Everyone knows that accidents happen. That’s why many of us carry insurance- on our homes, on our lives, and on our businesses. But, if you’re running a small privately held company, have you ever considered insuring your relationship with your shareholders?
Maybe the answer is yes and you’ve wisely had a shareholders’ agreement drafted. Great. Now, ask yourself- when was it written? Maybe 10 years ago? And if so, have you looked at it since? Unlike those annual fee increases that insurance companies send out, no one will be pestering you to review your shareholder agreement to ensure that it still refers to the correct shareholders or reflects the current arrangement with your business partners.
Well, with spring cleaning now here, what better time to pull out that dusty shareholder’s agreement?
Like a good insurance policy, a current and comprehensive shareholders’ agreement can save you and your family from a lot of uncertainty and grief, not only in the event of an untimely accident or death, but also in the event that a business partner wants or needs to exit the business.
A shareholders agreement is simply a legal contract between the shareholders and the corporation itself that, if made unanimously, becomes a fundamental governing document of your corporation. It works alongside the corporation’s other fundamental document (such as the Articles of Incorporation), but is different in that it is customized to fit the business and the shareholders’ specific interests. The key here is customization; a simple standard form agreement with boilerplate clauses is not likely to provide adequate coverage for your unique personal, family or business needs.
One of the key issues to be addressed by a shareholders’ agreement is the death or disability of a principal shareholder. With respect to the latter, typically, the agreement would define “disability”. This is often when a principal is not able to actively engage in the business for a certain period of time. The agreement would go on to provide for a buy-out of the disabled party’s interest. Similarly, if a principal shareholder suddenly passes away, a well-drafted agreement would contain a buy-out provision that would allow the other shareholders to either buy-out the deceased’s interest or cause the corporation to buy-out the deceased’s interest in a manner that does not put the other shareholder(s) in financial distress and permits sufficient cash flow in the business to allow for continued operations. These provisions will contain a valuation formula or method (either based on financial statements or on the opinion of a qualified business valuator) and should address both how the buy-out will be funded and a payment schedule for such funding.
When it comes to drafting the buy-out, a good legal advisor will speak to you about insurance. Often, in the event of an untimely accident or death of a shareholder, the remaining shareholders aren’t in a position to personally fund a buy-out. Proper life insurance coverage can assist. Partners can hold life insurance on each other, with the agreement providing that should one partner pass away or become disabled, the other collects the proceeds and uses them to fund the buy-out (known as the criss-cross method). Or, the corporation can be both the owner and beneficiary of the life insurance, which would allow the corporation to buy-back and cancel the deceased’s shares (by way of share redemption). The share redemption and the criss-cross method have different tax treatments; one results in a capital gain and the other in a deemed dividend and as a result, specific tax advice will be required.
It’s also worth noting that life insurance coverage wouldn’t be available to fund a buy-out that arises due to the disability of a shareholder. In this case, disability or critical illness insurance would be needed to fund the buy-out arrangement.
Finally, no matter what the type of insurance policy shareholders may be relying upon to help fund a buy-out, insurance values should be reviewed regularly to ensure they provide adequate coverage for what is (hopefully) an increasing buy-out value.
The death/disability provisions should also elicit discussion between shareholders. Some clients want the protection of knowing that in the event of their death, their families will be bought out, but some clients want to be able to pass on their equity to their families. There’s no “one size fits all” and each shareholder to the agreement may be coming from a different family life cycle stage and financial background. Additionally, given that financial and family situations are subject to continual change, it’s a good idea to periodically review your shareholders’ agreements to ensure that the drafting adequately captures those significant life changes.
Shareholders’ agreements also should address the possibility that a shareholder needs or wants to leave the corporation. Life is unpredictable and more often than not, even in the face of a good relationship between shareholders, when one shareholder decides to leave, the decision is not met with pure well-wishes from the remaining shareholders. Shareholders’ agreements address this with clauses known as shotgun clauses and put options that structure what is essentially a business divorce between shareholders and can help avoid unpleasant (not to mention, costly) litigation.
Shareholders’ agreements also address a wide variety of other issues, including: appointments to the Board of Directors, officer appointments, dispute resolution, controls on share transfers (to protect against unwelcome shareholders), future share issuances (to protect against dilution), capital contributions of shareholders, rights of first refusal, rights on divorce of a shareholder, non-solicitation and non-competition clauses.
Although a shareholders’ agreement cannot contemplate every possible scenario, one of the best reasons to put a shareholders’ agreement in place is that it forces the parties to discuss the issues which could arise prior to them facing those issues. Once the agreement is in place, then the parties can carry on with the peace of mind that any insurance brings.
The information provided above is for educational purposes only. This information is not intended to replace the advice of a lawyer or address specific situations. Your personal situation should be discussed with a lawyer. If you have any questions or concerns, contact a legal professional.