Checklist for Buy-Sell or Shareholder Agreements

January 2006

Purpose of this Checklist

This checklist is intended as a guide to raise discussion topics only, so that you will have considered some of the decisions that your professional advisors will require prior to drafting an agreement. Due to the complex legal and taxation issues involved, assistance from your Chartered Professional Accountant and legal counsel is always recommended.

Reasons for an Agreement

1. to provide for voluntary or involuntary departure of an owner;
2. to provide for death or disability;
3. to control management of the business;
4. to provide a problem solving mechanism;
5. to protect minority interests; and
6. to set out terms now to avoid future misunderstandings.

An agreement now will allow planning to avoid large taxation costs and professional fees at a later date.

Parties to the Agreement

Consider having all persons and companies sign the agreement that may directly or indirectly be affected to avoid later legal disputes. Consider all owners, their spouses (for matrimonial law reasons), and any related parent or subsidiary companies.

Management and Control

1. Specify who the directors and officers will be, if to be fixed, and the composition of any management committees.
2. What constitutes a quorum in a meeting? Who will have the casting vote in a tie; if there will be none, provide for arbitration in a draw.
3. Determine which matters will require unanimous consent; for example:
   • borrowing;
   • major purchases or leases (specify dollar values);
   • sale of all or part of the business;
   • business expansion (see h. below);
   • distribution of profits (bonuses, fees, dividends);
   • changes to the buy-sell agreement.
4. Will minutes be recorded for management meetings? If so, who will record them?
5. Who will be responsible for day to day management, including:
   • sales and marketing supervision;
   • project management;
   • production scheduling and control;
   • hiring, termination and supervision of employees;
   • signing cheques, purchase orders, and other documents;
   • banking and financial matters;
   • internal control procedures on accounting records.
6. Will shareholders be allowed to pledge their shares of the company for personal loan security?
7. What type of expenses will be reimbursed to owners involved in the business, such as rent for use of a home office, automobile expenses, business promotion expenses, etc? Who will approve these items?
8. What will be the business activities permitted by the owners to be carried on without further agreement?

Ownership

1. Will there be restrictions on transfers and/or new issues of ownership interests (i.e. partnership interests or capital stock?)
2. Provide measures for minority owners, such as the requirement for:
   • future share issues being proportionate to current holdings;
   • membership on the Board of Directors;
   • are unanimous decisions required for any specific items, such as sale of the business, new borrowings, business expansions etc? If so, define the terms and conditions of each scenario.
3. Consider family law implications. Discuss with you legal counsel the effect of marriage breakdown on share of ownership, and, from a business operations viewpoint, the possible effects in an unfavourable divorce settlement.
4. How will ownership transfers be financed:
   • life insurance or disability insurance (upon death or disability, respectively). (Determine type of insurance and whether to be personally owned on each others’ lives or corporate owned on all lives)?
   • self-funded from corporate or personal savings? (Determine how, and what controls over funding will be used.)
   • bank financing? How will you ensure adequate security will be available when needed?
   • over a period of time with installments on a fixed basis, or as a percentage of future profits until purchase is fully paid, for example.
   • issue of preferred shares redeemable by the company and/or by the shareholder in accordance with specific terms?
   • with payments to be fully taxable or treated as a capital gain to the vendor? i.e. consider allocations to goodwill, retirement allowances, consulting or wage payments, and/or to capital gains?
   • how will amounts other than the purchase/sale price be cleared, such as amounts receivable or payable to the business by the vendor (e.g. shareholder loans)?

Involuntary Transfers of Ownership

1. Will there be mandatory procedures (e.g. for sale to co-owners or temporary suspension of certain rights) upon:
   • death (consider life insurance requirements)?
   • permanent physical or mental incapacity (include a definition and consider disability insurance requirements)?
   • conviction for criminal acts or loss of professional licenses?
   • bankruptcy or insolvency (define insolvency in the agreement)?
   • divorce or separation where both parties are owners?
   • breach of the buy-sell agreement?
2. What procedures will occur for temporary disability (and how will it be defined)?
3. If life and disability insurance funding is to be used, obtain competitive quotes. Get an objective opinion on the amount of insurance and the type of policy needed.
4. During a disability, and until transfer of business ownership, if applicable, set out who will have responsibility for corporate decisions.

Voluntary Transfer of Ownership

1. How will existing owners be protected? Consider:
   • mandatory right of first refusal to remaining owners (on a proportionate basis?) at the same price as offered by any potential buyers. This allows existing owners to have first chance to buy the company at any particular price offered.
   • use of a “shotgun clause”, whereby an owner offering to buy full ownership must sell to the remaining owners at the same price if they do not wish to sell. This allows the first party to acquire the whole business and then sell it to an outside party, or to immediately sell it to the remaining owners.
   • use of a “piggyback” right for protection of minority owners, whereby a majority owner must require a third party purchaser to buy out all owners at the same price.
2. How will the business be valued? Consider:
   • use of a pre-established formula, thereby not requiring costly valuation procedures;
   • use of an outside appraisal consultant, such as a qualified business appraiser or the business’ auditor. Set out who will pay for such appraisals in the agreement;
   • income tax implications if not at fair market value.
3. Provide for notices to remaining owners, specified time periods for decision making and payments, and the procedures to be enacted in the event of default.
4. How will corporate owned life and disability policies be handled upon sale – retention by the company or transfer to the life insured?

Business Financing

1. Will all owners personally guarantee bank loans, if required? If not, what course of action will be taken if financing is required but unavailable without such guarantees?
2. Will provision be made for contributions of capital by owners? If so, will contributions be in proportion to ownership? Will there be interest paid on such advances, particularly if they are not proportionate? If so, at what rate? What steps will be taken if any owner withdraws excess amounts from the company?
3. Provide for indemnification of an owner where he/she is required to honor a guarantee or other legal claim on behalf of the business for more than his/her proportionate share.
4. Provide for payment of interest or guarantee fees to protect tax deductibility of losses to owners, if necessary.

Profit-Sharing Distributions

1. Will owners be paid specifically for the following (and, if so, how will such payments by determined):
   • working hours;
   • overtime hours;
   • investment of pre-startup time and costs;
   • startup equipment contributed to the business;
   • special expertise or customer/supplier contacts;
   • involvement of family members;
   • financial capital contributed (see Business Financing above).
2. When will payments be made?
   • base wage on a regular basis?
   • only after attainment of certain cash or working capital balances?
   • after repayment of unequal capital contributions or shareholder loans?
   • who will make the decision?
3. What form will payments take (consider an annual determination based on tax advice):
   • salary, wages, bonuses;
   • interest on balances owing;
   • dividends;
   • management fees?

Non-Competition Agreements

1. Specify whether a departing owner will be allowed to compete. If not, specify for how long and within what area?
2. Will current owners be able to have other outside business interests and investments, or only with permission from other owners?

Other Matters

1. All owners should be required to have wills, with their executors being advised to carry out the provisions of the buy-sell agreement and to obtain professional tax advice with respect to procedures to be enacted.
2. How often will the buy-sell agreement be reviewed to consider updates or changes in the law or personal circumstances?
3. Ensure all share certificates of companies are marked as being subject to the buy-sell agreement.
4. To allow flexibility, allow use of holding companies in addition to direct ownership by individuals, but ensure the same restrictions are stated for trading, assignment or hypothecation.
5. The valuation formula in the agreement should exclude life insurance proceeds from valuation of shares to avoid an increase in value at time of death.
6. Corporations owned by the shareholders can be associated if there is an option to purchase shares on partial disability, receivership, shares attached under a matrimonial property settlement or retirement of a shareholder, resulting in possible loss of the low tax rate. Such options do not create association upon death, permanent disability or bankruptcy.
7. If the agreement provides for insurance to fund death and disability, ensure the polices are put in place when the agreement is finalized.
8. If a buyout is not completely funded, ensure there is a provision for security until full payment is made.
9. Where shareholdings are unequal, will the buyout provisions result in a change of control? If so, you may wish to consider alternatives if this is not the desired outcome.
10. If parties are not dealing at arm’s length (i.e. they are related), the purchase price in the agreement must be fair market value at the time it is executed to avoid unfavourable tax consequences (Information Circular IC-89-3).

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Blair Corkum, CPA, CA, R.F.P., CFP, CFDS, CLU, CHS holds his Chartered Professional Accountant, Chartered Accountant, Registered Financial Planner, Chartered Financial Divorce Specialist as well as several other financial planning related designations. Blair offers hourly based fee-only personal financial planning, holds no investment or insurance licenses, and receives no commissions or referral fees. This publication should not be construed as legal or investment advice. It is neither a definitive analysis of the law nor a substitute for professional advice which you should obtain before acting on information in this article. Information may change as a result of legislation or regulations issued after this article was written.©Blair Corkum