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The addition of a new shareholder to an organization is a significant and important event that symbolizes a shared vision for future success. While the possibilities may seem endless and the potential for growth can outweigh any negative outlooks, bringing in a new shareholder can also lead to the breakdown of unity if all parties do not properly fulfill their responsibilities throughout the duration of the shareholder agreement.
A shareholder agreement is a contract between two or more parties that outlines their rights and obligations for a specific period. The agreement is intended to clarify operations. However, if the contract is poorly written, it can lead to confusion and result in costly legal fees upon dissolution as parties try to understand its meaning and application.
What could go wrong?
Signing an agreement is often seen as a mere formality. If something unexpected happens, the protections are documented, and individuals can refer back to the specific details. Many contracts are signed without a full understanding of their potential impacts, which may not be the fault of the signatories. While predicting the future is impossible, it’s still important to prepare for the worst.
Typically, the clauses of an agreement are scrutinized most often when they are presented for signatures and again when a ‘triggering event’ occurs. In an agreement, a “triggering event” refers to a specific incident that requires the involved parties to make a change in their approach. For example, if an agreement states that access to internal firm software should be revoked when an employee is terminated, then the triggering event would be the employee’s termination, and the necessary steps to remove access should be taken promptly afterward.
Frequent misalignments between day-to-day operations and the terms of the agreement are common but are not acceptable. The agreement should be revised to adapt to changes in methodology and process development. The longer the agreement is in effect, the higher the likelihood that the parties will lose focus on the original intentions of the agreement, making the document less relevant. All involved parties should regularly review the agreement to ensure it remains current and contains no ambiguous or outdated clauses.
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We recently conducted a financial investigation for a law firm that needed the assistance of a CPA to calculate the cash value upon separation for a managing attorney who separated from the firm. Both the law firm and the managing attorney believed that their arguments were valid based on the language of the shareholder agreement.
Many of the clauses in the agreement were contradictory and left each party with more questions than answers, and key terms used throughout the agreement were not accurately defined. Here are some concerning issues we uncovered:
- Gross revenues were mistakenly equated with profits
- Calculations and terms were not consistently presented
- No amendments were made since the agreement’s inception in 2014
- Daily operations did not mirror the shareholder agreement stipulations
- Clauses of the agreement had “dead ends” where they referred to irrelevant clauses
- Bonus payments were linked to performance, but the criterion was not clearly defined
The lack of preparation, communication, and accounting literacy on both parties at the inception of the agreement and throughout its life led to a hostile separation and an ongoing legal battle. All of these issues could have been avoided if the law firm and the shareholder considered the potential impacts of the agreement and corrected any deficient agreement clauses. Since our investigation was scoped to focus on the cash value upon separation, it is believed both the law firm and the managing attorney would have benefited from the assistance of a CPA firm to review the agreement and rehearse the strategy.
What can I do?
Below are six suggestions an organization and its shareholders should consider implementing to protect their interests and avoid any future disputes:
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Beware of the boilerplate
Just because it works for other companies does not mean it’ll work for yours. Consider the clauses of a generic agreement and determine if they are needed for your organization. Ensure the language is tailored to your needs.
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Define all terms
The terms and techniques can be open to interpretation if they are not well-defined and thought out. Take time to clarify what the agreement offers to all parties and avoid ambiguous terms or phrases.
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Be consistent
Your shareholder agreement should not dictate that it uses one method to calculate bonus payments, and then contradict that same calculation just a few paragraphs later. It seems simple, but make sure the presentation is consistent throughout the agreement.
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Rehearse the strategy
It may not feel necessary to review, but in the event a triggering event occurs, practice makes perfect. Write out the ramifications and steps you need to follow and be prepared for the worst.
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Record updates promptly
Make sure there is an amendment for any updates to the agreement and describe the methodology that must be applied. Ensure the updates are made on a timely basis and any issues are addressed and resolved promptly.
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Consult the experts
If you are unsure of proper accounting terms or legal practices, bring in the experts. A little guidance can save you and your interests down the road in the event of a shareholder dispute.
The introduction of a new shareholder to an organization represents a pivotal moment brimming with potential, yet it also brings to light the critical importance of a well-crafted shareholder agreement. While these agreements are often perceived as mere formalities, their impact on the longevity and unity of the organization cannot be overstated. As demonstrated by the recent issues encountered during our financial investigation, a shareholder agreement rife with ambiguities and outdated provisions can lead to significant disputes and costly legal battles. By adhering to these practices, organizations can better protect their interests, preserve unity, and navigate the complexities of shareholder relationships with confidence and clarity.
If you need further guidance or have any questions on this topic, we are here to help. Please do not hesitate to reach out to discuss your specific situation!
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.
