Shareholders' Agreement Helps Partners Avoid Trouble
Things change. People die. Marriages dissolve. Accidents happen. All of these events can dramatically impact a business. A shareholders' agreement can help ease the pain.
The Five "D"s
There are five "D"s typically covered by shareholders' agreements: death, disability, divorce, dispute and debt. A shareholders' agreement provides a roadmap for the parties to follow in case of these triggering events.
Useful for any business with more than one shareholder, this type of agreement allows owners to address potential crises before they happen. Shareholders' can take time to discuss a plan of action, create a funding mechanism, agree on terms and hash out the details before a crisis occurs.
The alternative is ugly: without an agreement, a company may be forced to rely on the Business Corporations Act to decide what's next. This can be a long, costly, drawn-out and frustrating process.
How Does It Work?
A shareholders' agreement defines each triggering event and its consequences. For example, if a shareholder dies, the agreement would cover what will happen to his or her shares. Are they passed on to someone else? Are other shareholders' required to buy out the decedent's interests? If so, how will the buyout be funded?
In the case of divorce, the shareholders' agreement may discuss how the business interest would be transferred so that the ex-spouse doesn't end up as a shareholder in the business.
If the shareholders are in a dispute, the agreement would spell out how to end the relationship; often shotgun or auction agreements would work.
And if one shareholder is overwhelmed by personal debt, the agreement might offer other shareholders' the right of first refusal so that the bankrupt shareholder's shares don't end up owned by his or her creditors.
The agreement should also define a valuation process for every "D." For example, in the case of a shareholder's death, the agreement could dictate an agreed-upon price or could detail how an independent valuation professional should be selected. Funding mechanisms - such as life insurance and who owns it - should also be covered by the agreement.
Don't Forget Tax Issues
A shareholders' agreement should also take taxes into consideration and provide guidance as to how to handle the tax consequences of a triggering event.
For example, while life insurance proceeds are tax-free for both the company and the individual, buy-back structure creates a capital gain and, therefore, a potentially substantial tax. The shareholders' agreement should outline a plan for how to handle this financial burden.
In the case of disability, share sales or redemptions are both taxable events. In divorce, shareholders may want to avail themselves of spousal rollover rules, and the agreement should allow flexible transfers to accommodate the taxes associated with them.
The key to an effective shareholders' agreement is to start early and revisit it often. The company's CA and lawyer can help shareholders' hash out the details so that the agreement protects the individuals as well as the company.
Contact our firm for help creating or refining a shareholders' agreement for your business.