Davis Clark thought he had everything covered. When he took on a partner in his Toronto-area service company 10 years ago, he drew up a shareholders' agreement setting ground rules for how the firm would be owned and managed. Clark (not his real name) even put in a proviso that he could never be bought out, although he could buy out his partner.
Yet Clark learned the hard way that it's not always what shareholders' agreements cover that causes problems; it's what they don't cover. Clark's agreement lacked a non-compete clause if he were to buy out his partner, as Clark decided to do last year. That left the partner free to use the buyout money to finance a rival business and compete for Clark's clients. Clark was also on the hook for severance for his partner and his partner's wife, who had played a role in the business.
Negotiations over the buyout were so rocky they took eight months and cost $50,000 in legal fees. All the while, says Clark, "My partner was making his executive salary and getting all the executive perks, which made me sick because he wasn't even working. If this kind of thing had happened in my marriage, I'd have probably jumped off a bridge."
The situation could have been even worse if Clark hadn't had a shareholders' agreement at all. Most SMEs never get around to creating the business equivalent of a marriage prenup—an oversight that can prove disastrous if big problems arise between the partners. These agreements can be useful in determining, say, what you'll do with a little extra profit and who can spend how much, and when. But where they really prove their worth is if the partners' relationship goes sour and someone wants out—or wants the other partner out.
"The best shareholders' agreement is one you never pull out, but it's there if you need it," says Ted Pease, a partner at Brantford, Ont.-based McIntosh & Pease, whose specialties include corporate law. Pease says the key is to think about the major issues and create an agreement before the business gets going.
"It can be devastating if the partners don't get around to it and then one of them dies or gets sick, or they start fighting," he says. "It's really difficult to negotiate a shareholders' agreement when you're fighting."
At that point, winding up the company may be your only option. But that usually has adverse tax consequences, says Pease, because you haven't planned a proper exit strategy. Another poor option is to battle for control in court, which is expensive and has a highly uncertain outcome.
Lisa Shepherd is glad she took the time to craft a shareholders' agreement without the sort of holes that caused Clark so much grief. Shepherd owns a Toronto-based marketing consultancy that's now thriving. But in 2006, the president of The Mezzanine Group found herself stuck with a partners' group that just couldn't agree on what to do next. The four partners were at loggerheads over how much to pay themselves and how much to plow back into the business. And they hadn't been getting along for about six months, making consensus even less likely.