The Shareholders' Agreement (15 minute read)

June 23, 2014

The Shareholders’ Agreement (15 minute read)

the shareholders agreement

For the last year or so, you’ve been thinking about leaving your job.  You enjoy what you do, and you work at a great place, but everywhere you go, you see and hear about people who have created their own businesses.  You have some great ideas and some great business skills – and a couple of good friends who are encouraging you to team up with them and “disrupt” the establishment.  You’ve now come to the conclusion that the three of you have what it takes to bring your idea to market and succeed.

Realistic Expectations

Sure there are going to be bumps along the way, but you’re prepared – you’ve set a realistic timeline for the development of your product, your spouse is very supportive, and you’ve built up enough savings to get you through until your product is developed.

You and one of your good friends will be the heart of the business. You are going to focus on designing and developing the product.  He is going to use his business contacts to develop a sales channel and a marketing plan. Your third friend will be the “silent partner” – he’ll invest enough money to get you off the ground, but he insists that he won’t try to control the direction of the business.  He’s a great guy and you know he’ll be true to his word.

Legal Issues

You decided that you’re not going to do this “half-way”.  “We’ll start a new corporation”, you say.  “We’ll each be shareholders and we’ll get a lawyer to do it up right.”  So you visit a lawyer who was recommended by a friend and you get your company set up.  You’ve got a 40% share, your friend has a 40% share, and the “silent partner” takes a 20% share.

Then your lawyer says “the three of you should have a shareholders’ agreement – to address the management of the company, the expectations of the shareholders, establish restrictions on the trading of shares, and deal with what happens if any of you want or need to leave the business or the business fails.”

“The business isn’t going to fail”, you respond.  “And we’re in it for the long haul – no one is going to be leaving anytime soon.”  With that, you decide that lawyers are too cautious anyway, and there’s really no risk of you getting into a serious argument with either of your two friends.  You’re full of confidence and excitement, and spending a bunch of time thinking about what could go wrong is just going to bring everyone down – how can you succeed if you keep thinking about failure?

Truth be told, you don’t know that much about shareholders’ agreements and how they work – but you’ve already used up a lot of your “legal fees” budget, and you decide to put it off until you’ve made some progress developing your product.  “Let’s get the project started,” you say.  “Then we can go back and sort out the paperwork later.”

3 Years Later

Your product was an instant success – you developed the proof of concept within a few months, and a minimum viable product followed a few months later.  You moved into some cool “loft-style” office space about a year ago, signing a 5-year lease.  Financing has been much easier than you expected, and three short years after you started the company, you look back and realize that you’ve succeeded – you’re on the verge of hitting the big time.

On your way out the door that day, you notice something odd.  A number of technical documents that you wrote in the early days of the company are sitting on your friend’s desk.  You haven’t had to look at those documents in a long time, and you wonder why your friend would need them.  You make a note to ask another member of your team in the morning.

Business Breakdown

The next day, you learn from your team that your friend has been spending a lot of time “reviewing” your technical documents, and that the time he has been spending out of the office has been spent with “consultants” of some unknown variety.  When you raise the topic with your friend a few days later, he tells you that he thinks the product at the core of the company’s success – the product that you developed –  needs to be modified in a very significant way.

As you get further into this discussion, you realize that your vision for the future of the company is quite different from your friend’s vision.  While you’ve been talking about developing the core product and then developing related products, your friend has been talking about selling the entire business to a big player in the industry.  To make matters worse, your friend keeps insisting that the silent partner is on “his side”.  “If you don’t agree with us, that’s fine”, he says.  “We’ll replace you as a director and we’ve found someone who will buy out your share of the business.”

If you weren’t paying attention before, you are now. The future of your business is on the line, and you realize your next phone call should be to a lawyer – someone like me, who deals with shareholder disputes.  You could lose your company and the product that you created and developed – not to mention your long friendship.

Hindsight is 20/20

How do you settle this dispute?  Can you limit the silent partner’s influence?  Can you be forced to sell your shares?  How much are they worth? Can you buy out both partners and take over the business?  As you think about these questions, it occurs to you that you never did go back and finish “the paperwork.”  You don’t have a shareholders agreement – and because of that, you don’t have a clear procedure for dealing with a dispute like this, nor do you have a clear procedure for buying or selling shares.

Unfortunately, the lack of a shareholders agreement makes this dispute unpredictable and difficult to manage.  You could try to negotiate an agreement now, but there’s no guarantee that you will be able to come to terms.  You might end up in court – which will be time consuming, expensive, and uncertain.

Not a “Magic Bullet”

In many cases, businesses operate successfully – for years – without a shareholders agreement.  The shareholders share a common view, and they are able to address concerns as they arise.

In other situations, an unexpected turn of events can lead to significant conflict.  Perhaps the business is failing, and needs an influx of cash from the shareholders.  Perhaps the shareholders no longer see eye-to-eye on the next big growth opportunity, or on a particularly significant operational issue.  Perhaps one of the shareholders has died unexpectedly, and his or her next of kin are not interested in staying invested in the business – they want to sell the shares and distribute the proceeds.

As a litigation lawyer who works with companies and individuals involved in shareholder disputes, conflicts like these are not really unexpected – they’re fairly typical.  That is why most shareholders agreements contain provisions to deal transferring shares, raising money from shareholders, and management decisions that require shareholder approval.

That doesn’t mean that a shareholders’ agreement is some kind of “magic bullet” – it’s not going to solve all of the problems raised in the story you’ve just read.  But it probably would make life a lot easier for the shareholder who is now being forced out of the business he helped create.

A valuable tool

When people team up to start a new business, a great deal of time is spent thinking about operations – the computer system, the website, the marketing, the staff, and of course, the product.  They don’t often spend a lot of time thinking about the company itself – shareholder rights, obligations, and expectations, dispute resolution, and exit procedures.

It’s not always fun to think about these things at the beginning – when you’re full of optimism and fresh ideas – but it is usually the best way to prevent or avoid disagreement and conflict later on.

By Salim Hirji Civil Litigation Small Business Share:

Welcome to the Hirji Law Corporation Blog – commentary and information about business disputes and the litigation process.

I will be blogging about dispute resolution, negotiation, recent court decisions, and the impact that disputes can have on your business.

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