You have started a business and have decided to raise capital by issuing equity. You want to incentivize early investment so you offer to protect potential shareholders’ shares by creating A Shareholders’ Agreement that would ensure their ownership stake is protected. A Right of First Refusal (“ROFR”), Pre-emptive Rights, or Piggyback Rights seem like the perfect forms of protection and incentive. However, if you are not careful, they can create overly restrictive share transfer abilities and discourage future investment. If you want to impose restrictions on the ability to transfer shares, then it is important that you understand the purpose of those restrictions and how you can draft them so they are not overly restrictive.
 
Rights of First Refusal
A ROFR requires any shareholder intending to sell their shares (“Intending Shareholder”) to first offer them to their fellow shareholders or the company[1]. ROFRs also grant shareholders the ability to control who their fellow shareholders are. It is a reasonable device to prohibit the sale of shares to competitors as long as it is not too onerous or time-consuming.
 
There are two kinds of ROFRs. The first kind, a Hard ROFR requires the Intending Shareholder to acquire a bona fide offer from a third party to acquire their shares before shares are offered to fellow shareholders.[2] The second kind of ROFR is a soft ROFR, which permits the Intending Shareholder to first offer the shares to the other shareholders, and then, if not taken up, offer them to third parties at the price offered to the other shareholders or higher.[3]
           
Hard ROFRs can make it difficult for shareholders to sell their shares because a potential third-party investor can easily lose a deal. Soft ROFRs are less restrictive because they must be exercised before any potential third-party purchaser is identified. If a ROFR is going to be included in a Shareholders’ Agreement, a Soft ROFR would provide more flexibility for shareholders to sell their shares.[4] Further, regardless of what sort of ROFR is implemented, the ability for shareholders to sell a certain percentage of their shares before the ROFR is triggered is a reasonable and effective addition to a ROFR.
 
Pre-emptive Rights
Pre-emptive Rights provide current shareholders with the right to participate in future financing and are frequently included in early-stage Shareholders’ Agreements. This right to buy future shares can be used to protect early investors’ shares from being diluted when a company decides to issue more shares.[5]
 
While the use of Pre-emptive Rights can be beneficial to shareholders, it can also serve as an obstacle to a company looking to attract investment from outside investors. The injection of non-professional investors into financing can result in an inability to provide a workable structure that includes Venture Capitalists, and as a result, stunt the growth rate or ability of a company.
 
If Pre-emptive Rights are to be used, they should be accompanied by either or both a Sunset Provision and a Pay to Play Provision. A Sunset Provision would provide the Pre-emptive Rights only for the period the shares are cheap and early stage capital is being raised.[6] In other words, the Pre-emptive Rights Provision would terminate after a certain period of time (For example: two years after the execution of the Shareholders’ Agreement). A Pay to Play Provision requires existing investors to invest on a pro rata basis in subsequent financing rounds or they will forfeit certain or all preferential rights.[7] This discourages the strategic use of Pre-emptive Rights in future financing rounds.
 
Piggyback Rights[8]
A Piggyback Right requires that an Intending Shareholder permit other shareholders to sell their shares along with it on a pro rata basis. The rational for this device is to ensure that shareholders with this benefit can exit a company at the same time and rate as the shareholder subject to the right. The issue with a Piggyback Right is that it can delay and drag out potential sales of shares because they require a notice period (to the other shareholders), and a buyer for more than one shareholder’s shares must be found. This can discourage not only potential buyers, but also shareholders, due to the difficult tasks of finding purchaser(s).

​Piggyback Rights should be used with caution, and potentially limited to irreplaceable executives and majority shareholders.[9] It shouldn’t matter if an indifferent shareholder decides to sell their shares, however, if an executive shareholder decides to sell all their shares, then other shareholders should have to opportunity to sell their shares as well as this could be an indication that the company’s value is going to decline.
 
Conclusion
Many forms of restrictions on the ability to transfer shares exist. ROFRs, Pre-emptive Rights and Piggyback Rights are but a few such restrictions that can be used to protect shareholders. However, if these provisions are included in Shareholders’ Agreements without understanding how they may implicate the ability to transfer shares, it can halt a company’s ability to attract investment in the future. If restrictions are to be imposed on the ability to transfer shares, they should be included in a manner that does not make their application absolute and avoids barriers that make the ability to transfer shares too onerous or impossible.
 
For more information contact the BLG Venture Clinic.
 
Suleiman Semalulu is member of the BLG Venture Clinic and is a third-year law student at the Faculty of Law, University of Calgary.

References
[1] Bryce Cyril Tingle, Start-up and Growth Companies in Canada: A Guide to Legal and Business Practice, (Canada: LexisNexis, 2018) [Tingle].
[2] Sara C. Pender, “Canada: Five Beneficial Clauses To Consider When Drafting A Shareholders’ Agreement” (July 19, 2013), online (blog): Mondaq < http://www.mondaq.com/canada/x/252080/Shareholders/Five+Beneficial+Clauses+To+Consider+When+Drafting+A+Shareholders+Agreement>.
[3] Ibid.
[4] Tingle, supra note 1.
[5] Joshua Kennon,” Understanding Shareholders Pre-emptive Rights” (February 8, 2019), online (blog): Investing for Beginners < https://www.thebalance.com/what-is-the-preemptive-right-358100>
[6] Tingle, supra note 1.
[7] Ibid.
[8] Ibid; Shanlee von Vegasack, “A Brief Introduction to Unanimous Shareholder Agreements” online (blog): BD&P < https://www.bdplaw.com/content/uploads/2016/06/Shareholders-Agreements.pdf>.
[9]  Tingle, supra note 1.

There is no “one size fits all” solution available when a new venture requires a shareholder agreement. The question of whether a Unanimous Shareholder Agreement (“USA”) should be used over a conventional shareholder agreement is one that entrepreneurs should consider when the time comes to put a shareholder agreement in place. This question is also likely to spark a debate (although, not a particularly exciting one) among lawyers. This blog post sets out to explain the main differences between USAs and conventional shareholder agreements.
What is a USA?
USAs are a creature of statute. It is imperative that entrepreneurs turn their minds to which statute their business is incorporated under, as this will determine whether their agreement amounts to a USA. The corporate statutes in all provinces except British Columbia and Nova Scotia contemplate the existence of USAs. The Canada Business Corporations Act (“CBCA”) defines a USA as being:
An otherwise lawful written agreement among all the shareholders of a corporation, or among all the shareholders and one or more persons who are not shareholders, that restricts, in whole or in part, the powers of the directors to manage, or supervise the management of, the business and affairs of the corporation....[i]
In contrast, the Alberta Business Corporations Act (“ABCA”) defines a USA as being:

1. a written agreement to which all the shareholders of a corporation are or are deemed to be parties, whether or not any other person is also a party...

that provides for any of the matters enumerated in section 146(1)....[ii]
These matters include the rights and liabilities of the parties, election of directors, management of the corporation’s business and affairs, or restriction of director powers.[iii] It is worth noting that it is possible to inadvertently enter into a USA by satisfying one of the statutory definitions above. If, for any of the reasons that follow, an entrepreneur does not want to create a USA, the shareholder agreement should explicitly state that it is not meant to be a USA.
How are USAs Different than Conventional Shareholder Agreements?
USAs are unique in that a person can become a party to the USA without signing it. If a USA is in effect when a person acquires a share of the corporation, that person is deemed to be a party to the agreement and will be bound by it.[iv] This means that those who invest in future equity financings carried out by a corporation will be bound by a USA (if one exists).
Another important distinction is the fact that, when the shareholders are exercising powers that have been transferred from the directors, they are subject to the same fiduciary duty attracted by directors in the ordinary course of their business. A consequence of this is that shareholders making decisions in place of the directors will lose their ability to pursue their own interests.[v] Shareholders acting in place of directors pursuant to a USA must act in the best interests of the corporation.[vi] In contrast, shareholders that are a party to a conventional shareholder agreement are free to act in self-interested ways.
Finally, it is often much more difficult to amend or terminate a USA in comparison to a conventional shareholder agreement. For CBCA corporations, it is uncertain as to whether a court would uphold the termination of a USA executed by any fewer than all the shareholders.[vii] The amendment or termination of a USA in the context of ABCA corporations certainly requires the consent of all shareholders.[viii] Termination provisions in conventional shareholder agreements can have a much more relaxed structure.
When Should a USA be Used?
Generally speaking, start-up growth companies should steer clear of USAs; however, there are certain situations in which a USA may be advantageous.
Firstly, a corporation may anticipate a turn of events that will result in a significant amount of its shares being widely held by individual investors – in this situation, a USA would provide an effective means to bind each one of these new shareholders to the terms of the corporation’s shareholder agreement.[ix]
Another situation in which the creation of a USA may be advisable is when a corporation whose shares are held primarily by non-Canadians wishes to be classified as a Canadian Controlled Private Corporation (“CCPC”) for tax purposes. If Canadian resident shareholders possess the right to appoint a majority of the board of directors by virtue of a USA, the corporation will qualify as a CCPC despite the fact its shares may be owned primarily by non-residents.[x]
Again, USAs are often not advisable for use in start-up growth companies mainly due to the fact that both current and future shareholders are bound by them. Conventional shareholder agreements provide a higher degree of flexibility and allow shareholders to consider only their personal interests.

Thomas Machell is a member of the BLG Business Venture Clinic and is a third-year law student at the Faculty of Law, University of Calgary.

References
[i] Canada Business Corporations Act, RSC 1985 c C-44 at s 146(1) [CBCA].
[ii] Business Corporations Act, RSA 2000, c B-9 at s 1(jj) [ABCA].
[iii] Ibid at s 146(1).
[iv] CBCA at s 146(3); ABCA at s 146(2) and 146(3); Note that recourse is available for persons who acquire a share of a corporation that is subject to a USA if they did not receive proper notice of the agreement’s existence.
[v] Bryce C Tingle, Start-up and Growth Companies in Canada, 3rd ed (LexisNexis, 2018) at 103 and 104 [Tingle].
[vi] BCE Inc v 1976 Debentureholders, 2008 SCC 69 at para 37.
[vii] Tingle at 106.
[viii] ABCA at s 146(8).
[ix] Tingle at 107.
[x] Canada v Bioartificial Gel Technologies (Bagtech) Inc, 2013 FCA 164 at para 58.