The importance of carefully documenting agreements regarding share ownership, particularly when brining management personnel into share ownership, was recently affirmed in the Ontario Superior Court of Justice. In the decision in Locke v. Quast , two former business partners had a dispute over whether there was an “earn out” provision for the issuance of shares.

In 2008, the second generation owner-manager of an iron works company (Quast) brought in a new manager (Locke) to help grow the company. At the time, Quast was the sole shareholder of the company. After a reorganization to “freeze” the existing value of the company to Quast’s benefit, Locke was provided with 20% of the growth shares of the company, with Quast maintaining ownership of the balance of the shares. Although a shareholder agreement was discussed and negotiated, it was not finalized and signed.

Management disputes arose between Locke and Quast which they were unable to reconcile. There was no contractual mechanism to resolve the dispute, in a shareholder agreement or otherwise. This eventually led to Locke bringing a legal claim under the oppression remedy to force a purchase of his shares.

Locke argued that the shares he was issued (for a nominal amount) were received in exchange for his agreeing to a lower salary. However, Quast maintained that there was a subsequent agreement that the shares would be issued according to an earn-out agreement and that it was not contemplated that the equity would be earned immediately. Contract language that allows for the repurchase of shares for the issue price for a period of time or in certain circumstances are commonly attached to shares issued in similar situations. This can be done by granting the shares through a stock option plan, a reverse vesting agreement or some mechanism in the shareholder agreement.

Unfortunately, in this instance, the earn-out agreement was a “napkin deal” and entirely verbal. The Court ultimately decided that there was no earn-out provision, and that the corporate records should prevail: awarding Locke the full value of his shares. The court relied on the corporate share register, which indicated the transfer of the shares without reference to any earn-out provisions. Furthermore, the shareholders agreement was never executed, and was likewise silent on the matter of any earn-out provisions. The corporation had no other documentation to rely on.

Keeping good corporate records is not only a good way to keep track of all corporate information, but also to document important business understandings. Should any agreements be made, they should be prudently updated in the corporate records to prevent any confusion down the road. Not only do corporate records save you from headache, but also potentially lengthy and expensive litigation.

Take Aways:

1. Shareholder Agreements are critical to document agreements between shareholders, clearly provide mechanisms for corporate decision making and to provide a dispute resolution and shareholder exit mechanism. In the absence of a shareholder agreement the parties can spend time and resources litigating the matter.

2. Shares issued in anticipation of future contributions should always be subject to clear earn out provisions and those provisions should be documented in appropriate agreements.

If you are contemplating a business transition and want to discuss the options and structuring, your can work with the knowledgeable Momentum Law team to come up with a plan. You can read more about some options HERE or book a consultation with our team if you are ready to discuss options.