Canada: Rules In Private: Part II

Governance at private companies can be simple. But when stakeholder interests aren't aligned, a company begins to slide into the realm of independent directors and shareholder agreements.

Private companies often require very little governance. But as a business begins to emerge from obscurity and attract an increasing number of investors, it may become desirable to introduce new measures. These are represented by an agreement signed by shareholders called a "unanimous shareholders agreement" (USA).

Aside from determining to some extent how the company will be managed, USAs typically contain provisions affecting shareholders' ability to sell or retain stock. Firstright provisions, for example, give some or all existing shareholders the opportunity to buy any stock proposed to be sold, whether prior to its offering (right of first offer) or prior to the completion of a sale (right of first refusal). Tag-along rights allow some or all shareholders to participate (usually in proportion) with shareholders who are permitted to sell and have agreed to do so.

Complex negotiations are common in USAs, given that some investors want to restrict founder liquidity, either with a view to maintaining entrepreneur "hunger," or on the basis that no one should enjoy a superior liquidity right. Founders, however, can often argue on the basis of being early investors who have taken the company to a new level and who will continue to maintain a meaningful stake. Sometimes founders negotiate for the right to sell some percentage of their holding (typically 25 to 35 per cent) free of tag-along, first-refusal or other significant restrictions.

The USA also typically provides that a total sale of the business can be approved by some agreed percentage of the shareholders. The threshold is often set so that no shareholder or class of shareholders can determine the matter. (A two-thirds approval requirement, after all, provides little protection if the founder owns 75 per cent.) So it may be the case that 75 per cent of all shareholders, including 51 per cent of the class of preferred shareholders, can commit to a sale of the entire business.

Similar control issues arise with respect to amendment or termination of the agreement. USAs usually terminate on completion of a liquidity event (such as an IPO or merger), or when one shareholder buys all of the shares, or when all of the shareholders simply agree to a termination.

Although a USA is by definition an agreement among all shareholders, requiring unanimous consent to amend or terminate the USA is unwise. While there is always the risk of a rogue shareholder attempting to leverage a situation, the more realistic risk is the difficulty of obtaining 100 per cent shareholder approval in a timely manner. As a result, USAs often include provisions allowing for amendment or termination by a suitable majority. It is important that the amendment provisions in particular be very clear about what the required majority is and what sorts of amendments may be permitted.

Any of a great number of the terms of the USA may require amendment, and it may even be, in the context of a later financing, that the USA will need to be replaced entirely. As such, it's better to provide a blanket right to amendment with the required majority rather than constrain the right in any way. Any limitations may create difficulty for a law firm required to provide an opinion, or for the other side of a transaction that is being asked to rely on the amendment power. The oppression remedy is available for any shareholder inappropriately addressed by the use of the amendment power.

A well crafted USA can be an important element in the evolution of private-company governance, but there is no one-size-fits-all solution. Founders and early-stage investors should be sure to get advice from counsel experienced in what are often complicated matters.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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