What would happen to your business if a partner died or became disabled? What if there’s a nasty dispute and a shareholder wants to leave the company? Or what if a partner divorces or goes into debt?
While you might not think they could happen to your business, “what if” scenarios like these happen all the time. This is one reason why businesses need well-crafted shareholder agreements to dictate next steps if one of these triggering events occurs. Without a strong shareholder agreement, the company may have to rely on the Business Corporations Act to determine what happens next. This process is often long, painful and costly — and the outcome may not be to the shareholders’ liking.
Following are a few common questions and answers regarding shareholder agreements:
When do you need a shareholder agreement?
Your trusted advisors will tell you that a shareholder agreement is essential for all companies with more than one shareholder. It is among the first documents you should discuss with your partners, attorney and accountant.
The shareholder agreement should be discussed in calm times, long before a triggering event occurs. Shareholders should take time to discuss a plan of action, create a funding mechanism, agree on terms and work out all the details while the partnership relationship is in good working order.
How does a shareholder agreement work?
A shareholder agreement defines possible triggering events — e.g., death, disability, divorce, dispute and debt — and their consequences.
Death or disability: In the case of a shareholder death or disability, the agreement would dictate what would happen to his or her shares. Will the shares be passed on to survivors, or will there be a buyout by the other shareholders? If the latter, how will they pay for the stock?
Divorce: Shareholders usually don’t want to be active partners with another shareholder’s ex-spouse. Therefore, the shareholder agreement should dictate how the business interest would be transferred to avoid that situation.
Dispute: If the shareholders are in a dispute, the agreement defines how the relationship will end. Sometimes, a shotgun or auction exit clause is included to decide the price.
Debt: If a shareholder is beset by overwhelming personal debt, a shareholder agreement can restrict the use of shares as payment for the debt and dictate that the other shareholders have rights of first refusal to purchase the shares. This keeps the bankrupt shareholder’s shares out of the hands of his or her creditors.
How do you decide on value?
The shareholder agreement should define a valuation process for each triggering event. For example, in the case of a shareholder’s death, the agreement could dictate an agreed-upon price, or it could detail how an independent valuation professional should be selected. Funding mechanisms such as life insurance should also be included in the agreement.
What are the tax consequences?
If the triggering event is also a taxable event, the shareholder agreement should provide guidance about how to handle the tax consequences. The tax consequences are different depending on whether the life insurance proceeds are used by the company or by the survivor to purchase the shares.
In the case of disability, share sales or redemptions are both taxable events. In divorce, shareholders may benefit from spousal rollover provisions — the agreement should allow flexible transfers to accommodate the associated taxes.
Like other legal agreements, shareholder agreements are only useful if they are current and up to date. Review your shareholder agreement at least once a year to be sure it still meets your needs.
For more information about shareholder agreements please contact one of our trusted advisors here.