Small Business

Why You Need a Better Shareholders' Agreement

Too many business partnerships are governed by goodwill or shoddy contracts—leading to disastrous results

Written by Andy Holloway
Special Report: Perfect Pairs – How to sustain a productive business partnership

Davis Clark thought he had everything covered. When he took on a partner in his Toronto-area service company 10 years ago, he drew up a shareholders’ agreement setting ground rules for how the firm would be owned and managed. Clark (not his real name) even put in a proviso that he could never be bought out, although he could buy out his partner.

Yet Clark learned the hard way that it’s not always what shareholders’ agreements cover that causes problems; it’s what they don’t cover. Clark’s agreement lacked a non-compete clause if he were to buy out his partner, as Clark decided to do last year. That left the partner free to use the buyout money to finance a rival business and compete for Clark’s clients. Clark was also on the hook for severance for his partner and his partner’s wife, who had played a role in the business.

Negotiations over the buyout were so rocky they took eight months and cost $50,000 in legal fees. All the while, says Clark, “My partner was making his executive salary and getting all the executive perks, which made me sick because he wasn’t even working. If this kind of thing had happened in my marriage, I’d have probably jumped off a bridge.”

The situation could have been even worse if Clark hadn’t had a shareholders’ agreement at all. Most SMEs never get around to creating the business equivalent of a marriage prenup—an oversight that can prove disastrous if big problems arise between the partners. These agreements can be useful in determining, say, what you’ll do with a little extra profit and who can spend how much, and when. But where they really prove their worth is if the partners’ relationship goes sour and someone wants out—or wants the other partner out.

“The best shareholders’ agreement is one you never pull out, but it’s there if you need it,” says Ted Pease, a partner at Brantford, Ont.-based McIntosh & Pease, whose specialties include corporate law. Pease says the key is to think about the major issues and create an agreement before the business gets going.

“It can be devastating if the partners don’t get around to it and then one of them dies or gets sick, or they start fighting,” he says. “It’s really difficult to negotiate a shareholders’ agreement when you’re fighting.”

At that point, winding up the company may be your only option. But that usually has adverse tax consequences, says Pease, because you haven’t planned a proper exit strategy. Another poor option is to battle for control in court, which is expensive and has a highly uncertain outcome.

Lisa Shepherd is glad she took the time to craft a shareholders’ agreement without the sort of holes that caused Clark so much grief. Shepherd owns a Toronto-based marketing consultancy that’s now thriving. But in 2006, the president of The Mezzanine Group found herself stuck with a partners’ group that just couldn’t agree on what to do next. The four partners were at loggerheads over how much to pay themselves and how much to plow back into the business. And they hadn’t been getting along for about six months, making consensus even less likely.

Fortunately, Shepherd had spent $5,000 in 2004 on a shareholders’ agreement when she brought her partners on board. One section spelled out how the partners would handle ownership buyouts. A buy/sell provision known as a “shotgun clause” allowed one or more partners to make an offer to buy the others’ shares—or, if rejected, to sell their own shares at the same price. Because the partners had already agreed on a process, Shepherd was able to conclude a deal in just three weeks to buy out her partners.

“That single clause was worth far more than its weight in gold because it enabled us to have a very quick resolution to an intractable business problem,” says Shepherd. “An awful lot of people I know don’t have shareholders’ agreements. They end up in stalemates with their business partners, and there’s no solution to it.”

Mezzanine’s agreement included a death clause requiring a shareholder’s estate to sell its shares back to the other partners. Even though this scenario didn’t arise at Shepherd’s firm, “this is a very important clause,” she says. “You do not necessarily want the spouse of one of your business partners—who may not have any relevant experience—to become one of your partners in the event of an unexpected death.”

So, how do you come up with a solid shareholders’ agreement? “There’s no such thing as a standard agreement,” says Mike Volker, a high-tech entrepreneur and angel financier in the Vancouver area. He suggests you find a lawyer with experience in this area who can provide you with a template with up to 100 clauses, then adopt the clauses relevant to your situation and customize them as needed.

Volker advises talking to other CEOs about what your agreement should cover, and asking yourself such questions as: Why are we in business? How will we handle a shareholder who wants out? How will we value the business? What’s the worst that could happen, and how would we deal with that?

Shepherd says if she were to have partners again, she’d include in the agreement an employment contract stipulating each partner’s responsibilities and performance expectations so the workload is shared fairly. And Clark—who has sworn off partnerships—recommends including a two-year non-compete clause and waiving severance for executive shareholders and family members who work at the firm. He also recommends clauses to ensure that during the transition, the departing partner should help inform customers about the change and not bad-mouth the business.

Some agreements aim to cover any eventuality. But Volker prefers a principles-based document about specific governance issues rather than trying to cover what should be management decisions.

“It comes down to ownership and governance, but that’s really everything,” he says. “I’ve seen agreements that are 100 pages long but are probably useless. Because something will come along that hasn’t been anticipated.”

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Originally appeared on PROFITguide.com
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