IMPLEMENTING A SHAREHOLDERS' AGREEMENT

Originally published on September 10, 2009

 

This past week I met with two unrelated owners of an incorporated business.  They were looking for some guidance in the event of their own death or disability.   How would their shares in the business be valued?  When would this value be paid?  How would the shareholders or the company itself finance these payments?

General rules

Typically corporations are governed by the applicable provincial legislature originating from the jurisdiction in which they were incorporated.  Generally speaking these rules state that the board of directors of a corporation is elected by a simple majority of the votes attached to its issued and outstanding voting shares.  These directors are generally responsible for managing or supervising the management of the business and affairs of the corporation.  These default rules will apply unless shareholders have a contract or agreement in place that lays out the ground-rules in advance of any dispute.

What's wrong with the general rules is that when there is a dispute, those shareholders who have little or no board influence may require litigation, secured at a significant expense and over a lengthy process, to settle their differences.  For this reason, shareholders are encouraged to enter into a shareholders' agreement which is a contract by and between its owners to provide contractual rights, responsibilities and remedies which do not always exist in the regulatory provincial or federal statutes.

Buy-sell agreements, method of valuation  and life insurance

Buy-sell agreements may be part of a shareholders' agreement or may simply be "carved out" as a separate agreement between the shareholders.  Mandatory buy-sell provisions, which are often referred to as “shot-gun” clauses are typically used in circumstances where there are only two shareholders.  The shareholder wishing to trigger the mandatory buy-sell provision would send a notice to the other shareholder indicating his or her desire to purchase all of the shares of the other shareholder at a specified price.  The shareholder receiving the mandatory buy-sell notice has only two choices: (1) agree to sell his or her shares to the offering shareholder on the terms set out on the notice or, (2) purchase the share of the offering shareholder on the very same terms. 

The valuation provisions within a stand-alone buy-sell or shareholders’ agreement should provide clear and precise direction as to how the value of the shares will be determined.  For new businesses, a pre-determined value may be the most appropriate.   Alternatively, the value could be determined based on a predetermined formula, such as a multiple of earnings.  Too often, the agreements simply state that the value of the shares will be determined by a qualified business valuator or accountant.  In the business of farming where there are appreciating assets such as farmland or equipment and livestock values in excess of cost, there could be considerable costs and time spent to measure the intended value of the shares.

 

 

 

For my clients, together we decided on a predetermined value for the goodwill or intangible value of the company.  Critics would argue that this negotiated value can become dated if it is not revisited annually.  I would argue that an "imperfect preset valuation now" is always better than the "perfect preset valuation that never arrives".  To ensure that there were funds available to purchase the shares of the deceased shareholder, my clients are obtaining criss-cross insurance, with each individual shareholder undertaking to obtain and maintain a life insurance policy on the life of the other.   On the death of a shareholder, the buy-sell agreement provides for the purchase by the surviving shareholder of the shares held by the deceased.

In my own family farm corporation, I have also used life insurance on the lives of myself and my siblings to ensure that there are funds available to finance the purchase of the deceased shareholders' shares.  No one wants financial hardship of the deceased shareholder's beneficiaries. This may be the reality if the estate finds itself in the unenviable position of owing capital gains tax while not receiving any proceeds for its shares.  

A share of capital stock of a family farm corporation

Individuals who dispose of shares in a family farm corporation pursuant to a shareholders' agreement may be eligible to claim the $750,000 capital gains exemption on the sale of these shares.  The $750,000 amount refers to the whole capital gain rather than just the taxable portion.

As discussed in previous columns, the corporation must meet various "active business" tests in order to qualify for this exemption and if a farming corporation has too much invested in "non-active business" assets such as cash or off-farm investments then it may not be eligible.  To remedy this situation it may be possible to reorganize holdings so that the shares do qualify.  accountants refer to this process as "purifying" the corporation.

Closing comments

It is important to note that there is no standard shareholder agreement appropriate for all circumstances.  While an accountant can help you with the valuation aspects of your agreement, a lawyer should be hired to ensure that the agreement is functional and meets the needs of it shareholders.

 

 

Allyn Tastad, certified general accountant, is a partner in the accounting firm of Hounjet Tastad Harpham in Saskatoon at 306-653-5100, e-mail at allyn@hth-accountants.ca or website www.hth-accountants.ca. He is also involved in the family farm near Loreburn, Saskatchewan.  The opinions expressed in this column are for information only.