Shareholder Disputes: Prevention Better Than Cure

Starting a new business or becoming a partner in an existing one is an exciting journey but as with any adventure, issues may arise along the way that may lead to disagreements between investors. A well-drafted shareholders’ agreement will provide solutions to conflicts in a non-litigious manner. We illustrate below a real-world scenario of a dispute between shareholders and lessons to be learned from it.

Litigious Situation

Opco is a manufacturer and distributor of nutritional supplements. A shareholders’ agreement was signed in 2007 between Mike and Phil, both active in the business. Mike and Phil own 59 percent and 41 percent of the shares respectively.

One year later, the shareholders agreed to a corporate reorganization whereby they sold their shares in Opco to newly formed Holdco, receiving common shares of Holdco in exchange. Opco became a wholly owned subsidiary of Holdco. The following corporate reorganizations occurred by way of tax-free rollovers:

• A transfer of real estate to Holdco;
• The common shares of Holdco were issued to family trusts formed by the shareholders with the original 59 – 41 percentage allocation. From a legal perspective, a trust is a distinct legal entity from the individual shareholders.

Eventually both shareholders ended up with three different classes of Holdco preferred shares in the same proportions as the original 59 – 41 percentage ownership. 

In 2010, as majority shareholder, Mike terminated Phil’s employment because of different visions they had regarding Opco’s future. Mike wanted to negotiate the repurchase of Phil’s shares, but Phil wanted to trigger the shareholders’ agreement buy-sell clause to set the value of the shares.

Next Step: Conflict

Two issues arose regarding the shareholders’ agreement.

Enforceability of the Shareholders’ Agreement: Mike’s position was that the shareholders’ agreement signed in 2007 was no longer applicable as it related to Opco. Mike and Phil were no longer shareholders of Opco since the reorganization in 2008 when it became wholly owned by Holdco. In addition, the common shares of Holdco were not held personally by Mike and Phil but rather through family trusts.

However, Phil’s position was that the changes to the corporate structure and the various tax planning transactions did not amend the intent of the parties and hence the shareholders’ agreement remained applicable. Mike did not want the pricing formula in the shareholders’ agreement to apply but if the shareholders’ agreement was no longer in force, he did not have a forcing-out mechanism to buy back Phil’s shares and his family trust’s shareholdings.

Interpretation of the Buy-Sell Formula: The shareholders’ agreement buy-sell clause set the value of common shares as being the latest value determined by the shareholders in accordance with a set formula. The formula specified: “the total value of the common shares is equal to the revenue on latest balance sheet divided by the number of common shares.”

Various problems become evident with the formula:

• The formula had never been applied, therefore there was no illustration that could be used to interpret the intent of the parties;
• The value was based on revenue on the latest balance sheet. Revenue does not appear on the balance sheet but rather on the income statement;
• The formula was overly simplistic in that it did not take into consideration the level of profitability of the business or the value of the underlying assets (e.g., a significant appreciation in value of real estate);
• The total value of common shares was defined as a per-share value, which is inconsistent with the “total” value; and
• The formula was not adjusted subsequent to the corporate reorganization and the creation of Holdco, issuance of preferred shares, etc. Hence it did not relate to the value of the Holdco shares which were the subject of the dispute.

LESSON LEARNED

A shareholders’ agreement is not intended to be a static document. It can provide resolutions to conflicts within a company but can be unworkable if not prepared by experienced professionals and regularly updated.

The valuation formula in the shareholders’ agreement was poorly drafted and the agreement was never revisited after changes to the corporate structure. In the litigation process, the agreement was found to be invalid because the parties were not shareholders of Opco at the valuation date.

Involving a Chartered Business Valuator (CBV) in the process of drafting the shareholders’ agreement will give comfort regarding the valuation aspects. A CBV can help in setting and updating the buy-sell clause, particularly the price-setting mechanism, to avoid it becoming irrelevant with the passage of time.

The CBV will also assist in determining the fair market value (FMV) of the shares when needed for transactions, tax rollovers or in case of disagreements between shareholders.

Conclusion

When preparing a shareholders’ agreement, it is important to involve experienced legal counsel and to revise the document periodically to keep it relevant and updated. Shareholders would benefit from involving a CBV to set the buy-sell clause and to determine the price/value of the business at various points in time.

For more information, contact Catherine Tremblay, Partner, Valuation and Litigation Support, at 514.861.9724 or c[email protected] or Fatim-Zahra Souiri, CFA, Manager, at 438.469.4753 or [email protected]