Essential elements of a partnership or shareholder agreement
Essential elements of a partnership or shareholder agreement
In my last article about the viability of partnership, I wrote about the difficulties of managing partnerships. In this article, I will focus more on the legal aspect and how agreements between partners (and shareholders) can help mitigate some of the challenges partners (and shareholders) face when building a business.
When two or more individuals work together in business, whether as partners or shareholders of a corporation, they enter into a legal relationship with each other whether they sign an agreement or not.
For the purposes of my last article, I lumped partners with shareholders. In this article, I will be a little more careful about distinguishing the two, because legally speaking, these are two separate concepts governed by two separate acts or laws.
The Partnership Act of Manitoba governs partnerships. Partnership arise when two or more individuals work together with a view of making a profit. They can arise intentionally if the partners agreed they would form a partnership or they can arise unintentionally when two or more individuals start working together on a project.
For example, if you are a carpenter and you work with another carpenter to build a spec. home and you share the costs of building and the profit once the home is sold, you are likely partners even if that wasn’t your intention when you started out.
The Corporations Act of Manitoba governs corporations and their shareholders. Corporations are legal entities. You can read more about the advantages and disadvantages of creating a corporation here . So, rather than partnering with someone else to work on projects with a view of making a profit, the “partners” can incorporate a company whereby they are both shareholders. The newly incorporated company would be the legal entity performing the projects and making the profits. The profits can then either be re-invested in the corporation or distributed to shareholders as dividends.
In partnerships, the partners are still separate entities within the partnership. They must submit their own individual income tax return. So, if a partner is not incorporated, then he or she is equivalent to a sole proprietor. All the profits become income and must be reported.
However, despite being solely responsible to Revenue Canada, a partner remains liable for anything that happens to or in the partnership. So if your partner does something that attracts liability, you automatically become liable. Partners can create liability because each partner can legally bind the partnership.
Conversely, when two individuals create a corporation, the corporation becomes legally responsible. The directors can bind the corporation (typically, when two shareholders create a company, they name themselves as directors.) As in partnerships where each partner can bind the partnership, each director can bind the corporation. However, the director rarely becomes liable personally. Only the corporation remains liable.
If something drastic occurs where the corporation does not survive (i.e. a lawsuit that leads to bankruptcy), then the corporation goes bankrupt. The shareholders do not, and their personal assets are protected. Whereas a partner would remain personally liable and risk losing his or her home and other personal assets.
As I previously stated, agreements can’t make partners or share owners get along. These are blunt instruments of last resort. When two parties can’t agree anymore, they pull out the contract or agreement that outlines the remedies available. In that way, they are like insurance policies. You don’t need them until something goes wrong.
However, agreements do provide the parties an opportunity to consider remedies in the event of discord while they are still on good terms. In addition to giving the parties remedies when the relationship falls apart, this aspect of negotiating an agreement informs the parties before hand of the possible consequences of their future behaviour. If you know that you can lose your ownership stake in the business because of an estranged relationship with your business partner, you will likely work harder to maintain that relationship in the first place.
Both partnership and shareholder agreements share common clauses. A good agreement should address the following issues:
- Partners or shareholders (I will refer to partners or shareholders as Parties for the rest of this article) must unanimously agree when binding the organization to any contract worth more than a specified amount;
- Parties must unanimously agree when making changes to the structure of the organization or when adding new Parties;
- If a Party does something that causes liability to another Party, that party should indemnify the innocent Party or Parties;
- A process to valuate an ownership stake and to buy out a Party;
- A process to prevent Parties from transferring or selling their stake to another Party without the approval of all Parties;
- A right of first refusal to all Parties if one Party wants to sell its stake;
- A process to resolve a conflict if the Parties become estranged, sometimes referred to as a “shot gun” clause;
- A process to deal with the death or disability of one of the Parties; and
- If a Party invests funds in the organization, how that party withdraws those funds.
These are general guidelines. The contract itself should be thorough and consider a number of things including the possibility that a Party may simply refuse to engage. What do you do when a Party does not respond to letters or signs documents? (You can create a power of attorney in the document itself that allows another Party to act on behalf of the negligent one)
So while a written agreement won’t undo a relationship gone bad, it will provide parties with a roadmap while they are still in agreement. That road map will also serve as notice to a Party and likely influence his or her decisions which will hopefully motivate everyone to remain on good terms. If that proves impossible, it will pave a road out.
If Parties fail to create an agreement, then the common law and the statutes take over. Which means that a court must impose a settlement. As previously written about here, litigation takes time and costs money. Few small corporations or partnership actually survive litigation.
Philippe Richer is President of TLR Law Group. TLR has been located in the St. Boniface neighbourhood, in Winnipeg, since 1996. The office serves the middle class and small business within the province. With a focus on estates, wills, real estate, and corporate law, he leads his team in providing accessible legal services. Philippe also authored the business law course for the Knowledge Bureau and instructed the français juridique class at the faculty of Law at the University of Manitoba.