As I discussed last week (Shareholders Agreement, Part 1), having a properly structured shareholders agreement provides a company with a road map should the partnership relationship fail or a partner leave the company due to retirement, death, or illness. Here are some typical strategies.
Pre-emptive rights to share offerings: The right for shareholders to maintain their ownership percentage by acquiring a proportional number of any new shares issued.
Right of first refusal: A shareholder who wants to sell shares must offer them to existing shareholders first. This helps maintain a market for the shares as well as controlling who will become a shareholder of the company.
Shotgun provision: Typically, one shareholder submits an offer to purchase all outstanding shares held by the other shareholder. The shareholder receiving the offer will then have a choice to either sell their shares or purchase the shares of the shareholder making the offer at the identical price and conditions offered. This is a quick and efficient last resort method for resolving situations where shareholders are no longer able to work together.
Fair Market Value versus discounted price are different methods of valuing the departing shareholder’s shares in various circumstances such as retirement, death, or illness. In some instances, fair market value may be used to determine how much the departing shareholder receives. A discounted price may be appropriate when a shareholder departs earlier than expected. Without a valuation method there can be costly disputes or an undue cash flow burden for the business.
Death or illness: I once lost a business partner in a plane crash. Having an agreement funded by life insurance saved our business. Shareholders want to ensure that if one of them dies, the survivors are able to purchase the deceased’s shares from his estate and carry on the business without interruption. The use of life insurance can provide liquidity and facilitate a smooth transition.
There are generally two types of shareholder agreements:
- Share-purchase arrangement, whereby the surviving shareholders use insurance to purchase the shares from the deceased’s estate.
- Share-redemption arrangement whereby the company redeems the deceased’s shares.
These two options provide very different after-tax proceeds to the estate, so professional tax advice should be used to ensure your estate maximizes its value. When relying on life insurance, shareholders should review their coverage on a regular basis to ensure sufficient funds are available when needed. Provisions should also be included to address the situation where the insurance is insufficient at the time of the buyout. This may include a buyout over a period of time to reduce the cash flow burden to the remaining shareholders or the business.
Where shareholder involvement in the company is extensive, provision should be made to deal with a shareholder becoming ill or disabled.
Dispute resolution: Agreements often set out dispute resolution methods designed to avoid litigation. This can be useful in disputes over share value or the application of the agreement. An arbitration process is often included to minimize costs to the shareholders and the business.
Any closely held company with more than one shareholder is subject to shareholder disputes, death, illness or retirement. The best way to avoid the resulting complications is to have a comprehensive shareholders agreement and regularly reviewed. As no two businesses are exactly alike, relying on a generic agreement is not recommended. Structuring an effective agreement requires independent advice and participation by all shareholders.
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