A company is owned by its shareholders. The shareholders appoint the directors who then appoint the management. The directors are the "soul" and conscience of the company. They are liable for its actions. Shareholders are not liable for company actions. Management may or may not be liable for company actions. Often these roles are assumed by the same individuals but as a company grows and becomes larger, this may not be the case. When a company is created, its founding shareholders determine how a company will be owned and managed. This takes the form of a "shareholders agreement". As new shareholders enter the picture, for example angel investors, they will want to become part of the agreement and they will most likely add additional complexity. For example, they may want to impose vesting terms and also mechanisms to ensure that they ultimately can exit and get a return on their investment. Not having such an agreement can lead to serious problems and disputes and can result in corporate failure. It's a bit like a prenuptial agreement.

Companies must comply with the law. Companies are incorporated in a particular jurisdiction (e.g. State, Province or Country) and must adhere to the applicable legislation, e.g. the Canada Business Corporations Act, or the B.C. Corporations Act. This legislation lays out the ground rules for corporate governance - what you can and cannot do, e.g. who can be a director? can a company issue shares? how can you buy or sell shares? etc. When a company is formed, it files a Memorandum and Articles of Incorporation (depending on jurisdiction) which are public documents filed with the Registrar of Companies. A shareholders agreement is confidential and its contents need not be filed or made public.

When a company is formed, its shareholders may decide on a set of ground rules over and above the basic legislation that will govern their behavior. For example, how do you handle a shareholder who wants "out" (and sell her shares)? Should it be possible to "force" (i.e. buyout) a shareholder? How are disagreements handled? Who gets to sit on the Board? What authority is given to whom for various decision-making activities? Can a shareholder (i.e. company founder) be fired? And so on...

A company which is wholly owned by one person need not have such an agreement. However, as soon as there is more than one owner, such an agreement is essential. The spirit of such an agreement will depend on what type of company is contemplated. For example, a three-owner retail shop may adopt a totally different approach to that of a high tech venture which may have many owners. When a company has hundreds of shareholders or becomes a "public" company, the need for such an agreement disappears and the applicable Act and securities regulations then take over.

Corporate Governance

There is no substitute for good corporate governance. Even small companies with few shareholders are better served by good governance practices. Instead of trying to anticipate every possible future event or trying to be overly prescriptive, a structure that ensures the installation of an experienced board of directors is arguably the best approach. Why? Because directors are responsible to the company - NOT to the shareholders as is commonly thought. If directors add diligently with this mandate, many problems that arise can be solved.

First Steps

Before jumping into a shareholders' agreement, some very careful thought must be given to the share ownership. Who owns how many shares (and for what contribution - cash? time? intellectual property, etc)? And, how are these shares held? This is the time to talk to tax experts about some serious personal tax planning. Too many entrepreneurs ignore this important facet of owning shares only to find that when they "cash in", they have a major tax headache. One should consider the merits of using Family trusts or issuing shares to one's spouse and children. How is share ownership (and subsequent selling) treated by the tax authorities? Is there a disadvantage to granting stock options to employees versus giving shares (with possible vesting provisions) to them instead? Please refer to related articles on "structuring" and "dividing the pie". A "Cap Table" (ie Capitalization Table) is essential.

What to Include

Some of the main points (ie. a checklist) to include in a shareholders agreement are:

• what is the "structure" of the company? (and how is equity divided among shareholders?)
• should the agreement be unanimous and involve all (or just some) of the shareholders?
• who owns (or will own) shares (i.e. the parties to the agreement), i.e. a "capitalization table" often called a "cap table".
• are there vesting provisions? (i.e. shares may be subject to cancellation is a shareholder/manager quits)
• are shareholders allowed to pledge or hypothecate their shares?
• who is on the Board? What about outside board members?
• who are the officers and managers?
• what constitutes a quorum for meetings?
• what are the restrictions on new equity issues, e.g. anti-dilution aspects, pre-emptive rights and tag-along provisions
• how are ownership buyouts to be handled? (e.g. shotgun clause approach versus voluntary sale approach)
• how are disputes to be resolved among shareholders? (arbitration clause?)
• how are share sales handled? e.g. first right of refusal
• what are a shareholders' obligations and commitment? (conflict of interest or commitment? Full-time or ??)
• what are shareholders' rights? (what information, financial statements, reports, etc.can shareholders access?)
• what happens in the event of death/incapacity?
• how is a share valuation determined (e.g. to buy out an estate in the event of death)
• is life insurance required? e.g. funding for purchase of shares from estate or for key person insurance
• what are the operating guidelines or restrictions (budget approvals, spending limits banking, etc)
• what types of decisions require unanimous board and/or unanimous shareholder approval?
• compensation issues - remuneration of officers & directors, dividend policies
• are other agreements required as well, e.g. management contracts, confidentiality agreements, patent rights, etc?
• should there be any restrictions on shareholders with respect to competing interests?
• what could trigger the dissolution of the business?
• what is the liability exposure and is there any corporate indemnification (and insurance)?
• who are the company's professional advisors (legal, audit, etc.)?
• are there any financial obligations by shareholders (bank guarantees, shareholder loans, etc)?

• don't confuse shareholder issues with management issues
• don't confuse return on capital with return on labor (i.e. cash investment vs founders' time commitment)
• don't assume that everyone will always be agreeable (greedy? who-me?)
• don't get bogged down in legalese - decide what you want, then have your lawyer put it in proper form
• do make sure everyone's objectives and visions are compatible (this can be a major problem area)
• do separate the roles of shareholders, directors, and managers (these roles often get confused in these agreements)
• do talk to others who have gone through this process
• do ask yourself what the downside is,  i.e. what's the worst that can happen to you under the agreement?
• do get some tax advice. It is very important that some tax planning be done early to avoid a headache later when you've made millions. e.g. you want to make sure that you are not compensated by being given shares, you want to make sure you own shares early so that you can use the small business lifetime capital gains exemption, maybe a family trust or holding company should own your shares.

After drafting an agreement, it is a good idea to ask a few key questions to ensure that the agreement will in fact be useful. Ask yourself the following:

1.Am I happy with my ownership stake? (If I'm the key founder, am I treating others fairly?)
2.Can I get out of this deal if I need to? i.e. can I sell the shares?
3.Can I buy more shares (ie more control) if I'd like to?
4.Am I committing to something I cannot live up to?
5.Will I be able to exert sufficient influence to protect my investment?
6.What is my total financial exposure and legal liability (present and future) on this deal?

Other Points to Consider

Preparing and discussing such an agreement will give you valuable insights into other parties' styles, objectives, etc. It should force a close and honest evaluation of who will do what and who is committed to doing what. Most importantly, are the founders' personal goals, objectives and propensities to take risk compatible? If one founder envisages a small, closely-held company as way to be self-employed and another envisages a dynamic, go-for-it enterprise, this marriage won't work!  Even if you're not sure about certain things and no matter how thorough you are, you will overlook something. Do it, then fix it if necessary, i.e. revise an agreement later rather than defer having one in the first instance.

Typical Format and Contents for a Shareholders Agreement (see sample agreement in conjunction with this discussion)

SHAREHOLDERS' AGREEMENT

This agreement is made as of ___________ (date).

BETWEEN:

List all parties, including individuals, individuals' holding companies, and the corporation itself.
Also show (here or in an appendix) the number of shares (and classes) owned by each of the parties.

ARTICLE 1: DEFINITIONS

Define all terms used throughout the agreement, for example: Common share ratio, Special Directors' resolution, Buyer, Seller, Vesting (a very important one that is often misunderstood), etc.

ARTICLE 2: ORGANIZATION OF THE CORPORATION

Board of Directors: How many? Who initially? Meet how often? How are directors appointed/replaced? Quorum? Voting - majority, unanimous, etc? (may also refer to By-Laws re elections) Officers: Who initially? Remuneration? Banking: who is authorized? ALL financial transactions to go through a corporate bank account. Who (Officers vs Directors - majority or unanimous) can: approve expenditures over a specific amount? approve acquisitions? elect officers? payment of cash or stock dividends? enter into debt obligations? approve stock purchase/option plans? dispose of any part (or assets) of the business? sell rights to products, licenses etc? transfer shares? liquidate or windup the corporation? approve contracts outside the ordinary course of business? enter into any contract above $x? authorize the lending (or borrowing) of money by the corporation? guarantee any obligations? hire employees (at various levels)? approve salaries and bonuses? alter share structure? redemption of shares? enter into consulting arrangements?

This section should also state that the shareholders will ensure that a business plan (i.e. budget) is prepared and updated, approved, and in force at all times.

In this section, some possible sub-sections could include the following:

Governance
Composition of Board
Compensation of Board
Meetings of the Board
Matters Requiring Board Approval by Special Resolution
Directors, Shareholders and Company Obligations
Founders Obligations and Vesting Provisions
Termination in the event of Death
Management Contracts

ARTICLE 3: RIGHT OF FIRST REFUSAL

It may be desirable to give all shareholders the right to purchase shares from a shareholder desiring to sell his shares prior to his shares being sold to a third party (i.e. a pre-emptive right). How does a Seller offer shares? Time acceptance periods? There likely should be provisions for pro-rata distributions for any shares not purchased. How could a shareholder(s) offer to buy shares from other shareholders?

ARTICLE 4: COATTAIL ("TAG ALONG") & FORCED ("DRAG ALONG") & BUY-OUT ("SHOTGUN") PROVISIONS

If a group of shareholders wants to sell its shares, constituting a majority of shares, the minority holders should have the right to tag-along - i.e. include their shares in a sales to outsiders.

If a buyer wants to buy the company and most shareholders are keen to sell, the small minority that wants to hold out for a better price or refuses to sell (ego problem maybe?), may be obligated to go along with a deal if more than a given number (say 90%) of shares are being offered to a buyer.

If a shareholder withdraws, should he be able to "force" the other shareholders to buy his shares? If he is forced out, can he keep his shares? If a shareholder (like a founder) gets shares for making certain commitments to the company over time, certain vesting conditions need to be specified. For example, if a founder quits, he should forfeit a percentage of his shares (if he agrees to a 3-year vesting and quits after 6 months, then he forfeits 5/6 of his shares. Perhaps the departing shareholder should sell some of all of his shares back to the company (or to other shareholders, pro-rata). In this case, a method of valuation (see below) would need to be established. (could include vesting details and termination on death in Article 2)

A "shotgun" clause is often used to force a buy-out. It works like this: Shareholder A offers his shares to Shareholder B for a certain price per share (in the case of 2 shareholders). B can accept this offer or, in turn, offer the same terms to A in which case A must accept. This ensures that A will offer a "fair" price. In essence, one party will end up buying the other out (of course, the two parties can amicably simply agree on a price - this is easy if a shareholder wants to exit to pursue other interests. It gets tougher if both want to own and run the company. The shotgun approach is ideal for small businesses where the values are not too high because they favor the party with more cash resources. For high tech companies with high valuations and several shareholders, the shotgun approach would not work very well.

What happens is a shareholder dies? There should be a fair means by which the surviving shareholders can (optionally or mandatorily) purchase shares from the estate of the deceased shareholder. The company ought to have life insurance policies in place so that such buy backs can be funded. It is a good idea to get some expert tax accounting advice on this matter as well. How will a value be placed on the shares? Options: outside valuation expert (expensive and unpredictable) or get the shareholders to mutually agree to a value and append this to the agreement as a schedule (which is periodically updated) or use a formula (multiple of earnings or sales, book value, etc) or a combination of the above.

ARTICLE 5: PRE-EMPTIVE RIGHTS

If new shares are to be issued from treasury, shareholders will generally be entitled to buy these before the company offers them to an outside investor (to avoid dilution). If an outside investor (e.g. venture capitalist) is brought in, these pre-emptive rights would likely have to be waived.

ARTICLE 6: RESTRICTIONS ON TRANSFER, ETC.

Spells out Share transfer restrictions, consents from others that may be required, etc.

ARTICLE 7: TERMINATION

Under what circumstances is the agreement terminated? (e.g. bankruptcy, dissolution, unanimous consent) Are there any penalties? What consitutes a breach? This is important where owners are committing "sweat equity" - what if they don't perform? If a shareholder defaults, what happens (time to correct default?), termination and buyout?

ARTICLE 8: GENERAL COVENANTS

What is the legal jurisdiction? Should also cover routines such as Notice of meetings - addresses, etc. and some other details, e.g. that the agreement is binding on heirs and successors.

SCHEDULE A: SHAREHOLDINGS LIST and/or CAP TABLE

List all parties' holdings - class and number.

SCHEDULE B: VALUATION SCHEDULE

Allow for a valuation of the business to be agreed to and updated regularly (e.g.every 6 months) include a space for signatures.

Feel free to look at a sample agreement, albeit unprofessionally drafted, for some specific dertails. It will at least get you started. DON'T rely solely on your lawyer's advice. Lawyers do have their biases and may steer you in a direction that is not in your best interest. (Note - are they acting for you personally or for the company or for other shareholders?)  Talk to other entrepreneurs who have gone through this exercise. Their experience may be worth many legal lunches!

Mike Volker is the Director of the University/Industry Liaison Office at Simon Fraser University, Past-Chairman of the Vancouver Enterprise Forum, President of WUTIF Capital and a technology entrepreneur. 

Copyright 1996-2008 Michael C. Volker
Email: mike@volker.org - Comments, suggestions and corrections will be appreciated!
Updated: 20080530