In Episode 2 of “Awesome Lawsomes and the Corporate Cookbook,” we saw Astro of Chuma Space Corporation discussing his company’s Unanimous Shareholder Agreement with Dr. Nath. What is a Unanimous Shareholder Agreement and why should your corporation have one?
Private corporations, especially if they are owner-managed, exist in a dynamic business environment. To avoid unnecessary stresses and reduce the risks associated with each new opportunity, it is critical for the shareholders to have a clear set of rules among them. The agreement used for these rules is called a Unanimous Shareholder Agreement (“USA”).
What is a USA?
A USA is an agreement signed by all of the shareholders of a corporation. Without the existence of a USA, the common law as it exists does not place many restrictions on how shareholders deal with each other, and with their shares in relation to third parties. Therefore, it is necessary to negotiate and set out clear terms that would regulate the shareholders’ dealings with each other and with their shares in relation to third parties.
A USA will often address various issues. For example:
Issuance of shares.
Repayment of shareholder loans.
Transfer of shares resulting from the death, incapacity, insolvency or the marital breakdown of a shareholder.
Purchase and sale of shares (e.g. right of first offer, right of first refusal, piggy-back rights and drag-along rights).
Process for resolving shareholder disputes
Shareholder’s right to compete with the company or solicit employees and/or clients away from the company.
What makes a USA unique?
Once a USA is signed by all of the existing shareholders of a corporation, it will automatically bind all future shareholders, whether the future shareholder signs the agreement or not. This notion is called the deemed party rule, because all future shareholders are deemed parties to the agreement.
How can the USA restrict Share Transfers?
A key feature of a USA is preventing shares from being transferred to unknown or undesirable parties. This objective must be reconciled with the desire of shareholders to maintain liquidity of their shares. The following safeguards are common when selling shares of a company governed by a USA:
Right of First Offer: A shareholder proposing to sell their shares must first make an offer to sell their shares to the existing shareholders. The offer must be made on the same terms that they are willing to accept from a third party. If the other shareholders do not accept the offer, the selling shareholder is free to sell their shares to a third party.
Right of First Refusal: When a shareholder proposing to sell their shares first obtains a bona fide (real) offer from an arm’s length third party that they are prepared to accept, the other shareholders will then have a right to acquire the shares at the same price and on the same terms set out in the third-party offer. If the other shareholders do not want to purchase the shares, then the selling shareholder may sell the shares to the third party.
Piggyback (Tag-Along) Rights: This right requires a purchaser of a shareholder’s shares to also purchase the other shareholder’s shares on the same terms. Piggyback rights are often demanded by minority shareholders.
Drag-Along Rights: This right is the reverse of piggyback rights. Typically, a controlling shareholder(s) requires that minority shareholders also sell their shares to a third party to whom the controlling shareholder is selling its shares.
Even if compelled to sell, the transfer of shares should be smooth. A USA should provide detailed transaction mechanics, including time periods for all notices and actions to be taken, as well as details regarding closing dates and procedures.
How can the USA mitigate Involuntary Transfer of Shares?
Shareholders may want to ensure that unwanted parties do not become shareholders as a result of a death of an individual shareholder, a bankruptcy or insolvency of a shareholder in which case a creditor may become a shareholder, or a transfer or disposition of assets in the event of matrimonial proceedings. A USA can mitigate unwarranted share transfers by:
Requiring approval by the directors or shareholders of such a transfer.
Providing that unless a transfer is approved in accordance with the USA, a new shareholder may not vote, receive dividends or exercise any of the usual rights of ownership.
Rights of other shareholders to acquire the shares if any of the forced sale contingencies occur.
How can the USA resolve Disputes?
Disputes among shareholders are common and can range from minor disagreements on day-to-day matters to deadlocks at the board or shareholder level. A USA should provide mechanisms to resolve disputes. The following are examples of dispute resolution procedures:
Unilateral Decision by One Party: Disputes with respect to day-to-day business matters could be resolved by one party having a casting vote at board meetings.
Discussion or Negotiation: Some USAs provide for a formal process to initiate discussions between parties, including a timetable for meetings.
Mediation: Parties can agree to undergo formal mediation. Drafting issues can include identifying how the mediator will be selected and the procedures to follow in conducting the mediation. The required procedures for mediation may be incorporated by reference to a statute.
Binding Arbitration: As with mediation, the key is setting limits on the process in advance. It will be important to consider the arbitrator’s powers to bind the parties. For example, whether they can only deal with determining monetary damages or whether the mediator will have discretion to tailor the remedies appropriately.
Shotgun: Once triggered, one party will end up exiting the company, while the other party will remain.
Sale of the Business: This is the most drastic remedy. Both parties will commit to an auction process to sell the entire business. The threat of this remedy can often serve to bring the parties together at an earlier stage.
Astro discusses Chuma Space Corporation’s USA with Dr. Nath
How can the USA exercise control over the board of directors?
A common term of a USA is that all shareholders must exercise their vote and decision-making power in accordance with the terms of the agreement.
If there is no USA in place, the board of directors virtually have unlimited power in managing the corporation. However, if the shareholders feel the need to restrict the power of the board in their management, restrictions can be built into the USA. For example, the shareholders could make a provision that says the board of directors must get shareholder approval for any decision surrounding a capital expenditure over a certain dollar amount.
More often than not, the corporation is a party to the agreement. Therefore, the board of directors are bound to exercise their discretion and their decision-making power on the board, in accordance with the provisions of the USA.
How can the USA affect a Shareholder Exit?
A USA will often provide for a number of ways for shareholders to exit the company. These may include:
Put or Call Options: A put option is an option of a contract giving the owner the right, but not the obligation, to sell an amount of underlying security at a specified price, within a specified time. A call option is the opposite, giving the holder the right to buy shares. A Put or Call Option is typically exercisable after a specified period of time or upon the occurrence of a specific event. The obligation to purchase shares under a Put Option could fall to all the other shareholders on a pro rata (proportional) basis, or just to the company. Events which may trigger a Put or Call Option may include the death, incapacity, bankruptcy of a shareholder, the retirement or termination of employment, or a material breach by the shareholder of the USA.
Shotgun or Buy/Sell Clause: In a Shotgun scenario, a shareholder delivers an offer: (i) to buy the shares of another shareholder; and (ii) an offer to sell their shares to the other shareholder on identical terms. The other shareholder receiving the offers must decide which of the two offers to accept. This mechanism works bet in cases involving two shareholders. Where a company has more than two shareholders, the drafting of a Shotgun Clause becomes much more complex. The uncertainty for both parties typically acts as an incentive to reach a negotiated settlement to any disagreement.
Sale to a Third Party: A sale to a third party will be governed by the provisions, described above, restricting share transfer including Right of First Offer, Right of Frist Refusal, Piggyback Rights, and Drag-Along Rights.
How can the USA affect Valuation?
The share value can easily become a major dispute when a shareholder wants to exit the corporation. For this reason, it is important to have an agreed method of valuation in the USA. There are several methods that can be used in a USA to determine share price. These include:
Periodic Agreement: The parties commit to agree upon a value from time to time, for example on an annual basis.
Specified Formula: This could be based upon book value, a multiple of earnings or cash flow, or another appropriate basis for the company.
Determination by a Third Party: Parties will often enlist professionals, such as accountants or business valuators to determine share value. In this case, it is important that parties agree in advance to be bound by the independent valuator’s determination.