The Wisdom of Forging a Shareholders’ Agreement

Tech companies, particularly those just starting to take off, need to consider a myriad ofbusiness and legal issues in their vision for the future. Especially in light of the dot-com bubbleburst, startup tech companies need to pay particular concern to how shareholders can bestprotect their interests — and the interests of the company — if and when a dispute betweenshareholders arises.

This author has received many inquiries from tech companies about business and legal strategies, and a recurring question is “What is the best way to avoid preventable disputes and reduce the risk of litigation?” Though a completeanswer will depend on the unique qualities of your business, with a strong legal foundation anda well-drafted shareholders’ agreement, tech companies can breathe easier and concentratetheir time and money on growing their business and not on preventable litigation.

Employee Stock Options

Many IT companies nowadays are offering profit-sharing arrangements such as employee stock options as part of their overall compensation package in a bid to attract and retain keypersonnel. IT professionals generally are attracted by the ability to share in the company’sprofits and growth.

For a startup company, providing stock options avoids the need foran outlay of cash and can provide an incentive program the company can utilize to increaseproductivity and retain key employees.

While providing stock options is a great tool to obtain and retain top talent, having a well-drafted shareholders’ agreement can prevent or limit future disputes. It can also serve topromote a harmonious relationship between the parties and ensure all those involved properlyunderstand their role in the company, their responsibilities, and their entitlements — thuselevating the quality of the work place.

The Benefits of a Shareholders’ Agreement

A shareholders’ agreement is a legal contract that binds the shareholders. Following are afew examples of the benefits of a shareholders’ agreement:

  • Unlike a company’s articles of incorporation, which is a public document, there is norequirement to publicly file a shareholders’ agreement. The shareholders’ agreementcannot be publicly accessed, and the terms of the agreement therefore will be keptconfidential as between the signatories to the agreement.
  • A shareholders’ agreement can provide for succession planning in situations such as thedeath or disability of one of the shareholders.
  • Compared to the cost of shareholder litigation, the minimal legal fees for ashareholders’ agreement mean the agreement is worth its weight in gold if it canprevent or restrict expensive litigation in the future.
  • A shareholders’ agreement can provide protection to minority shareholders by settingout clearly the parties’ responsibilities, rights and duties.
  • A shareholders’ agreement provides for a smooth transition process for a leavingshareholder.
  • When the benefits and entitlements of a shareholder are specifically laid out, keyemployees are more motivated to work for the company with an understanding as tothe parties’ expectation for remuneration and profit sharing.
  • The shareholders’ agreement can bring clarity and smooth transition in otherwisecomplex business reorganization situations such as a merger or takeover.
  • The shareholders’ agreement can help prevent hostile takeovers and unwantedcompetitors from acquiring the company’s shares.

The ‘Shotgun’ Clause

Having buy-sell, or “shotgun,” clauses in your shareholder agreement can dramatically lessenand even prevent the possibility of future litigation. A shotgun clause allows any shareholderto offer shares for sale to one or more shareholders at a stated price.

If the offereebelieves the valuation is too high, that shareholder then has the right to purchase the offeror’sshares at that the same price. This process ensures that the shareholder starting the processwill choose a fair value, and it makes for an easy way to arrive at a fair value of your company’sshares without the need for a formal valuation.

In the end, it provides a quick, cost-efficientway to deal with an appropriate exit strategy for a dissatisfied shareholder, or a takeoverstrategy for the ambitious shareholder.

In the case where there are significant disparities in the various shareholders’ financialcapacities, the shotgun clause can be custom-tailored to include a time-specific delay to allowthe parties a chance to be on equal footing. Once all the shareholders are on a level playingfield, the purchase and sale of shares under a shotgun clause can be made more fairly.

Other Important Clauses

A well-drafted shareholders’ agreement allows the company to avoid disputes over matters such asthe nature of the shareholders’ responsibilities and job performance expectations. A noncompetition clause in the shareholders agreement can prevent a leaving shareholder fromcompeting against the company within a certain geographic area and time frame.

If the company provides executive salaries and stock options to key employees, a valuableclause to include would be that an employed shareholder waive all rights to severance pay in the case of a termination. This can avoid the concern of a small startupcompany having to pay out large severance packages, or the costs of having to litigate the issuein the case of a defunct employee suing the company for possible executive severance pay.

A Shareholders’ Agreement Will Lead to Savings

Having the shareholders’ intentions properly recorded in the shareholders’ agreement canavoid future disputes and expensive and preventable litigation costs. Typical legal fees forshareholders’ agreements range from US$2,000 to $5,000. If the shareholders’ agreementshould prevent litigation, the company would essentially save anywhere from $40,000 to$100,000 or more in legal fees, depending on the complexity of the case and the parties’intention to appeal the matter.

The moral of the story is that whether you are looking toincrease productivity and loyalty in your employees, protect your legal liabilities as a shareholder,or control the future direction of the company, a well-drafted shareholders’ agreement is wellworth its weight in gold, and the return on investment is substantial if it can prevent even asingle dispute among shareholders.

Scott Au is a business lawyer at Heydary Hamilton. His practice is focused on corporate and commercial transactions, trademarks and franchising law.

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