Five good reasons to have a shareholders agreement

Every company with more than one shareholder should have a shareholders agreement. Here are five reasons why:

1. Management – Without a shareholders agreement, minority shareholders are at the mercy of the majority. They can be shut out of important management decisions like hiring employees, signing a lease, taking out a bank loan, declaring dividends, issuing new shares, entering into supply contracts or buying another business. A shareholders agreement can guarantee shareholders a seat on the board and the right to participate in major decisions.

2. Buy outs – Sometimes partnerships don’t work out as planned. One partner can’t do what they said they could; one works 70 hour weeks while the other works 40; one is down to earth while the other has a big ego. And circumstances change: due to illness or disability, a better opportunity elsewhere, maybe a decline in motivation. Many shareholder agreements have a shotgun clause, which allows one shareholder to offer to buy out the other shareholder. A fair price is often the result, because the clause allows the person who receives the offer to either sell their shares or buy out the offering shareholder for that price. Without a shareholders agreement, a shareholder would need a court order to force a buyout.

3. Default – Shareholders occasionally do things they shouldn’t – compete with the company, share its secrets, or stop showing up for work. Or they might run into financial problems and expose their shares to seizure by creditors. Upon such an event, it would likely be in the other shareholders’ interest to buy that shareholder out. A typical default clause in a shareholders agreement allows them to do so, and with a 20-30% discount off fair market value, to act as a deterrent. Without a shareholders agreement, to try to force a sale they would have to seek a court order. A court process is expensive, time-consuming and distracting, and there would be no guarantee of obtaining a court-ordered sale.

4. Dispute – If a dispute ends up in court, it can not only cost the litigants a lot of money, but it airs a company’s dirty laundry and can cause major damage to a company’s reputation. A shareholders agreement typically requires arbitration when a dispute arises. Arbitration is held behind closed doors and the process can be streamlined to make it cost-efficient.

5. Death – If a shareholder dies without a shareholders agreement, his or her shares go to the estate. That means the other shareholders are likely to be in business with the spouse of the deceased. The spouse may not know the business, can demand that the financial statements be audited, and could be entitled to dividends. He or she would also have access to the company’s financial statements, which may increase the risk of the company’s sensitive financial information falling into the hands of a competitor. The spouse might also be tempted to try to shop the deceased’s shares around. A shareholders agreement can force the estate to sell those shares to the other shareholders. The price can be fair market value as determined by a valuator, or determined by a pre-agreed formula (by a multiple of net earnings, for example).

A well-thought out and well drafted shareholders agreement can save a company a lot of time, expense and grief. It is a key part of a company’s plan on how to deal with challenges as they arise.