Shareholders Agreements – An Introduction
If you’ve decided to incorporate a corporation as part of starting a business, you should be thinking about a shareholders agreement. While sometimes unwisely skipped for cost or timing reasons, a shareholders agreement can be a valuable tool to set expectations among shareholders, provide for the management of the corporation and help plan for organic changes that may impact the corporation, the shareholders and the corporation’s business. Questions or comments? Like this article? Leave a review and more will follow! It only takes a few seconds.
Having a shareholders agreement in place can help the parties focus on the business and provide for mechanisms to protect the corporation’s interests. Without a shareholders agreement in place, the likelihood of disputes increases and, as with any disputes, the outcomes in the absence of a shareholders agreement may be far from what the shareholders originally intended.
No Shareholders Agreement is the same or should be. Every business is different and every business deal is different, including those among the corporation and its shareholders. In some cases, the shareholders are only able to agree on certain items to address in a shareholders agreement.
A shareholders agreement is one part of the documentation that will govern the corporation’s activities, and operates together with the corporation’s Certificate of Incorporation, by-laws and applicable statutes and case law governing corporations. The corporation may have other agreements, such as employment agreements and confidentiality, invention assignment and restrictive covenant agreements that are addressed as part of the negotiation of the shareholders agreement.
What Are Some of the Issues Addressed in A Shareholders Agreement?
Restrictions on the Transfers of Shares.
Many closely-held corporations operate with a core team of shareholders who also serve as the corporation’s directors, officers and key employees. It is common for these individuals to want to restrict the transfer of the shares in the corporation to prevent people they do not know (“corporate outsiders”) from gaining an interest in the corporation and affecting its management and operations.
A shareholders agreement may contain restrictions on the transfer of shares by the shareholders, perhaps with limited exceptions for estate-planning purposes. Similarly, a shareholders agreement may restrict the issuance of new shares for the same reasons, unless those shares are issued to existing shareholders pro rata or based on another agreeable mechanism.
Often, the parties provide for a right of first refusal which requires a shareholder wishing to transfer his or shares to first offer them to the corporation and/or the other shareholders prior to selling them to a third party. A right of first refusal is one mechanism used to increase the likelihood of enforceability of restrictions on transfers, as absolute restraints on transfers of shares are disfavored and may be held unenforceable by courts.
Who is the boss? Who runs the show? Corporations are typically under the management and control of the corporation’s directors, who are elected by the shareholders. A shareholders agreement can contain provisions requiring each of the shareholders to vote their shares to elect each shareholder as a director. The directors are then responsible for electing the officers of the corporation. Some States have specific requirements as to specific officers that a corporation must have. A New Jersey corporation must have a President, Secretary and Treasurer, but may also have other officers. The power and authority of these officers are governed by the corporation’s by-laws, by actions and authorizations of the Board of Directors (the “Board”) and applicable law.
A shareholders agreement will also factor into the overall compensation picture for the shareholders. Shareholders who are employees of the corporation may receive wages for these services, and also receive income from the corporation on account of the shares held. It is important for each shareholder to understand their individual economic and work expectations and to harmonize those with others involved in the business.
Sometimes the economic deal is set forth in the shareholders agreement, employment agreement and other compensation-related documents (e.g., bonus and incentive plans, benefit plans, etc.) and in other cases latitude is given to the Board to set and adjust compensation based on the corporation’s and an individual’s performance.
Day to Day Management and Major Decisions.
Typically, the officers of a corporation run the business in the ordinary course subject to supervision of the Board. Whether through the by-laws or authorizations of the Board, officers are empowered to take certain actions on behalf of the corporation including binding the corporation, subject to any limitations that may be found in the Certificate of Incorporation, by-laws, resolutions of the Board, the shareholders agreement or other document or instrument.
What about big decisions such as opening up a credit line with a financial institution, engaging in a strategic transaction or entering into an agreement to sell all or a material portion of the corporation’s assets? These decisions are typically dealt with at the Board level, but can also be addressed in the shareholders agreement by requiring the approval of the shareholders (or shareholders holding a certain percentage of outstanding shares) prior to the corporation entering into different types of transactions. These provisions are especially important to shareholders holding minority interests in corporations, as they may not otherwise have the ability to influence or control the corporation’s activities.
If not already addressed in other agreements, a New Jersey shareholders agreement may also contain provisions designed to protect the business. These include confidentiality, non-competition and non-solicitation provisions. Note that directors and officers also have fiduciary duties, such as the duty of loyalty and duty of care, which complement these restrictive covenants.
What About Buy-Outs Under a Shareholders Agreement?
Absence an agreement to the contrary, a shareholder typically does not have a general right to be bought out by the corporation or the other shareholders, nor does the corporation or the other shareholders have the right to require a shareholder to sell their shares. In some cases, a shareholders agreement focuses primarily on buy-out provisions as shareholders typically want to protect their economic interests in their shares, and the shareholders who remain want to have the ability for the corporation or the remaining shareholders to buy-out a departing shareholder’s shares.
Consider the following scenarios:
- Death of a shareholder
- Permanent disability of a shareholder
- Retirement of a shareholder
- Termination of a shareholder for cause
- Termination of a shareholder without cause
- Shareholder’s breach of the shareholders agreement or other identified agreement
These are just some of the scenarios in which buy-outs may be addressed. Shareholders may also want to address provisions that allow them to “put” their shares to the corporation (i.e., require the corporation to purchase their shares) or terms under which the corporation has the right to “call” (i.e., require a shareholder to sell) their shares. In all of the scenarios, the shareholders must determine the terms of the buy-out including price, timing and related provisions.
So as not to adversely impact the corporation’s financial affairs, a buy-out may be structured with a down-payment at a closing and a balance to be paid through a promissory note over a period of time. In cases of death or permanent disability, buy-out insurance can be procured that can serve as a funding source for the buy-out payments so as not to burden the corporation’s cash-flow.
Obviously, determining price is an important issue and a shareholders agreement may address this in a variety of ways. In certain cases, a certificate of value is used that is updated on a periodic basis. In other situations, a formula may be a good fit, or the parties can decide to use an appraisal methodology.
What Other Issues Can be Addressed in a Shareholders Agreement?
As noted above, a shareholders agreement has to match the business, the parties and the deal struck among them. No one agreement is the same, and all parties should have separate counsel and tax advisors involved in the negotiation and drafting process to protect their respective interests. Many shareholders agreements address a variety of other issues from dispute resolution mechanisms to how third party financing will be handled and and treated, especially when joint and several personal guarantees are involved.
In these cases, shareholders often enter into contribution agreements in connection with a shareholders agreement to allocate third party liabilities among them in a manner consistent with their percentage ownership of outstanding shares. This will enable a shareholder who has satisfied more than the shareholder’s pro rata share of a specific third party liability to seek contribution from the other shareholders.
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Copyright 2018, 2020 Geoffrey G. Gussis, Esq. All Rights Reserved. Learn more about me, the legal services I provide, and other articles I have written. Contact: firstname.lastname@example.org or (732) 898-0549. Licensed to practice in New Jersey and New York. Like this article? Leave a review and more will follow! It only takes a few seconds.