DAVIES ACADEMYDAVIES ACADEMY – for continuing legal education

April 21, 2010

Pitfalls in Shareholders Agreements

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Purpose of Shareholders Agreement

Governs Relationship Between Parties• Running of business• Relationship between current and future shareholders

– Majority owes no duty to minority under corporate law

• Restrictions on powers and responsibilities of directors– Shareholder approval rights (vetos)

• Restrictions on transfer of shares and exit rights• Dispute resolution mechanism

– Avoid deadlock

• Agreement customized to other specific needs on a case by case basis

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Other Initial Issues

• Understand the business and the needs of the shareholders• Who prepares the agreement

– Conflict issues• Unanimous Shareholders Agreement

– DefinitionsSection 146 CBCASections 123.91 – 123.93 QCASections 213-220 BCA

– Parties: holders of non-voting shares and third parties?– Amendment – Preemptive rights

Section 55(2) BCA: Shareholders have no preemptive right in respect of shares to be issued (i) for a consideration payable in property or services, (ii) as a share dividend or (iii) pursuant to the exercise of conversion rights or options

– PublicityExistence Termination

– Enforceability against and cancellation by a new shareholder– Access: by shareholders and creditors

• Intuitu personae rights

Tips:• Consider having 2 shareholders agreements

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Corporate Governance

Board of Directors• Board representation• Who comprises the board?• What does the board generally do?• How do you get on (and off) the board?• Directors’ liability• Material decisions

– Majority, super-majority, unanimity, hard vetos on specific matters– Directors or shareholders

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Veto Rights

• Type of actions or decisions where shareholder approval rights may be desirable: – Structural

– the change in the number of directors of the company– the change in the maximum number of shares that the company is authorized to issue– the dissolution of the company– the winding-up or bankruptcy of the company– the amendment, adoption or repeal of any of the company's by-laws or articles

– Operational– the making of any contract by the company outside of the ordinary course of business – the making of any contract by the company involving an expenditure in excess of a threshold amount – the appointment of signing officers for the signature or endorsement of all cheques, etc. for the payment of

debts of the company or for the withdrawal of funds– the engagement of any person with an aggregate salary or other form of remuneration in excess of a

threshold amount per annum– the appointment of auditors, lawyers or bankers of the company– the appointment of officers of the company– any agreement with a shareholder or a person acting at non-arm's length with a shareholder– any agreement to borrow money, grant an indemnity or provide a guaranty– any material deviation from a budget or business plan

– Mixed– the issue of shares, share purchase warrants or options for shares of the company or the transfer of shares

[other than as contemplated in the agreement]– the amalgamation of the company– the granting of a hypothec on the company's assets or any part thereof– the sale, transfer or assignment of any asset (or assets) of the company having a value in excess of a

threshold amount – the entering into of any partnership or joint venture with any other entity– the declaration of dividends by the company

• Approval threshold: majority, super-majority, unanimity– At shareholders or board level

• Majority shareholder vs. minority shareholders

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Future Financial Requirements

• Cash call–Failure to fund–High interest loan–Dilution–Forced sale

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Future Financial Requirements

• Preemptive rights–Issuance subject to veto rights?–Usual exceptions: convertible securities, stock option plan, [securities as

consideration for services or otherwise, dividends]Section 55(2) BCA

–Proportional subscription vs. based on highest desired subscription

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Facilitating or Impeding Exits

• Transfer of securities or titles of indebtedness• Right of first opportunity and/or right of first refusal• Tag along (piggy back)• Drag along (take along)• Put/call • Shotgun• Buyback/redemption (Dissent Rights)• Forced Exit Rights (Death, Disability or Termination)

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Transfer of Securities or Titles of Indebtedness

• Restrictions–Standstill–Define “Transfer”–Exclude liens–Targeted securities–Cover securities of corporate shareholders?–Competitors

• Permitted Transfers–Affiliate–“One voice” concept–Re-transfer–Other exit mechanisms provided–Consent–Terms and conditions

• Liens and realization

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Right of First Opportunity

ROFO vs. ROFR:• More vs. less liquidity• Before going to the market vs. after having obtained an offer

Purpose:• Market shares to other shareholders before seeking third party buyers• Enhanced liquidity for seller• Streamlined sale mechanism

Watch For:• Loss of control over who your co-shareholders are• Difficulty determining the market price• Tag-along rights

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Right of First Refusal

Purpose:• Bring other shareholders a marketable (third party) deal to match• Keep shares “in the family” (and undesirable shareholders out)

Watch For:• Define “Offer”: good faith third party, cash or “near-cash” consideration and no

asset up for sale other than shares (and titles of indebtedness, if applicable)• Additional delays, which may be good or bad depending on who you act for• Negative impact on liquidity• Potential third party acquirors may not take you seriously• Increased cost• Difficulty matching the price if non-cash consideration is offered• Tag-along rights

Tips:• Break Fee or Expense Reimbursement

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Right of First Opportunity/Refusal: Unexercisable Right?

• Exercising a right of first opportunity/refusal may be impossible as shareholders have to find potentially large sums of money on short notice to exercise

• What if not all offered shares are picked up by the beneficiaries of the right?–Multiple rounds–Partial or total sale

• Must deal with shares of other classes as well as convertible securities and titles of indebtedness

–Stapled?• Cooperation obligation on the part of the company and the other shareholders

–Due diligence dataroom–Lenders and third party purchaser to have access to due diligence materials–Confidentiality agreement–Obtaining waivers or releases under guarantees

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Tag-Along Right

Purpose:• Allow shareholders to sell their shares along with the selling shareholder• Reduces one major source of illiquidity for minority shareholders• Protects against desertion

Watch For:• Proportionate rights versus add-on rights• You may never get out of the company vs. decreased liquidity for partial sale• Additional delays• Interrelation between tag-along and other exit mechanisms

Tip:• If you give a tag-along, seek a drag along (majority shareholder)

• If you give a drag along, seek a tag-along (minority shareholder)

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Drag Along Right

Purpose:• Allows a (super-) majority of shareholders to compel reluctant (minority)

shareholders to sell• Compelling others to sell increases liquidity• More likely to find a purchaser who desires all rather than less-than-all shares

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Drag Along Right (cont.)

Watch For:• Determination of appropriate percentage to trigger the drag• Unfavourable valuation or different cost base• Allocation of value among the classes and convertible securities• Bad timing• Tax consequences• Interrelation with ROFR• Power of attorney for “dragees”• Location of share certificates• Non-cash consideration (including service (consulting) agreements)• Non-competition covenants• Liability for representations and warranties

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Put/Call

Put• Against another shareholder (retraction if against the company)• Interrelation with other exit mechanisms• Timing• Pricing and payment• Tax consequences: capital gains vs. deemed dividends• Creation and duration of the rights

Call• In favour of a shareholder (redemption if in favour of the company)• Timing (potential conflict with other exit mechanisms)• Pricing and payment• Tax consequences

Watch For:• Change in control (e.g. bank covenants)• Solvency tests• Terms of transaction: notice, delays, date and place of closing, etc.• Financial (or accounting) consequences

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Shotgun

Purpose:• Rapid “solution” to a deadlock• Straight forward approach to eliminate a shareholder

Watch For:• Imbalance• Works best when there are only two equal shareholders

Likely easier for a party with 90% to afford to pay for the other party’s 10% than the inverse• Shareholder with a weak financial or strategic situation is vulnerable• Operator vs. investor disparity• Important financial risk• You can lose all your interest in a company that you want entirely for yourself• An offer for shares that is substantially lower than your perception of their value may have to be

accepted if the shareholder does not have the liquidity to buy even at that price• Hostile environment: importance of being precise (e.g. notice)• Absence of representations and warranties

– A real risk to a non-management investor• Anti-flipping protection• Minimum price• Titles of indebtedness of the company held by shareholders and guarantees given by shareholders• Tax consequences

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Buyback/Redemption (Dissent Rights)

Purpose:• “Easy” way to liquidate a position if the company has the liquidity• Keep management in check through the threat of exercise

Watch For:• On its face, it is a cash exit but can be impacted by

– Solvency testsAs in the CBCA, the accounting test is not included in the BCA

– Absence of liquidity by the company– Loss of veto rights and board representation– Bank and other lenders usually require subordination

• Deterrent for future investors due to fear that redemption rights will be exercised• Tax consequences

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Forced Exit Rights (Death, Disability or Termination)

Purpose:• Provide liquidity to deceased, disabled or terminated shareholder who was active in the

business• Provide for distribution of life insurance proceeds payable to the company• Avoid participation in the growth of the company by non-active heirs of formerly active

shareholders or by disabled or non-participating shareholders

Watch For:• Determination of fair market value• Option to sell or requirement to sell• Timeline for the process• Security for purchase price• Tax consequences

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Valuation: A Question of Value

• Valuation may be an agreed value or a method of assessment–If an agreed value is used, problems arise if the actual value is vastly different from

the original value stipulated in a long-ago formulated shareholders’ agreement–If a method of assessment is used, transaction costs and delays increase dramatically

• How will the assessed value of a company be applied to the different classes of shares?

• Death or other departure of a shareholder• Human nature – annual determination of value – will it happen? What if it does

not?• Difficulties dealing with:

–Liquidity discount–Control premium–Minority discount

Watch For:• Unenforceability of discounted price in an insolvency situation

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Life Insurance

• Shareholder: key-individual• Death of a shareholder• Payment of insurance premium• Beneficiary(ies): company or the other shareholders

–Tax consequences: deemed dividend vs. capital gain–Insolvency/subordination

• Trustee• Assignment: prohibited or permitted in favour of a creditor or an exiting

shareholder• Notice to insured if termination or amendment• Exclude insurance proceeds from enterprise value

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Example of Application of Life InsuranceProceeds

• Assumes two equal (50-50) partners• Value of business prior to death: $20 million• Proceeds of life insurance: $10 million• Value of business immediately after receipt of life insurance proceeds:

$30 million• Buyout price of deceased shareholder:

– $10 million (life insurance proceeds) or– $15 million (fair market value)

• Implication:– if $10 million, surviving shareholder gets $20 million of value (assuming no diminution in value on death)– if $15 million, business needs to come up with $5 million on top of life insurance proceeds to buy out deceased shareholder

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Other Relevant Provisions

• Boilerplate/standard clauses–History/case law–Time of the essence–Notice and business day–Severability–Entire Agreement

• Sunset–Term–Percentage

• Books of account and auditors• Confidentiality• Non-competition/Non-solicitation• Alternative dispute resolution mechanism and/or court• Choice of law

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Anti-Dilution MechanismsA Final Word of Caution

• Investors often require anti-dilution protection• Classes of shares: common vs. preferred• Exchangeable /convertible shares• Types of clauses:

–full ratchet (fully maintains percentage or price)–weighted average ratchet–pay to play

• Understanding what is required before signing the term sheet: can be very costly for the company and/or any existing shareholders who do not have these rights

• Triggering Events–Automatic conversions/exchange–Exchange at the option of the shareholder–Excluded events–Winding up

Questions

Thank you

This presentation will be available for download at www.dwpv.com/academy

Sébastien Savage

ssavage@dwpv.com

514.841.6532

Justin D. Vineberg

jvineberg@dwpv.com

514.841.6533