I should have written it down. How many times have I said that in my life?
It is a bad habit to automatically assume that one will remember incidences to the last detail. How many appointments are missed and names forgotten when one relies on their memory?
I have been an accountant for owner managed businesses for over 25 years. The owner manager generally focuses on running the business and making money and administration and governance are often put on the “back burner.” Unfortunately, the shareholders’ agreement is one of the items that sometimes end up on the back burner creating negative consequences for the business and the shareholders.
Whether the shareholders are related (family business) or unrelated, details should be set out in a shareholders’ agreement and/or an employment contract (or at least an outline of how individuals are remunerated). In a closely held corporation, the shareholders are really partners in a venture. Partnerships get into trouble when partners verbally agree on remuneration and other significant items that should be in a shareholders’ agreement. Typically, people do this to save money by avoiding the cost of actually having a binding agreement produced. Family businesses rationalize no agreements are required because “we are family.” However, messy situations inevitably arise and lawyers are called in to settle disputes resulting in significantly higher costs. Remember: “a verbal agreement is not worth the paper it is written on.”
The main objective of a shareholder agreement is to cover the three D’s: death; disability; and, disagreement. The biggest challenge is to agree on a valuation methodology under the three scenarios.
Death
In the event of death, there is usually life insurance set up to cover the cost for the surviving shareholder(s) to purchase the deceased’s shares. This seems simple enough, but issues do creep up. Do you have the survivors buy the shares, or are they redeemed by the corporation? Are the life insurance policies owned by the corporation or held by the individual shareholders? Usually, there is a term policy held in the corporation and shares are redeemed upon death so that the deceased shareholder’s beneficiary never has any claim on the corporation. Sometimes there is a significant difference in premiums between shareholders depending on the age and health of the various shareholders. Usually, the corporation pays all premiums as the owner and beneficiary of the policies. Shareholders should remember to increase the insurance coverage as the business increases in value and include coverage to compensate for the shareholder no longer being involved in the business (i.e. buy out insurance and key-man insurance).
Disability
Statistics show that individuals are 10 times more likely to be physically or mentally disabled than they are to die by age 60. Since most people are working well past 65 years of age, it is essential to consider long term disability and critical illness insurance. Unless a shareholder is severely disabled, he or she will probably want to come back to work. Your insurance should consider the value of the business with and without this owner/manager, the value of hiring someone to replace the owner/manager for a period of time and the employ of part time employees if the disabled owner/manager returns to work part time. There should be strict criteria regarding when it is necessary to buy out a disabled shareholder and how the buyout will be financed. If a shareholder returns from disability leave and he or she is unable to perform at their previous level, how will the company respond? How long can a shareholder be on disability before a buy-out is initiated? These are issues that should be addressed in the shareholders’ agreement. Shareholders should also remember that life, disability and critical illness insurance policies are held by the corporation to deal with corporate risks. The shareholder should consider personal insurance to deal with personal risks.
Disagreements
Shareholders may find themselves in a situation where a disagreement results in a shareholder wanting to leave the company. How is it decided which partner is bought out? Does the whole company get sold? This should be in the agreement. Typically disagreements are settled with a “shot gun” arrangement. One side tries to buy the other out, but the potential seller has the option to buy out the potential purchaser at the offer price. This may seem to be fair, but if one shareholder is significantly more affluent than the other, the affluent shareholder will have the advantage. In any case, there should be a mechanism in the shareholders’ agreement to cover the resignation or firing of a shareholder.
Valuation
The valuation of a business can be problematic. Who does the valuation? Is there a shot gun? Is there a predetermined value? Regardless of the mechanism chosen, it should be fair to all shareholders. Majority shareholders must be very careful to act in a manner that is fair to all shareholders, especially with all the press on shareholder oppression (Conrad Black is the most advertised culprit).
Shareholder Remuneration
Another area that has that potential to create negative feelings is the determination of remuneration. Should every shareholder be paid equally? How is the remuneration calculated? Is everyone aware of the method of calculation and are the final remuneration amounts reviewed and supported? Imagine walking into an office where there are two equal shareholders. One is being held up by the neck with feet dangling about six inches off the floor. They were discussing the inequity of the remuneration (to put it mildly).
The lessons to be learned:
- Prepare a shareholders’ agreement and consider the 3 D’s.
- Get advice from lawyers, accountants, tax advisors and insurance advisors to ensure all issues are being considered.
- Evaluate your insurance requirements both personal and corporate.
- The valuation method must be determined and reviewed annually (put in writing!).
- The remuneration basis should be mutually decided upon and reviewed annually (No shareholder should say about the other – “I did not know they were making that”).
There are some critical issues in this blog. I hope you don’t find yourself saying “I SHOULD HAVE WRITTEN THEM DOWN”.