Shareholder Agreement Essentials: Buy-Out Clauses
Going into business with someone is not unlike entering a marriage. While the parties may enter the relationship with the best of intentions and a shared vision about the future, things can change. If you’re considering walking down the aisle with a business partner(s), it is essential that some consideration be given to how the parties can exit the business should the need or desire arise. The business equivalent of a pre-nuptial agreement will prevent the potentially poisonous scenario of being stuck in a relationship you can’t get out of.
Your shareholders’ agreement should contain a least one of the following buy-out provisions.
The ‘shotgun’ clause is a mechanism that allows a shareholder to buy out their partner(s). While there are many different variations of ‘shotgun’ clauses, they typically involve one partner offering to buy out the other partner(s) at a specified price. The other partner(s) must either accept the offer and sell their shares or buy out the partner who made the initial offer at the same price. This type of clause is to be used with caution as it can be abused by shareholders with more financial means than another.
Right of First Refusal
The ‘right of first refusal’ is used when one shareholder receives an offer from a third party to purchase their shares. Before accepting the offer, the shareholder who receives the offer must first offer to sell their shares to the other business owners on the exact same terms. If the remaining shareholders do not opt to buy-out their partner then the sale to the third party must be concluded on the same terms offered to the existing shareholders.
The ‘tag-along’ clause if often used in conjunction with the ‘right of first refusal’. If the shareholders decide not to buy-out their partner who has received an offer for their shares, they can elect to use the ‘tag-along’ clause which would require the third party to buy their shares as well. This is often used in scenarios where the remaining shareholders do not wish to go into business with the third party and/or represent a minority stake in the company.
The ‘drag-along’ clause is used to compel a shareholder to sell their portion of the business to a third party if a majority of the other shareholders are in favour of the sale. It is up to the shareholders to set the voting threshold for selling the business when they are drafting the shareholders agreement. For example, the shareholders could elect that if 2 out 3 owners agree to sell the business then the ’drag-along’ clause can be applied. Alternatively, the formula could require a certain percentage of voting shares.
Full-time Intention Clause
A clause can also be included in the shareholders’ agreement specifying that each shareholder is expected to work for the business on a full time basis. If a shareholder is no-longer interested or able to commit full-time to the business then the remaining shareholder(s) can purchase their shares.
There are many reasons why shareholders may choose to exit a business. Agreement amongst the shareholders at the outset on how a shareholder can leave the business will prevent a great deal of conflict in the future.