Last week I met with two unrelated owners of an incorporated business. They were looking for guidance to prepare their business to deal with their death or disability.
How would their shares in the business be valued? When would this value be paid? How would the shareholders or the company finance these payments?
Typically, corporations are governed by provincial laws of the jurisdiction in which they were incorporated. Generally, these rules state that a corporation’s board of directors is elected by a simple majority of the votes attached to its issued and outstanding voting shares. Directors are generally responsible for managing or supervising the management of the business and affairs of the corporation.
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These default rules will apply unless shareholders have a contract or agreement in place that lays out the ground rules in advance of any dispute.
A problem with the general rules is that if a dispute arises, shareholders who have little or no board influence may turn to litigation, which can be costly and lengthy, to settle their differences.
For this reason, shareholders are encouraged to enter into a shareholders’ agreement, which is a contract between its owners to provide rights, responsibilities and remedies that do not always exist in the regulatory provincial or federal statutes.
Buy-sell agreements may be part of a shareholders’ agreement or may be treated as a separate agreement between the shareholders.
Mandatory buy-sell provisions, which are often referred to as shotgun clauses, are typically used when there are only two shareholders.
The shareholder wishing to trigger the mandatory buy-sell provision would send a notice to the other shareholder indicating his desire to buy all of the shares of the other shareholder at a specified price.
The shareholder receiving the mandatory buy-sell notice has only two choices: agree to sell his shares to the offering shareholder on the terms set out on the notice or buy the shares of the offering shareholder on the same terms.
The valuation provisions within a standalone buy-sell or shareholders’ agreement should provide clear and precise direction as to how the value of the shares will be determined. For new businesses, a pre-determined value may be the most appropriate.
Alternatively, the value could be determined based on a predetermined formula, such as a multiple of earnings.
Too often, agreements simply state that the value of the shares will be determined by a qualified business valuator or accountant.
In the business of farming, where there are appreciating assets such as farmland or equipment and livestock values in excess of cost, considerable money and time could be spent measuring the intended value of the shares.
My clients decided on a predetermined value for the goodwill or intangible value of the company.
Critics would argue that this negotiated value can become dated if it is not revisited annually. I would argue that an imperfect preset valuation now is always better than the perfect preset valuation that never arrives.
To ensure each of them has the money available to buy the shares of the other shareholder in the event of his death, my clients are obtaining crisscross insurance, with each individual shareholder undertaking to obtain and maintain a life insurance policy on the life of the other. The buy-sell agreement provides the surviving shareholder money to buy the deceased person’s shares.
I have used life insurance on myself and my siblings in my family’s farm corporation to ensure funds are available to finance the purchase of the deceased shareholders’ shares.
No one wants the deceased shareholder’s beneficiaries to suffer financial hardship. This may be the reality if the deceased’s estate is in the unenviable position of owing capital gains tax while not receiving proceeds for its shares.
Individuals who dispose of shares in a family farm corporation under a shareholders’ agreement may be eligible to claim the $750,000 capital gains exemption on the sale of these shares. The $750,000 amount refers to the whole capital gain rather than just the taxable portion.
A farming corporation must meet various active business tests to qualify for this exemption. It may not be eligible if it has too much invested in non-active business assets such as cash or off-farm investments.
To remedy this, it may be possible to reorganize holdings so shares do qualify. Accountants refer to this process as purifying the corporation.
It is important to note that there is no standard shareholder agreement appropriate for all circumstances. While an accountant can help with the valuation aspects of an agreement, a lawyer should be hired to ensure that the agreement is functional and meets the needs of its shareholders.
