunity to make a tax-efficient plan in case a shareholder dies.
FSAs could create unexpected tax consequences to shareholders. We rarely see a FSA that accounts for the circumstance of a shareholder’s death. Usually if a shareholder passes away, the other shareholders want the shares to revert back to them or the company—they’re not interested in running the business with that shareholder’s heirs. There are a number of careful tax and legal considerations that will go into preparing a mechanism that deals with this circumstance. Who can buy the shares? How is the purchase price determined? How is the purchase price paid? For how long after the death of a shareholder can her shares be purchased? The responses to all of those questions will each influence the amount of tax payable by the deceased shareholder’s estate.
5. Uses undefined lingo intended to have a larger meaning.
Poor language construction in FSAs could render key provisions unenforceable. This problem is best described by example. Often a mechanism for the sale of shares will invoke “fair market value” as being how a sale price is calculated, but that term is either not defined or is defined poorly. Fair market value can mean many different things, depending on the valuation mechanism. A common misconception is that defining fair market value is as simple as inserting a generally acceptable formula for valuating a company. But the reality is that every company is different and a formula for one company is often inappropriate for another company (e.g. it can be difficult for formulaic fair market value to factor in a company’s prospects and potential). A well-drafted valuation mechanism will resolve ambiguity either by implementing unambiguous language, or by implementing the careful advice of an accountant that works closely with the company.
Looking at the broader problem, FSAs will often use other industry-specific lingo intended to make reading the agreement easier, but ultimately creates confusion. We’ve seen agreements that state they “grant a right of first refusal to the remaining shareholders” without actually describing the terms of that right. Another commonly abused term is “clients”. If it isn’t defined, this can lead to arguments about what a client of the company consists of.
6. Doesn’t mirror shareholder expectations of the identities of the directors.
If an FSA doesn’t include a workable mechanism for choosing directors, deadlock can result. The shareholders of a company have very little inherent authority to influence the direction and activities of a company. A voting shareholder (one who owns shares that include a right to vote) has the authority to vote for directors and to cast votes in certain other special corporate procedures. In order to truly make decisions on a company’s behalf, a person needs to have the authority of directorship (or otherwise have a director delegate their authority to them).
When a couple friends start out a new company together, they usually expect to have decision-making authority for the company and accordingly will each be directors of the company. Directors are voted-in by a majority of votes of the voting shareholders. What happens if those friends have different ideas about the company and begin to refuse voting for one another as directors? This can create a deadlock situation where no business of the company can be transacted which can ultimately require an expensive trip to the courthouse for some judicial intervention.A good shareholder agreement should set out either a mechanism for appointing directors, or an agreement as to the identities of the directors. FSAs usually fail to account for election of directors, or if it is addressed, addresses it in a manner that doesn’t account for additional shareholders who may want to participate in company decisions.
A good shareholder agreement should set out either a mechanism for appointing directors, or an agreement as to the identities of the directors. FSAs usually fail to account for election of directors, or if it is addressed, addresses it in a manner that doesn’t account for additional shareholders who may want to participate in company decisions.
7. Doesn’t place restrictions on the directors of the company.
Failing to place reasonable limits on the directors of a company makes it more difficult to resolve acrimony relating to the manner a director exercises his powers. Directors of a company ultimately obtain their powers and duties from the statute under which a company is incorporated. In certain jurisdictions, a shareholder agreement can be used to limit directors’ powers and duties. Even in the jurisdictions that don’t permit the limitation of directors’ powers and duties by shareholder agreement, restrictions on directors’ powers can be enforced so long as they have been agreed to by the directors or the company or both (though the obligation to comply with those restrictions is ultimately subject to the director’s duty to act in the best interest of the company, and the damages resulting from a breach by a director is often nil).
What kinds of restrictions should directors be subject to? That depends on the nature of the relationship between the individuals involved, the company’s business, and a host of other factors. But common restrictions are spending restrictions and hiring and firing restrictions. We rarely see FSAs contemplate the need to restrict a director’s powers. This can result in situations where one director is overspending the company’s money to an extent that it doesn’t comply with an approved budget. When the overspending falls short of being outside of the best interest of the company, it can be difficult to stop that director from continuing that behaviour.
8. Jurisdiction and choice of venue for bringing lawsuits are poorly selected.
Careless implementation or drafting of a FSA can create more things to fight over and increase future legal fees. Contracts usually include an important provision that sets out which jurisdiction’s laws apply to interpreting a dispute over the contract. Without that provision, it’s possible for a litigant to take the position that the law of a different jurisdiction from that in which the company is located should apply. This can create undue expense in pursuing court action.
Relying on an FSA that is based on a contract originally prepared for a specific jurisdiction can mean that you’re relying on the law from a jurisdiction that has nothing to do with your company. We frequently see carelessly-implemented FSAs brought to us that invoke an unrelated jurisdiction, or that require that litigation be resolved in the courts of a particular city that is unrelated to the company. A similar problem we see in FSAs which relates to careless drafting is the inclusion of arbitration provisions as well as a requirement for disputes to be heard in front of a court. Those provisions are usually in direct conflict and create ambiguity and ultimately more expense for litigants.
Summary
The adage “something is better than nothing” will occasionally hold true but for the most part we find that FSAs are usually no better than nothing. This may seem harsh but the reality is that the ownership of shares in a company can be associated with complex relationships that require sophisticated legal mechanisms to properly govern those relationships. Seeing the value in a shareholder agreement but not the value in a properly drafted shareholder agreement is sort of like understanding the value of a seatbelt, but opting to use some bailing twine in lieu of the seatbelt—it will probably injure you and will have very limited use.