Shareholders Agreements: Insurance for Entrepreneurs
By: Michael Mentzel
If you just bought a brand new car, would you drive it off the lot without insurance? Of course you wouldn’t, but many entrepreneurs in a hurry to get their business going set up corporations without considering the risks of proceeding without a shareholders agreement.
Like insurance, you are likely to give a shareholders agreement little thought when things are going well, but if the relationships among the shareholders become contentious, you will find that the time and effort put into crafting a shareholders agreement was worthwhile.
Although shareholders agreements come in endless varieties, they usually address the following issues:
- Protection for Minority Shareholders. The day-to-day operations of a corporation are controlled by its officers who work under the supervision and at the direction of its board of directors. Major corporate decisions require the approval of the majority of the corporation’s board of directors and for certain decisions, the shareholders owning a majority of the outstanding stock of the corporation. In order to ensure that the shareholders who do not own a majority of the outstanding stock in the corporation have a voice on the board of directors, a shareholders agreement often will designate the number of directors, the composition of the board (i.e., who will have the right to nominate or designate a specified number of board members) and a requirement for all members to vote for these designees. In a closely held corporation, even the right to hold certain officer positions (and the obligation as board members to vote to maintain these officers in these designated positions) may be specified. Although a shareholders agreement may ensure minority shareholders are represented on the board of directors, it may be appropriate for certain decisions that will have a significant impact on the corporation, such as the decision to issue more stock or sell stock to those who are not current shareholders, the borrowing or expenditure of funds in excess of a specified dollar amount, or the decision to hire or terminate key management, to require approval of a supermajority (i.e., 75% or even 100%) of the board, or shareholders owning a supermajority of the outstanding shares. An additional minority protection known as a “tag along” permits the shareholders owning less than 50% of the outstanding shares to prevent the majority shareholders from selling the majority of shares and reaping any control premium, by permitting all stockholders to participate in the sale.
- Restrictions on Transfers of Shares. As a general principle, corporate shares are freely transferable. Since bringing on different shareholders might be objectionable to existing shareholders, most shareholders agreements provide for restrictions on transfers of shares, including requiring unanimous approval or a right of first refusal for the company or the other shareholders to buy the offered shares before those shares can be transferred to a third party.
- Provide for Orderly Transfer of Ownership. If all shareholders are actively involved in the business, it is often desirable to provide for an orderly transfer of shares in the event of the death, disability or unwillingness of a shareholder to be further involved in the business. One approach to address these issues is to provide a previously established value or formula under which these shares will be purchased by the company.
- Provide for Protection of Majority Shareholders. If the majority of the shareholders want to sell their shares in the company and the minority do not, it may not be possible for the majority to transfer their shares at a favorable price. Shareholder agreements often include “drag along” rights which permit the holders of the majority of shares to force the remaining shareholders to accept a desirable offer and sell their shares on the same price and terms approved by the majority in order to allow the sale of the company to take place.
- Provide a Method of Dispute Resolution in the Event of a Deadlock. In situations where there are just two shareholders and it is impossible to resolve a dispute between the shareholders, a “shotgun clause” which permits a shareholder to offer to buy the shares of the other shareholder, but requires that he or she be prepared to sell his or her shares at the same price and terms if the other shareholder refuses to sell his or her shares, can prevent the alternative which would be expensive and time consuming litigation.
The above are just a few of the major issues that can be addressed in a well drafted shareholders agreement. A shareholders agreement provides a backdrop against which the shareholders will usually be able to resolve their differences and provides the necessary insurance if they cannot.