This resource has been prepared by Nicholas dePencier Wright of Wright Business Law for educational purposes. This information is current as of the date of writing and does not constitute legal advice, which should be obtained prior to relying on anything herein.
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The Importance of a Shareholders’ Agreement for Closely Held Private Corporations in Ontario
In Ontario, closely held private corporations — typically smaller companies with a limited number of shareholders — face unique challenges when it comes to balancing ownership and operational control. For these businesses, a shareholders’ agreement is a vital legal document that can help prevent disputes, clarify the rights and obligations of shareholders, and provide mechanisms for resolving conflicts. This post will discuss the importance of a shareholders’ agreement, the key provisions typically included, and how it helps protect the interests of all shareholders.
- What is a Shareholders’ Agreement?
A shareholders’ agreement is a legal contract among a corporation’s shareholders that sets out the rights and obligations of each shareholder and establishes rules for the management and ownership of the company. While not required by law, a shareholders’ agreement is often critical for private corporations, especially closely held ones, because it supplements corporate laws and fills gaps in the Ontario Business Corporations Act (OBCA) or Canada Business Corporations Act (CBCA) by addressing specific needs and concerns that arise in smaller, private companies.
- Why Closely Held Private Corporations Need a Shareholders’ Agreement
In closely held corporations, shareholders are often involved in the day-to-day operations of the business. Unlike in larger, publicly traded companies, where shares can be easily bought and sold, ownership changes in closely held corporations can have a significant impact on the business and other shareholders. Without a well-drafted shareholders’ agreement, the corporation may be vulnerable to conflicts that could disrupt the business or even jeopardize its survival.
Here are several reasons why a shareholders’ agreement is essential for closely held corporations in Ontario:
a. Clarifying Roles and Responsibilities
A shareholders’ agreement can clearly define the roles and responsibilities of each shareholder, which helps avoid conflicts related to decision-making and management control. For example, the agreement may specify the management roles of specific shareholders or outline which shareholders have voting power on certain key issues. This clarification prevents misunderstandings and provides a foundation for fair decision-making.
b. Protecting Minority Shareholders
One of the critical functions of a shareholders’ agreement is to protect minority shareholders. Without it, majority shareholders could make decisions that unfairly disadvantage minority shareholders, such as issuing new shares that dilute their ownership. A shareholders’ agreement can include provisions that prevent the majority from abusing its power, such as “tag-along” rights, which allow minority shareholders to participate in the sale of shares if a majority shareholder decides to sell their interest.
c. Establishing Mechanisms for Resolving Disputes
Disputes are inevitable in any business relationship, and closely held corporations are no exception. A shareholders’ agreement can set out mechanisms for resolving disputes, such as mediation, arbitration, or buy-sell provisions that allow one shareholder to buy out another in the event of a deadlock. Having these mechanisms in place can save time, money, and stress by preventing the need for lengthy and costly litigation.
d. Regulating the Transfer of Shares
One of the most critical aspects of a shareholders’ agreement is its ability to control the transfer of shares. In a closely held corporation, the arrival of a new shareholder can significantly impact the business’s dynamics. The shareholders’ agreement can include “right of first refusal” clauses, which require that any shareholder wishing to sell their shares must first offer them to existing shareholders before selling to an outsider. This provision helps maintain the corporation’s ownership structure and stability.
- Key Provisions in a Shareholders’ Agreement for Closely Held Corporations
A well-drafted shareholders’ agreement typically includes several core provisions designed to protect the interests of the shareholders and the corporation. Some of these key provisions include:
a. Buy-Sell Provisions
Buy-sell provisions outline the process for one shareholder to buy out another in specific situations, such as death, disability, retirement, or voluntary exit. These provisions help ensure continuity and stability by allowing the corporation or remaining shareholders to buy out the departing shareholder’s interest at a predetermined price or formula.
b. Right of First Refusal
As mentioned earlier, the right of first refusal gives existing shareholders the first opportunity to purchase shares that another shareholder intends to sell. This provision prevents unwanted third parties from becoming shareholders and preserves the corporation’s ownership structure.
c. Drag-Along and Tag-Along Rights
Drag-along rights: If majority shareholders wish to sell their shares to a third party, drag-along rights can force minority shareholders to sell their shares as well, ensuring that the buyer can acquire 100% of the company. This provision makes the corporation more attractive to potential buyers.
Tag-along rights: Conversely, tag-along rights protect minority shareholders by allowing them to participate in the sale if a majority shareholder decides to sell. This provision ensures that minority shareholders can exit on the same terms as the majority shareholders.
d. Restrictions on Competition and Confidentiality
In a closely held corporation, shareholders often have access to sensitive business information. A shareholders’ agreement can include non-compete and confidentiality clauses to prevent shareholders from sharing proprietary information or starting a competing business if they leave the company.
e. Dividend Policies and Profit Distribution
Shareholders’ agreements can also include provisions on dividend distribution, specifying when and how profits will be distributed to shareholders. This clarity can prevent disagreements, especially when some shareholders depend on dividends for income while others prefer to reinvest earnings in the business.
- The Benefits of a Shareholders’ Agreement
Having a shareholders’ agreement offers several benefits to the shareholders and the corporation:
Reduces the Potential for Conflict: By setting clear guidelines and expectations, a shareholders’ agreement minimizes misunderstandings and reduces the likelihood of conflicts among shareholders.
Provides Legal Protection: The agreement creates enforceable rights and obligations, protecting shareholders in the event of disputes or unforeseen circumstances.
Preserves the Stability of the Corporation: By regulating the transfer of shares and setting out buy-sell provisions, the agreement helps maintain a stable ownership structure, which is essential for the company’s long-term success.
Increases Predictability and Certainty: With an established process for handling major decisions, the shareholders’ agreement provides predictability, which can be especially valuable when facing unexpected situations, such as the death or disability of a shareholder.
- Drafting a Shareholders’ Agreement: Key Considerations
Creating a shareholders’ agreement requires a tailored approach, as every closely held corporation has unique needs and goals. Here are some important considerations when drafting an agreement:
Customizing the Agreement to Fit the Business: A shareholders’ agreement should reflect the specific needs of the corporation and its shareholders. Consulting with legal professionals who understand the nuances of Ontario’s corporate laws is essential to ensure the agreement covers all critical areas.
Reviewing and Updating the Agreement: As the corporation grows and circumstances change, it’s crucial to review and, if necessary, update the shareholders’ agreement to reflect the current state of the business.
Seeking Legal Advice: Legal professionals with expertise in corporate and business law can help draft a clear, enforceable agreement and ensure compliance with Ontario’s Business Corporations Act (OBCA). The OBCA provides a legal framework for corporate governance, but a well-drafted shareholders’ agreement tailors that framework to the corporation’s specific needs.
- Conclusion
For closely held private corporations in Ontario, a shareholders’ agreement is not just a legal formality — it’s a crucial tool that safeguards the interests of all shareholders and provides a roadmap for managing ownership and operational issues. By establishing clear guidelines and mechanisms for dispute resolution, share transfers, and profit distribution, a shareholders’ agreement enhances the stability and success of the corporation. It reduces the potential for conflicts, provides legal protection, and ultimately supports the company’s longevity.
Closely held corporations in Ontario are encouraged to consult with legal advisors to draft a shareholders’ agreement that reflects their unique goals and requirements, ensuring all parties are well-protected and the business is set up for long-term success.
Sources:
Ontario Business Corporations Act, RSO 1990, c B.16.
Canada Business Corporations Act, RSC 1985, c C-44.
Canadian Bar Association