It all starts with a great idea, people getting together over a handshake and starting a business together. Then, one day, times become tough, issues arise, and shareholders who were once best friends don’t agree with each other anymore. Next, one shareholder wants to leave the business, but there is no legal document providing the rules of the road to resolve those issues.
Enter the shareholders’ agreement, a business agreement akin to a prenuptial agreement but for the shareholders of a corporation designed to help shareholders deal with a variety of issues that arise in the course of any business.
This article will discuss what a shareholders’ agreement accomplishes, why it matters in closely held corporations, and key provisions to include and understand.
What Is a Shareholders’ Agreement and Why Does It Matters for a Closely Held Corporation
Simply put, a shareholders’ agreement is an agreement among the shareholders of the corporation (sometimes also the corporation itself) that governs the relationship, rights and obligations among the shareholders in operating their business. Shareholders’ agreements exist only for corporations, but an operating agreement for a limited liability company or a limited partnership agreement for a limited partnership typically covers similar matters.
Shareholders are not required by law to adopt and enter into a shareholders’ agreement, but good business management supports the idea of adopting one. Indeed, such an agreement can address how to resolve a slew of issues before they even arise, removing uncertainty and setting forth expectations among the shareholders at the outset of their relationship.
For example, they are often used to cover the following concerns:
- To identify or limit who may become a shareholder;
- To control voting rights among the shareholders and to otherwise provide for the management of the corporation (instead of a simple majority, it might be wise to require a higher majority to take certain actions like borrowing money or making capital investments);
- To provide a mechanism for resolving disputes or management deadlocks outside of costly litigation;
- To ensure that the remaining shareholders and/or the corporation may acquire the shares of a shareholder when certain triggering events take place, for example, death, disability and termination of employment;
- To provide for minority shareholders a “tag-along” or “co-sale” right to participate in any sale of shares by a shareholder or group holding a major interest in the corporation;
- To give a majority shareholder or group a “drag-along” (less bluntly called a “bring-along”) right by which they can compel minority shareholders to participate in share sale transactions that the majority negotiates, so that the majority can deliver all the shares in a sale (or at least all the shares covered by the agreement); and
- To set forth non-competition and/or non-solicitation terms to prevent shareholders from harming the corporation.
Four Key Provisions Business Owners Should Understand
Decision Making: Generally, decisions in a corporation can be enacted by a simple majority (more than 50%) of the shareholders. There are certain exceptions to that rule as in most jurisdictions a super majority (66.67%) is required to enact decisions related to fundamental aspects of the business. However, a shareholders’ agreement may vary some of those approval thresholds to better fit the shareholders’ desires.
For example, decisions regarding financing or corporate structure may be set to require a super majority vote or even a unanimous vote while other less important decisions may require only a majority vote. Consideration should be given to the ownership structure as some of those thresholds are better used to protect minority shareholders from not having a say in major decisions.
Transfers and Ownership of Shares: In a closely held corporation, it is paramount that shareholders get along with each other to run the business. Typically, a transfer of shares requires the approval of the board of directors of the corporation; such a board may not have any representative for the minority shareholders and, accordingly, their interest may not be well protected as they relate to the departure of shareholders.
Additionally, certain triggering events for transfers of shares, such as death or disability of a shareholder, should be covered in the shareholders’ agreement to avoid unwanted surprises. For example, upon the death of a shareholder, his or her ownership is considered an asset and becomes part of their estate. This transfer could lead to the family members of the deceased shareholder becoming shareholder(s) in the corporation without the consent of the existing shareholders.
To avoid this scenario, a shareholders’ agreement should provide for a compulsory buy-out, including mandating that the administrator of the estate sell the shares upon the death of a shareholder.
Valuation of Shares: A significant benefit of a shareholders’ agreement is to either set the value of a shareholder’s interests or establish a method of valuation. It is crucial to remove uncertainty in the valuation of the shareholders’ interests in the event of a death, disability or any other triggering event that does not involve an offer from a third party to acquire the interest with a valuation proposed by such third party.
There are several ways to value the interests, such as:
- Setting a fixed price that is periodically reviewed;
- Setting a formula based on several factors; or
- Appraisals from experts, which such appraisal becomes binding on the shareholders and the corporation once any objections have been resolved (and the objection mechanism and periods are set forth in the shareholders’ agreement to avoid a protracted process).
Exit: A well-written shareholders’ agreement will provide for different exit strategies in the event that the shareholders can no longer be in business together. Agreeing to certain terms from the start of the business relationship can eliminate drawn-out and expensive negotiations later on.
A shotgun clause allows a shareholder to trigger a forced buy-sell scenario, meaning the “triggering shareholder” makes an offer to the remaining shareholders to buy their shares at a specific price. The remaining shareholders can then either accept the offer to sell their shares at that price or are alternatively forced to buy the triggering shareholder’s shares at the same price.
Other clauses, including a drag-along and tag-along clause, can also be included. The former forces minority shareholders to sell their shares in the event that a majority shareholder wants to sell all their shares to a third party; the latter gives the option to minority shareholders to sell their shares along with the majority shareholder.
An Ounce of Prevention …
A shareholders’ agreement can remove a lot of uncertainty and headache in dealing with various business issues and should be adopted when two or more shareholders are in business together. Shareholders should negotiate and adopt one when they begin their business relationship, as it will always be easier to come to an agreement when no tensions exist and they all want the business to succeed.
Guillaume Aimé is a senior associate attorney at Gallagher & Kennedy in Phoenix and focuses his practice in the areas of securities and business transactions, including SEC reporting, public and private mergers and acquisitions, and entity formation.
