Shareholder Agreements in Family Businesses Part 1: Decisions & Disability

by Sunjeet Grewal and Sterling Hein

Families that incorporate a closely-held company to operate as a family business often move forward on the assumption that a shareholder agreement between family members is unnecessary due to the closeness of their relationships. In reality the dynamics of family relationships, when combined with the risks and goals of running a business, make family companies prime candidates for a shareholder agreement. This post and its part 2 will look at why and how a family business can benefit from a shareholder agreement.

What is a shareholder agreement?

To understand what a shareholder agreement is, we need to look at how the inherent rights of shareholders and directors within a company interplay.

The directors of a company are the individuals appointed by majority vote of the shareholders to make high-level decisions for the company. Generally, a company doesn’t make a single decision without the directors approving of that decision. Companies must have at least one director, but can have as many directors as the shareholders want to appoint.

The shareholders of a company are the owners. As owners, their basic rights include appointing the directors and sharing in profits. There are some limited circumstances where shareholders are given the right to approve or dissent to certain types of legal transactions, but ultimately they have very little say in how the business of the company is operated: that’s for the directors to decide.

In closely-held companies, the shareholders often have the expectation that they will also be the directors and that they, or certain related individuals, will be employed by the company to carry out particular duties. Without an agreement requiring all shareholders to honour those expectations, a single shareholder often does not have the legal authority to enforce those expectations.

A shareholder agreement in British Columbia therefore is an agreement between the shareholders on certain terms that will govern the company’s management and the relationships between the shareholders, including the bringing in of new shareholders, the transferring shares, and the protection minority shareholders. Most shareholder agreements also cover four important topics: (1) Decisions; (2) Disability; (3) Death; and (4) Disputes (these are the “Four D’s”).

This post discusses two of the Four D’s: the impact a shareholder agreement has on family business decisions and its ability to help in the case of shareholder disability. Part 2 will look at death and disputes.

Decisions

The dynamics of a family business can require heightened sensitivity and planning in terms of how the business is run and a shareholder agreement provides a great solution. For instance, in a family business, shareholders often have equal power which can lead to potential voting deadlocks. Voting deadlocks can expose the company to expensive litigation proceedings to break the deadlock. To prevent potential deadlock, a shareholder agreement may include a tie-breaking procedure or even a simplified pooling arrangement. A shareholder agreement often stipulates how directors and officers can be chosen, or who must act as a director or officer.

In terms of voting thresholds, in the absence of a shareholder agreement, the British Columbia Business Corporations Act (the “BCBCA”) requires a simple majority for most decisions.  In a shareholder agreement the parties can decide that despite that requirement, their reasonable expectation is that a higher voting threshold, such as a unanimous vote, will apply to certain decisions.

Sometimes family members want to maintain a particular percentage ownership of a company in order to preserve voting power or ownership. This usually means limiting the ability for the company to issue new shares, which might have the effect of diluting the ownership of existing shareholders. Shareholder agreements can put the control over proportional ownership in the hands of the existing shareholder by giving them the right to buy any shares proposed to be issued in the company, each share purchased would exclude the issuance of that share to a new would-be shareholder.

In a family business, restrictions on who can become a shareholder can be important in order to maintain the dynamics of the business. This can be achieved through a shareholder agreement by imposing restrictions on the issuance and transfer of shares. The shareholder agreement also allows for decisions and consensus on issues such as future borrowing and financing to be made and for provisions of guarantees and indemnities to be included so to prevent potential future disputes.

Decisions about the make-up and activity of the business as well as the future of the business can all be addressed in a shareholder agreement. For example, provisions regarding who can be employed, their salary, and terms of employment can be helpful when some of the shareholders are reluctant to hire other relatives. In a family business there are typically fewer number of shareholders that have significant control over the company. As a result, making these decisions earlier on in the form of a shareholder agreement can be helpful and create security for the family business. Creating a shareholder agreement and contemplating potential scenarios that may arise in the future will help ensure the longevity of a family business and familial relationships as well as increase chances of avoiding costly litigation.

Disability

Due to the personal relationships between the shareholders of a family business, unwanted situations like the disability of a shareholder can be even more difficult to handle. Addressing circumstances of both long-term and short-term disability in a shareholder agreement can be beneficial as each comes with different sets of obstacles and issues which would be very difficult to decide at the time the disability occurred.

With short-term disability, a common concern is income flow during recovery time for the disabled shareholder and securing a temporary replacement for the duration of the disability. Generally, a shareholder agreement will stipulate the length of time for which the shareholder’s full salary will be given. For those shareholders that are a part of the day-to-day functioning of the business, setting out a process of finding a temporary replacement or deciding how the duties of that shareholder will be delegated for the time being provides much needed clarity in difficult times.

Where a shareholder experiences long-term or permanent disability, a different set of concerns arises. Costs of having a shareholder disabled for long periods of time may weigh heavily on a family business. There is the option to attain disability or critical illness insurance which would pay a lump sum to the disabled shareholder, however, this insurance may be expensive. A more cost effective solution would be to create a buy-out option for the remaining shareholders within the shareholder agreement to either buy-out the shares of the disabled shareholder or give the remaining shareholders the option to sell to a third party. When including this type of provision in a shareholder agreement, shareholders should take the time to think about the future of the business and consider provisions that were created in the shareholder agreement regarding appointment and selecting of other directors and how these would function together.

There are a number of scenarios which favor the use of a shareholder agreement in a family business. The relationships between the shareholders of a family business creates the need for more sensitivity, consideration and planning than may be the case in a business that lacks these familial connections. This is especially true in regards to decision-making regarding the business as well as dealing with the potential disability of a shareholder. A shareholder agreement can deal with these areas effectively and efficiently and make difficult decisions easier to navigate.

The next post in this short series will look at how a shareholder agreement can help a business deal with death and disputes.