1. Shareholders’ Agreements 101
The shareholders of a company are its owners, holding basic rights such as appointing directors and sharing in the company’s profits. Normally, a shareholder’s influence on the company’s day-to-day operations is minimal, as management primarily lies within the authority of the directors. However, in the context of closely-held family corporations, shareholders commonly take on multiple roles as shareholders, directors and employees of the company, often alongside other family members. Without a mutual agreement obligating all shareholders to uphold expectations in the family business, a single shareholder of the business typically lacks the legal power to enforce such expectations.
To address this issue, it is important for family businesses to have a shareholders’ agreement in place. A shareholders’ agreement is a legally binding contract among a company’s owners, outlining both ownership rights and responsibilities, as well as the overarching guidelines for running the business. In the family business context, this agreement is a private arrangement between shareholding family members that governs their relationships as business owners. It includes terms regarding share ownership and transfer, appointing directors and officers, and what happens to shares upon death or divorce of a family member. A shareholders’ agreement is separate from the Articles of Incorporation, which is a document filed with the corporate registry outlining the basic components of the company, such as the composition of the board of directors and the number and classes of shares the company is authorized issue. One of the main advantages in drafting a shareholders’ agreement at the outset of starting a family business is that it offers the parties the flexibility to explore various solutions for resolving potential disputes that may arise between shareholders.
2. Common Problems Family Businesses Face
The complex nature of family dynamics is one of the main challenges faced by most family businesses, making it difficult for many businesses to survive beyond a single generation. Many family businesses begin as joint ventures among spouses or relatives who share equal ownership and take on roles as shareholder-directors. These businesses often operate smoothly until transitions like selling or passing on the business to successive generations occur. Despite initial harmony, relationships can sour, leading shareholder-directors to clash over business operations.
Family dynamics naturally lean towards informality, whereas business operations thrive on formality. Families establishing a closely-held company for their family business often assume that creating a shareholders’ agreement among family members is unnecessary because of the nature of their close, trusting relationships. In the initial stages of establishing a company between family members, financial constraints may also deter spending on legal formalities like a shareholders’ agreement. However, this can have negative consequences for the future of the business. As ownership of a family business shifts across generations, it frequently leads to discord among members. Unfortunately, negative feelings such as resentment, jealousy, and rivalry have the potential to create significant disruptions within the family business, including deadlock.
3. The Dreaded Deadlock
Deadlock occurs where directors or shareholders hold equal votes but cannot agree on the way forward. Deadlocks among shareholders can pose a significant threat to any business, as they render businesses incapable of making crucial decisions, divert management attention from business growth, hinder future investment or sale prospects, and lead to substantial legal costs if a dispute escalates into legal proceedings.
These issues can intensify when family members control the business. In first-generation family-owned businesses, deadlock situations rarely arise as the founder usually maintains control. However, as shares pass down to a new generation and may be held by two or more siblings or cousins, a 50/50 split or deadlock becomes more likely. Personal alliances rather than business necessities can complicate conflict resolution, and events like the illness or death of a crucial family member involved in the business can create succession challenges.
For family businesses with a limited number of shareholders, having a backup plan for decision-making in case of disagreement is prudent. Oftentimes, the involved parties postpone seeking a facilitated resolution, including by legal counsel, until conflicts have escalated. By this stage, it may be too late. Deadlock might lead to court proceedings and the company’s winding up, destroying the goodwill of the business and forcing asset sales at reduced prices. Everything that has been diligently built could be lost.
However, a well-crafted shareholders’ agreement can outline procedures for handling disagreements or deadlocks before they occur. While it may not prevent all disputes, an effective agreement can significantly reduce the likelihood of disputes escalating to deadlock stage.
4. Why Address these Issues in a Company’s Shareholders’ Agreement?
A shareholders’ agreement, like any contract, offers tailored flexibility to suit the specific needs of the parties involved. Unlike the Articles of Incorporation of a company, the terms of a shareholders’ agreement can remain confidential, preserving privacy in sensitive family relationships, especially when dealing with cultural, religious, or familial matters within a family business context. This ensures that the company can maintain privacy in the event of a family dispute, unlike dispute resolution through court hearings, which are of public record.
Additionally, modifying a shareholders’ agreement is more straightforward and cost-effective than amending the Articles of Incorporation. A shareholders’ agreement can also require that any future shareholders become a party to the agreement before they can receive shares in the company, which can be particularly beneficial in family business scenarios where shares are often transferred to subsequent generations or spouses who were not initially party to the original shareholders’ agreement.
5. Dispute-Resolution Strategies in Shareholders’ Agreements
(a) Preventative Clauses
(i) Appointing an Independent Party to Mediate Disputes
The shareholders may collectively consent to designate an unbiased third party, potentially a mediator or arbitrator, or an advisory board to aid in the decision-making process and resolve the issue. Mediation could be required prior to any of the other dispute resolution or deadlock-breaking provisions. Binding arbitration in agreed upon, material circumstances, particularly if relating to the company (as opposed to being between or among shareholders only) may limit the escalation of disputes.
(ii) Vote Pooling Arrangements
Subject to applicable law, two or more shareholders can manage voting processes through a pooling arrangement: a contractual method where corporate shareholders establish a voting trust by combining their voting rights and entrusting them to a trustee. This is alternatively termed a voting agreement or shareholder-control agreement, as it is designed to control corporate affairs. For companies that have non-family shareholders, a shareholders’ agreement can include mechanisms whereby family members hold meetings and vote on shareholder matters in advance of full shareholder meetings. In this way, families can pre-determine how the family-owned shares will be collectively voted at the broader shareholder meetings. In family businesses, where shareholders commonly possess equal voting authority, such pooling arrangements serve to prevent potential voting deadlocks that could otherwise endanger the company’s stability.
(iii) Casting Vote Provisions
The chairperson of the board, or other specified individual, can be given a pre-determined casting vote in event of a deadlock at director or shareholders’ meetings.
(b) Worst-case-scenario Clauses
(i) Establishing an Exit Plan
In cases where shareholder-directors cannot reach a consensus, pursuing a negotiated exit might offer the most viable solution. This can take various forms. For example, a “share-buyback” clause provides a process whereby one shareholder might opt to exit the business by having their shares repurchased by the remaining shareholder(s) or the company itself (provided that the company or remaining shareholder(s) possesses the funds to do so).
Another option is a “shotgun” clause, which serves as a final recourse when shareholders fail to resolve a conflict through discussion and negotiation. Under this type of clause, one party proposes either to purchase the shares of the other party or to sell their own shares to the other party at a predetermined price. The other shareholder then has the option to either agree to the sale or reverse the offer and become the buyer at the same price. This is the ultimate “divorce” clause between shareholders and works best when there are two 50/50 shareholders with equivalent wealth.
(iii) Winding up the Company
An alternative or supplement to a “share-buyback” or “shotgun” clause is a dissolution or liquidation clause. In the event that either the shareholders or the board are hopelessly deadlocked, then any shareholder could require the dissolution or liquidation of the company. If a shareholder triggers the dissolution clause, it should be conducted promptly (i.e., usually within a year). Triggering a dissolution clause is obviously a very drastic measure and should be a last resort in the context of multiple director or shareholder deadlocks within a specific period of time. The mere fact that it could be triggered may be a powerful tool for ensuring collaboration among shareholders and avoiding deadlock.
While deadlocks within a family business can create significant challenges, preemptive solutions can mitigate their impact if established before conflicts arise. The senior generation in a family business can proactively institute these measures as a prerequisite for transferring ownership to subsequent generations.
This article has explained one problem commonly experienced in family businesses – the dreaded deadlock. Fortunately, by formulating a comprehensive shareholders’ agreement designed to manage potential disputes, deadlock may be avoided. The invaluable role of a well-crafted shareholders’ agreement cannot be overemphasized. It serves as a safety net ensuring proper corporate governance and safeguarding the rights of shareholders if trust breaks down between or among family members.
While the initial costs in legal fees and of time and energy might dissuade some from preparing such an agreement, these up-front costs pale in comparison to the costs of potential breakdowns and ensuing legal battles. For those contemplating passing on their business within the family, seeking advice can help navigate potential pitfalls. The earlier these matters are considered, the more favourable the outcome tends to be. The Clark Wilson Family Office group looks forward to assisting your family business in creating a shareholders’ agreement that addresses your specific family circumstances and goals.