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Shareholder Agreements Help Prevent Disputes

Most businesses are owned by two or three individuals – the reality is that it’s easier to start a company when the load is shared. But, problems are bound to crop up, especially if one of the owners (whether a corporate shareholder or LLC member):

  • Dies or becomes incapacitated;
  • Gets divorced, with the possibility of the ownership interest going to the spouse;
  • Stops coming to work;
  • Wants to sell out to a third party;
  • Wants to retire; or
  • Becomes adversarial or causes a deadlock.
These problems are often difficult to solve at the time they arise and can cause a business to grind to a halt. Instead, savvy business owners set up a shareholders’ agreement (or similar contract) when they start their business or shortly thereafter. Think of it as a pre-marital agreement.

One of the most common issues addressed in these contracts relates to when and how an ownership interest will be bought back – for this reason such contracts are often called “Buy-Sell Agreements.” Topics that should be addressed include:

  • Rights of first refusal if ownership interests are being sold to “outsiders.”
  • Rights of surviving shareholders to buy back ownership from a deceased shareholder’s estates.
  • Rights to buy back stock from someone who has filed bankruptcy or becomes incapacitated (drug addiction or other serious health issues).
  • Retirement of owners.
In most instances, the owners will want to set the price well in advance. The value can be set by price per ownership unit (which can be revisited annually, especially as the company grows and becomes more valuable), or by formula. Often, the price will differ depending on the circumstances. In any event, by setting a price well in advance there is no haggling down the road. Moreover, it generally gives a minority shareholder better value for his or her interest.

One of the most important situations to address is the death of an owner. Perhaps you might want to go into business with your former partner’s spouse or children, but in my experience that’s not the norm. On the other hand, a major part of the deceased owner’s estate likely comprised his interest in the business – and his heirs rightfully should get fair value, but not at the risk of financially crippling the company.

There are many options to address this issue: If one owner dies, the business can buy back his interest, or the other owners can buy the interest from the deceased owner’s estate. Each of these options will have different income tax consequences depending on the type of entity of the business, such as an S corporation, a C corporation or a partnership.

Most agreements will provide either for a payout over time at a prescribed interest rate, or for the payout to be funded by life insurance. A properly funded agreement can convert the non-liquid assets tied up in the business into cash. This provides funds for the heirs to pay obligations and taxes. Moreover, cash can be invested to generate income, and cash is more easily divided among heirs.

Another important issue is whether there will be restrictions on transferability of ownership interests. Perhaps you were happy to go into business with your best friend, but (unfortunately) like most marriages such partnerships often end in divorce. Should you or your partner be able to sell out to an outsider – perhaps an outsider with whom the remaining owner has no interest in doing business?

Common restrictions on share transfers include:

  • Requiring the approval of shareholders to transfer shares and requiring new shareholders to be bound by that agreement;
  • Requiring that shares can only be sold to those actively involved in the business; and
  • Giving shareholders the right of first refusal to purchase the shares of another shareholder before a sale to a third party.
Consideration should also be given to a “shotgun” clause, which is only applicable where there are two shareholders. Simply put, a shareholder would trigger a shotgun clause by offering to purchase the other shareholder’s shares. The offer would set out the purchase price for the shares and the terms and conditions of the purchase. The receiving shareholder must either agree to sell to the offering shareholder or to purchase the shares of the offering shareholder on the same terms and conditions. If the shareholders have disproportionate share holdings or disproportionate wealth, care must be taken in structuring a shotgun clause because a wealthier shareholder may be able to determine the outcome.

What if your business partner loses interest in the business? A shareholder agreement can stipulate how income should be distributed. Or if your co-owner suffers personal financial hardship would you want to be in business with his or her creditors? A shareholder agreement can provide a mechanism to rescue that ownership from the hands of creditors – but only if done well in advance.

Shareholder agreements can, and should, also address management issues. I commonly include provisions that set forth what decisions can be made by one owner, and what decisions require unanimity or a majority vote. These fundamental decisions vary from business to business, but often include: sale, liquidation or winding up of the company; material acquisitions and dispositions; significant borrowing or lending; name changes; hiring or firing of employees; increasing employee compensation or benefits; entering into new lines of business; commencing or settling lawsuits; and issuance of additional equity. In addition, a well drafted shareholder agreement should also include provisions to break a deadlock between owners.

Depending on the nature of the business, shareholder agreements often contain restrictive covenants designed to protect the company by preventing departing shareholders from directly competing with the company after they depart. Restrictive covenants are especially important in service businesses where the opportunity to damage the company through solicitation and servicing of its clients is greater.

Every business is unique. Nonetheless, a shareholder agreement is a smart and effective way of short-circuiting disputes before they occur. If there’s more than one owner of your company, you should seriously consider consulting your attorney to have an agreement drafted.

by Thomas C. Pavlik, Jr.
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