Shareholder Agreement

SHAREHOLDER AGREEMENT
Essential Tool
For
Succession Management

Having a shareholder agreement (sometimes called a stockholder agreement) is an essential tool for facilitating the succession management process in a family business.

"But having a stockholder agreement in place, early in the life of a family business, makes sense - these types of agreements can help avoid many of the pitfalls associated with the distructive misunderstandings that happen in a family business," according to top family business expert Don Schwerzler. "As the family business grows in size and complexity, having an updated shareholder agreement in place is simply a smart success strategy. Every family business is unique and complex in its own way - and a shareholder agreement can help grow the family business while at the same time helping to maintain healthy family relationships."

Schwerzler has been studying and advising family businesses for more than 40 years and he is the founder of the Family Business Institute in Atlanta, Georgia.

Shareholder agreements can sometimes be described as a "what happens if..." type of document.

For instance, in the US, more than 50% of all first-time marriages end in divorce.

Only about 30% of family businesses successfully transition from the first generation to the second generation.

Are those two statistics related - you bet!

Look, if you are in a family business, having a shareholder agreement that spells out (before it is needed) what happens if there is a divorce - that can help avoid having that same agreement negotiated, acrimoniously, between two opposing divorce lawyers!

Here are a few reasons for having shareholder agreements:

Reasons for A Shareholder Agreement

• Most family businesses are incorporated and therefore subject to a Company Act that typically provides that a shareholder is free to share their shares.
• At death, shares form part of an estate that can be left to one's spouse, children or any other beneficiary.
• With divorce, shares form property that could be divided such that an ex-spouse might become a shareholder.
• Disagreements arise and shareholders "want out".
• Other disruptions such as medical incapacity or financial circumstances may force a shareholder to sell shares.
• All of these circumstances could result in an "outsider" being a legal shareholder of the business and having the rights that go with ownership. And that will not likely be comfortable or workable for existing shareholders.
• On the other side of the coin, as the shareholders work hard to build a successful family business, their own and their family's financial well-being is tied up in the fortunes of the business. Sooner or later they will want to retire and benefit from their years of hard work and effort invested in the business. So, it is in the best interest of the shareholders to make provisions to look after each other and their dependents. But, what tool is there to help solve these diverse and conflicting goals?

The Shareholder Agreement

aka "The Texas Shootout"

Typically, the shareholders should agree in writing that in certain circumstances such as death of a shareholder the corporation will buy back the deceased's shares. Rather than have the business keep cash on hand "just in case", it's usual to have the business own life insurance on the shareholders. On death, the business collects the proceeds and uses the funds to buy the shares from the estate.

For situations like divorce or disagreement, a shareholder agreement could provide that if a shareholder wishes to sell shares, they must first be offered to the other shareholders. Or that existing shareholders have first option to acquire shares that a shareholder wishes to sell.

The price at which shares will be bought and sold is always difficult in non-traded businesses [and sometimes in traded ones!]. And the taxing authority will likely have an interest in the transaction as well to ensure that capital gain is not under-reported by unusually low pricing. So, fair market value is often specified, and must be determined at the time of a transaction. Sometimes formulas are built in, but often these attract undue tax scrutiny unless they can be shown to provide something close to fair market value.

Shotgun Clause

Not all transactions occur because of death or disruption. Sometimes one party wants to acquire another's interest. Here, a shotgun clause is sometimes included to try to ensure a fair price. One shareholder offers shares for sale at a price... the others can accept that price or reject it, in which case the potential buyer must buy at the price the shares were offered for sale.

Suppose there is an active shareholder, involved in managing the business, and an inactive one who has inherited shares. They disagree. The inactive one wishes to "sell out"... if inactive offers a price that is too high, active rejects it and the agreement forces inactive to buy out active at the high price. Of course, if inactive offers at a price that is too low, active will be happy to snap up the interest! From the other side, if active tries to buy out inactive and offers too low in order to get a bargain, inactive can reject the offer and force active to sell to him at the low price that was offered.

Professional advice is always important to ensure that a shareholder agreement meets the legal requirements for the jurisdiction where the agreement is made as well as planning objectives.

Our intent is to describe estate planning scenarios and solutions. We do not provide tax or legal advice - for that you should consult your attorney and CPA