Introduction to Shareholder Agreements
We’re about to demystify the world of corporate law, and show you how to make sure your company is protected with a strong shareholder agreement. So sit back and get comfortable! We’re about to break down the whos, whys, hows, and more of a shareholder agreement.
What Is A Shareholder Agreement?
Chances are, your corporation already has Articles of Incorporation and Bylaws. Those documents govern the relationship among the company, the shareholders, and its directors. A shareholder agreement is a legally binding contract that governs relationships among the shareholders. Without a shareholder agreement, shareholders generally have no rights against one another if one shareholder acts in a way that another shareholder believes is wrong; or worse, if other shareholders in the company conspire to oust one shareholder all together. Most shareholders – especially those in closely held corporations with fewer than 100 shareholders – have certain expectations about how their fellow shareholders will act, vote, hold and sell their shares, and more. A shareholder agreement takes those expectations and makes them legally binding. It can be an invaluable tool to protect founding members from being forced out or losing control of the company’s vision and direction. It can protect minority shareholders’ rights from the majority. In short, it’s the only contract shareholders have to protect their rights and expectations vis-a-vis other shareholders in the company.
What Does A Shareholder Agreement Do?
What is the purpose of a shareholder agreement?
A shareholder agreement is a written contract between you and the other shareholders in your business. It can contain any number of provisions, but some of the most common include voting agreements, to ensure certain shareholders vote together; rights of first refusal and buyout clauses to ensure one shareholder doesn’t sell to outsiders if the remaining shareholders don’t necessarily want to do business with those outsiders (or worse, be controlled by them if a majority interest is at issue); and more. A shareholder agreement can be very simple or it can be very comprehensive depending on your needs.
Who Needs a Shareholder Agreement?
While most corporations can benefit from a shareholder agreement, they’re not necessarily in all cases. Shareholder agreements are most helpful (and arguably critical) in the following situations:
- Any business with multiple shareholders
- Any business with a founder who is still a shareholder
- Any business with outside investors
- Any business with employees who are also shareholders
- Any business with multiple locations or branches/units (such as franchises)
In each of these situations, there is a potential for hostile takeovers; being forced out of the company; losing control over the direction and vision of the company; or having your investment devalued without your consent. A shareholder agreement can prevent these unexpected and unwanted events from happening in your business.
What Goes Into A Shareholder Agreement?
As we’ve mentioned, the shareholder agreement should be customized to fit your specific business structure and goals. There are some common elements that are included in most shareholder agreements. Here are some examples:
- A description of what each party is agreeing to do, including any restrictions on the sale or transfer of shares
- The parties’ rights and responsibilities with respect to voting for officers and directors
- A procedure for handling disputes between shareholders or disagreements over major decisions like mergers or selling the company
Preventing Takeovers, and Addressing Withdrawals and Exits
While you may have a shareholder agreement in place, your business’s success and stability is at risk if the terms of that agreement aren’t adequately addressed. Your shareholders should be aware of how to prevent takeovers, and how to address withdrawals and exits from the company. A shareholder agreement takes the business owners’ expectations about what will happen if someone wants to withdraw, or sell to an outside investor, and turns them into legally binding and enforceable obligations.
A shareholder agreement should also include provisions for any new shares that are issued or bought by existing shareholders. While these provisions often address situations where an individual buys more shares than they already own (for example, when someone buys another 10% share from their friend and – surprise! – they’re now the majority voting power, not you), they can also deal with situations where one shareholder tries to buy out another. As an example, let’s say you and your best friend go into business together. A few years into the project, things are going well, and your business partner is going through a divorce. Unfortunately, the ex-husband gets your friend’s shares in the divorce, and you’re now in business with your best friend’s ex. A good shareholder agreement can prevent a situation like this before it even arises.
Voting agreements are another important aspect of shareholder agreements. Shareholders can agree to vote on certain issues in a certain way, such as who shall serve as the organization’s CEO or whether or not to sell the company.
Providing Rights of First Refusal to Buy Shares
The right of first refusal is a provision in the shareholder agreement that would require any party interested in buying your shares to submit an offer that you and your fellow shareholders can consider. This means that if any shareholder wishes to sell their shares, the other shareholders have the option of buying them before they are sold to a third party.
The reason for this is simple: it gives you some control over who owns your company and when they sell it. It also helps to ensure you don’t suddenly and unexpectedly find yourself as a minority shareholder, when you own 40% and your prior partners each owned 30%, but they both sell their 30% to an outsider who now controls your company.
Preventing Stock Valuation Disputes
The biggest benefit of a shareholders agreement is that it can help prevent stock valuation disputes. These are extremely expensive and time-consuming to resolve, so if you can avoid them altogether, it’s definitely worth doing so. Shareholders who want out can negotiate in advance, via a shareholder agreement, what their stock will be worth if and when they want to sell. So, rather than going to court with your soon-to-be-former business partners to argue about how much your exit from the company is worth, you can save tens or even hundreds of thousands in attorney fees by negotiating a valuation provision into your shareholder agreements up front.
Deadlines for Transferring Shares
In addition to helping you determine the value of your company, a shareholder agreement should also address how much notice is required for a shareholder to sell their shares. This can be especially important if the business is already generating revenues or has plans for growth in the near future.
It’s important that you set deadlines for transferring shares so that shareholders aren’t selling out without giving other members of the team sufficient time to make investments in the company.
Shareholders’ Veto Rights
Shareholders’ veto rights are a way to prevent one or two shareholders from taking over the company. They give all or certain other shareholders the power to stop major decisions without their approval. These rights can also keep key employees or founders involved in your business by making sure they have a say in big decisions such as mergers and acquisitions.
Protections for Minority Shareholders
While shareholders’ agreements are often used to protect the interests of majority shareholders, they also provide protections for minority shareholders. Some of the provisions we’ve already discussed that can provide invaluable protections for minority shareholders include:
- Providing rights of first refusal to buy shares
- Preventing stock valuation disputes
- Providing voting agreements and veto rights
Protections for Founding Shareholders
If you are a founding shareholder, then you should be familiar with the benefits of entering into an agreement. If not, here is a quick overview. A Shareholder Agreement can protect your rights as a shareholder in several ways:
- Protects against hostile takeover attempts
- Protects against forced sales or buyouts by other shareholders
- Provides stability and predictability
Consider A Strong Shareholder Agreement To Protect Your Company and Your Investment
Remember, the last thing you want when forming a corporation is for things to go wrong. Having a detailed Shareholder Agreement in place will help protect both the founders and shareholders alike. It is well worth the time, money and effort to ensure that you have all of your ducks in a row.
At Skepsis, we’re a law firm offering flat fee and subscription based legal services custom-tailored to your business. This way, you can get the legal services and advice your business needs without having to guess at budgets, and without having to stomach high hourly rates. Our flat fee and subscription plans save our clients up to tens of thousands of dollars in legal fees each year. If your business is ready for a shareholder agreement, click here to get started or find out more. Not sure if your business needs a shareholder agreement? Book a consult today.