A properly drafted shareholders' agreement protects the interests of both the controlling shareholders and the minority shareholders. A shareholders' agreement may contain any number of specific clauses, rights and obligations. Here, we explore five of the most common clauses in a shareholders' agreement.
a) Shot Gun Clause
A shot gun clause allows a shareholder to offer to sell his/her shares to another shareholder at a price and on the terms dictated in the offer. The shareholder receiving the offer may either accept the offer and acquire the shares of the offering shareholder at the price and on the terms stipulated in the offer or reject the offer which requires the shareholder receiving the offer to sell his/her shares to the offering shareholder at the price and on the terms stipulated in the offer. This clause is also referred to as a reciprocal buy-sell clause. It provides liquidity and control over who can acquire an equity interest in the company, while providing an exit strategy for shareholders when specific triggering events do not apply.
b) Hard Right of First Refusal
In order to protect the rights of shareholders looking to divest of their interest, as well as those of the remaining shareholders, shareholders' agreements often contain right of first refusal clauses. A hard right of first refusal requires a shareholder looking to divest of their interest to solicit offers from third parties; they must then present the offer to the remaining shareholders. The remaining shareholders are then given the opportunity to purchase the shares at the same price and under the same terms as the offer presented. Should the remaining shareholders decide not to make an offer, the selling shareholder may sell the shares at the price and under the terms stipulated in the offer. This right typically favours the shareholders holding the refusal right as a third party acquirer will rarely spend the time considering a potential acquisition when faced with a superseding right of first refusal.
c) Soft Right of First Refusal
A soft right of first refusal requires a shareholder looking to divest of their interest to present a price and term of sale to the remaining shareholders. If the shareholders holding the right of first refusal do not elect to acquire the shares at the stipulated price and under the terms specified within an agreed time period, the selling shareholder is free to sell his interest to a third party at a price and under terms no more favourable than those offered to the remaining shareholders. The soft right of first refusal typically favours shareholders looking to divest of their interest. In the event the offer is not accepted by the remaining shareholders they are free to solicit third party offers without concern of the rights of refusal of the remaining shareholders.
d) Drag Along Provision
Many purchasers of a privately held company will only finalize the transaction if it allows them to acquire 100% ownership. In cases such as these the majority shareholders would not want to see a deal stalled by one or more minority shareholders who are not interested in selling their shares. A drag along provision stipulates that if a third party offer for all of the outstanding shares of the company is acceptable to the majority shareholders, all of the shareholders are required to sell their shares at the price and on the terms dictated in the offer. This provision is also known as a mandatory sale clause and provides liquidity to the majority shareholders.
e) Tag Along Provision
A tag along provision offers the non-selling shareholders the opportunity to force the purchaser to acquire not just the majority shareholders' shares but all of the shares. The minority shareholders' interest would be purchased at the same price and on the same terms as the majority shareholders. This type of clause protects the minority by allowing them to sell if the majority is being sold to an incompatible third party. This provision is also known as a coattail provision.
In conclusion, in preparing a shareholders' agreement, business owners ought to be aware of the mechanisms available to them to protect their ownership interest and the liquidity of their investment. When drafting shareholders' agreements, shareholders should consider the potential benefits the five foregoing clauses may provide.
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