Every company that has two or more shareholders must have a shareholders' agreement. Related family shareholders should definitely have a shareholders' agreement as disputes between related parties are often the most bitter. Value tip: Having a shareholder is like a marriage – pick your partner carefully – easy to get into and can be very difficult, traumatic and expensive to get out of.
A shareholders' agreement generally will specify the ground rules among shareholders as to how the shareholders will interact and manage the business in:
Normal times (directors' roles; dividends; financing)
Disrupted times (disputes, divorce, death, incapacity, one wishes to sell)
When things are not all rosy among the shareholders, having the ground rules laid out in advance provides some certainty to shareholders and other stakeholders such as bankers as to the likely outcome. The shareholders' agreement can limit the damage that can be done in disrupted times and assist in avoiding surprises.
Joe and Bill, old friends, started a business with $50,000 of their own money each and borrowed $300,000 from the bank. At the end of the first year the business had made $1m pre tax profit. Not bad for a couple old guys! However the business, running 24/7, employed 12 children from the two families and the two spouses. The obvious disputes arose and after 18 months in business they decided to split. The shareholders' agreement laid down the ground rules for resolution: put an all cash offer in the form of bank cheques in a sealed envelope, simultaneously exchange envelopes, the higher bidder gets the other guy's shares, the lower bidder gets the cash and rides off into the sunset. The successful bidder (by a premium of $500,000), while a little apprehensive post the win, was delighted that his 6 children, who in his words were otherwise unemployable, still had jobs. He never looked back and was hugely successful. Without the shareholders' agreement, the dispute may have crippled the business and everyone would have lost out.
Generally you would expect to find the following addressed in a shareholders' agreement:
Direction and Management of the business
Administration of company – mechanism to appoint chair and directors
Funding and dividends – cash retention versus dividend payout
Valuation of business – definition of value and value methodology
Insurance – corporate funded life insurance to fund share buyback
Voting rights – how many votes under what circumstances
Transfers of shares – who can sell/buy; right of first refusal; tag and drag along rights
Compulsory buy out – on death, incapacity, termination
Restricted owners – cannot transfer shares to spouse on divorce.
Admittance – new shareholders bound by the agreement
When conflicts arise the shareholders' agreement should set out the mechanism for conflict resolution, thereby potentially keeping the matter out of the Courts.
Departing shareholders, having in-depth knowledge of the business, should be limited as to their ability to compete against the company.
A shareholders' agreement is a contractual, private agreement among the shareholders, which may restrict what a shareholder can do with their shares and may contain clauses setting out value determination in certain situations. These contractual terms will have an impact on control, marketability, liquidity and share price.
If well constructed, the shareholders' agreement may allow for a quick and fair exit from the company for the departing shareholder.
Shareholders' agreements generally contain clauses on how the business or an interest therein is to be valued when a shareholder exits the company. Generally the valuation will be by:
- Independent appraisal at fair market value or some other value term
- Formula (eg shares are valued at 4 times last years after tax profit)
Value tip: Value formulas are quick, easy and cheap and like most things in life you get what you pay for.
One issue to watch out for is the potential impact of minority discounts that could be applicable to non-controlling blocks of shares. The agreement should be specific as to whether minority discounts should be applied or not.
It is important to make sure the agreement is well constructed by lawyers, accountants and even business valuators who are experienced with these agreements.
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