by Sunjeet Grewal and Sterling Hein
In a previous post, we discussed how family businesses can create unique sets of concerns, sensitivities and disputes which require careful planning and attention. A shareholder agreement is an integral part of that planning to help with the continued smooth operation of the business. In the last post we introduced the Four D’s a shareholder agreement is intended to plan for: (1) decisions; (2) disability; (3) death; (4) disputes. In that post we looked at how families can make decisions and plan for potential disability of a family member involved in the family business. In this post we will explore the third and fourth D’s: firstly, how shareholder agreements can effectively address issues arising from the death of a shareholder. Secondly, how general disputes between shareholders can be addressed.
The death of a shareholder in a family business can create a number of difficulties. Along with personal and emotional impact, the family of the deceased shareholder may be in need of the income earned by the deceased shareholder and selling the shareholder’s shares may be their only alternative. Also, additional issues may arise if the deceased shareholder was actively involved in the business. In this case, the remaining shareholders may suffer from the loss of the deceased shareholder’s contribution to the family business. The remaining shareholders may need to find a replacement shareholder. In some instances, the remaining shareholders may also want the ability to remove the family or estate representatives of the deceased from the business. These issues can be resolved using a shareholder agreement. A compulsory buy-out provision can be included in the agreement where, in the event of a shareholder’s death, the remaining shareholders or the business could be required to purchase the shares of the deceased shareholder and, in turn, the estate representative would be required to sell these shares.
The inclusion of a buy-out provision in the shareholder agreement necessitates a valuation of the shares and requires a source of funds to complete the share purchase identified in the shareholder agreement. A procedure of valuation in the event of a compulsory buy-out triggered by the death of a shareholder is often included in the agreement. Valuation could be achieved by either indicating a value confirmed in writing, calculating the market value of the shares using an agreed upon formula, or by agreeing that a third party will assess and indicate the market value of the shares. The source of funds to purchase these shares is often a life insurance policy which usually is obtained and paid for by the company, and the receipt of those funds may carry favourable tax treatment for the company, the remaining shareholders, and the deceased’s estate. The most suitable option for the specific circumstances should be included in a shareholder agreement.
The thought that a business run by family members carries the potential for contentious disagreements may seem unlikely. However, in-fighting occurs more often in the family business dynamic than many would anticipate. Contemplating how shareholders can buy one another’s shares in the event of a dispute will save a family business and each shareholder a great deal of time and money. The specific needs of each business should be fully considered when making these decisions. We will explore some of the more common resolutions used by businesses in shareholder agreements.
Right of First Refusal
Where a shareholder receives an offer from a third party to purchase their shares, the right of first refusal will allow the remaining shareholders to purchase those shares on the same terms and conditions as those made in the offer. The right of first refusal discourages third parties from taking the time and effort to make an offer as there will likely be opposition from the other shareholders in the family business. However, this option may be less desirable for a non-selling shareholder that does not have the funds to buy the departing shareholder’s shares, which would result in the remaining shareholders having to enter into a relationship with a stranger.
Tag Along and Drag Along Rights
A tag along option gives a non-selling shareholder the opportunity to sell their shares along with the shares of the selling shareholder to a third party on the same terms and conditions. A drag along option would allow the selling shareholder to force the non-selling shareholder to sell their shares on the same terms and conditions—resulting in the sale of the entire business to a third party. Both of these options usually are paired with a right of first refusal so the opportunity to exclude the third party is available. However, neither of these options are commonly used in shareholder agreements involving a family business.
Shotgun / Mandatory Buy-Sell
In a shotgun clause, one shareholder makes an offer to another shareholder to buy that person’s shares, or sell to them the offering shareholder’s shares, at a particular price and on particular terms. The shareholder that receives the offer is required to accept one of the two options and if he or she fails to choose an option, is deemed to have chosen a particular offer. This is a drastic measure that ensures at least one shareholder is going to be leaving the company, and often can be harmful to the relationship between the relevant shareholders. If this kind of clause is going to be used in a family business, it’s sometimes a good idea to require that the price offered must be fair market value so that a shareholder with high financial capacity cannot “low-ball” a shareholder known to have significantly less financial capacity. If a family wants a shotgun clause to permit shareholders to set the buy/sell price, it’s usually best only to do this where power and financial capacity is relatively equal between shareholders.
Right to Sell Entire Business
The right to sell the entire business is an option used in the alternative or in addition to the shotgun clause. This option would include the sale of the entire business, meaning all shares and/or assets of the business would be sold. In many shareholder agreements, this option is often coupled with a right of first refusal for the non-selling shareholder. However, as stated above, third parties are generally more hesitant to make offers when the right of first refusal is present.
Windup and/or Division
A second alternative or addition to the shotgun clause is the windup and/or division clause. This clause would provide for the sale of the assets of the business. Once sold, each shareholder would receive their portion of the proceeds and that would be the end of the business. The windup and/or division clause poses two potential disadvantages. First, there is the risk that the corporation will get a lower price for its assets when the business is sold in this manner. Second, none of the shareholders will retain an interest in the business. The use of this clause is most effective in situations where the family business assets are passive investments like real estate, for example, which would sell at full market value.
However, there are methods that could be used in a shareholder agreement to alleviate the risks of this method. One of which is referred to as the “butterfly” transaction, which could be implemented if appropriate. A butterfly is a tax transaction that occurs, which distributes some or all of the assets of a business to the shareholders on a tax-deferred basis. In a family business where shares can be divided easily, this transaction will allow shareholders to get their portion of shares and separate from the other shareholders.
Arbitration clauses are beneficial and can be created in a shareholder agreement for a family business. These clauses are often included in shareholder agreements in the hopes that disputes or disagreements can be resolved in minimally damaging and cost effective ways while attempting to keep family relationships intact.
Hopefully this two-part blog series has made it clear that shareholder agreements in a family business are helpful and effective. Engaging in a family business creates unique obstacles and the need for attention to certain details which would otherwise be of less importance. Implementing a shareholder agreement can create the solutions and steps necessary to keep a family business intact when dealing with difficult issues relating to decision-making, disability, death and disputes. Making thorough and thoughtful plans in advance through a shareholder agreement will allow for clarity and security when such future events occur.
In discussing a shareholder agreement with your family and your lawyer, you should always also involve a tax accountant as there are many tax-driven considerations that go into a shareholder agreement.