Careful – that little share issuance may be more trouble than it’s worth

Every now and again, a client comes to our door wanting to issue shares in their small, private company to a no doubt deserving and loyal employee, franchisee or other investor. My first reaction is always the same: I ask “Why? Why on earth would you want to do that?”

The answer is almost always the same, as well: “I want this person to feel a sense of ownership in the company -- I want them to share in its success.”

What the client typically does not realize (and what I am forced to explain to them, much like the proverbial rain falling on their parade), is that there are a number of consequences that flow from giving someone a minority share interest in a Canadian federal or provincial corporation. And they're not all good.

Canada’s federal and provincial corporation statutes provide a number of serious protections to minority shareholders that need to be considered, and weighed very carefully, before issuing shares to any person.

On the lower, less invasive end of the spectrum, there are rights to requisition shareholder meetings, to see annual financial statements, and to be treated equally to all other shareholders of the same class. Moving up the ladder, there are statutory “super-majority” approval thresholds and shareholder dissent rights (including the right to be bought out at fair value) in respect of fundamental matters involving amendments to the corporation’s articles, amalgamation and sale of the business. Depending on the number of shares to be issued, any or all of these rights may place real limits on what the majority shareholders can cause the corporation to do and how the corporation will be governed.

And we’re not even at the high end of the spectrum yet.

At the high end, minority shareholders have the right:

to apply to the court for an investigation of the corporation and any of its affiliates;
to apply to the court for leave to bring a “derivative action” (i.e., to sue on behalf of the corporation, or to intervene in an existing action to which the corporation is a party) if they feel the corporation is not adequately prosecuting or defending its rights;
in certain circumstances, to cause the corporation to be wound up; and
to apply to the court for relief from oppression (i.e., for any remedy that the court deems appropriate), if they feel that the corporation is being run in a way that is oppressive or unfairly prejudicial to them.

The addition of these rights and remedies can tip the balance of power within the corporation’s ownership (and change the very nature of the franchise, employment or other relationship in question) in ways that the parties may neither anticipate nor want. From the employer's, franchisor's or other majority shareholder's perspective, these changes are almost always unwelcome and, absent a full analysis, understanding and acceptance of the consequences by the client, are to be avoided if at all possible.

So what is the client to do if she wants to reward an important participant in her business, to give him a bit more “skin in the game”?

There are many ways to contractually mimic the functions of share ownership and to create the desired incentives and rewards without invoking the drastic (and potentially game-changing) rights and remedies discussed above. These can range from the very simple (such as a linear bonus or commission structure based on measurable, objective performance criteria) to the very complex (such as the design and implementation of a “phantom stock” arrangement which approximates the gains and losses that the phantom stockholder would receive if they were holding actual shares).

The point is, like most things in the world, what seems simple today may end up being extremely complicated tomorrow. Franchisors, employers and other business owners would be well- advised not to let the deceptively simple idea of “just issuing some shares” launch them into the incredibly complex world of minority shareholder rights. At the very least they should first speak to their lawyers about the consequences of doing so and seriously consider some contractual alternatives.