Shareholder Agreements:What you and your fellow shareholders should have in writing.

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Shareholder Agreements:
What you and your fellow shareholders should have in writing.

By Mary Hanson

When two or more individuals form a closely held corporation, a shareholder agreement (also called a buyout agreement or buy/sell agreement) should be executed. If the corporation itself will have obligations under the shareholder agreement, officers of the corporation should also execute the agreement on behalf of the corporation.

The shareholder agreement is a contract among the shareholders and the corporation to address issues involving stock ownership in a small corporation. It is also possible to place restrictions in articles of incorporation or bylaws, but the most common arrangement is a separate agreement executed by the shareholders and the corporation.

There are a number of circumstances in which the corporation or the shareholders should want to buy out another shareholder. Without an agreement, each shareholder typically holds his or her stock without any restriction on transfer, and without the possibility of the stock being bought back by the corporation or the other shareholders, no matter what the shareholder does.

The most common provisions in a shareholder agreement are for the buy back of stock in the event of death, and a right of first refusal allowing the corporation or the other shareholders to purchase the stock of a shareholder who wishes to transfer his or her stock to an outsider.

Many other provisions can be included and should be considered. For example, if a young company requires the active participation of all shareholders, it may be appropriate to have the buyout agreement provide for repurchase of the stock of any shareholder who ceases to work at a required level, or to perform his or her designated responsibilities.

The following are some of the provisions which might be included in a shareholder agreement:

Restrictions on Transfer

A provision restricting transfer of stock prevents all shareholders from freely transferring shares. The shares are marked as restricted in accordance with the agreement, and any transfer, to be valid, must comply with the terms of the agreement.

With the right of first refusal, the corporation and the other shareholders have a right to make the purchase themselves on the same terms as those offered by or to the third party, before the shareholder can go ahead and sell the stock. This enables the corporation and the other shareholders to prevent the transfer of stock to an outsider.

Mandatory Buyout in Event of Death

One of the key provisions in a shareholder agreement is the obligation of the corporation or the other shareholders to buy back the stock of a deceased shareholder.

Most shareholders in an owner-operated business do not want to be co-owners with the spouse or children or other heirs of a deceased shareholder. Most often, the spouse or children do not have the business skills that made the original owner valuable to his or her co-owners.

Buyout agreements most often provide for the mandatory buyout of the deceased shareholder's stock by the corporation. If the corporation doesn't have enough money to make the purchase (because of California Corporations Code restrictions that prevent a corporation from draining its resources), other shareholders must buy the shares the corporation cannot buy.

To facilitate the purchase, life insurance is often purchased. The shareholder agreement should make provision for circumstances where the purchase price for the buyout exceeds the amount of insurance or when the insurance proceeds exceed the purchase price.

Some shareholders say they want their heirs to inherit the company stock in the event of death. I question the benefit of taking such a position, since the heirs of a deceased shareholder are almost certain to be better off with cash paid out from the business for the deceased shareholder's stock, than with an interest in a business in which they are outsiders. Most small corporations do not declare dividends, and an heir who is not employed by the corporation is likely to get no benefit from being a stockholder.

Also, it is unlikely that a third party will be interested in purchasing a shareholder's stock in a small corporation. A primary reason for the buyout obligation in the event of death, is to provide a "market" for the shareholders' stock which does not normally exist.

Optional Buyout in Certain Events

In many shareholder agreements the corporation or the other shareholders have options to buy the stock of another shareholder, which are triggered by certain events. These options give the corporation or other shareholders the ability to buy out one of the shareholders in certain circumstances.

The circumstances which might be covered in a shareholder agreement, triggering an option to purchase the stock of one of the shareholders include:

(1) the bankruptcy of a shareholder;

(2) the permanent physical or mental disability of a shareholder whose services are needed by the corporation;

(3) failure of a shareholder to perform his or her designated responsibilities, quitting work for the business, or failure to work a required number of hours;

(4) retirement of a shareholder or withdrawal from a work relationship with the business; and

(5) activities by a shareholder in competition with the business of the corporation.

Shareholders should anticipate updating these provisions every few years. After the business is well established it may not require the personal efforts of its shareholders. It may be appropriate to amend the agreement to allow shareholders to continue to hold stock whether they have retired, been disabled, or have left the company for other reasons.

Method of Buyout

The buyout provisions set out how the buyout is to be implemented, including the method of determining the price of the shares to be purchased and the method of giving notice of exercise of options, of transferring the stock, and of making payment for the purchase of the stock.

The best valuation method, in my opinion, is the appraisal by an experienced and qualified business appraiser. The use of a formula is not uncommon, but there is a serious risk of the calculation being so far off (high or low) that it invites a dispute.

Typical payment terms include a 20% down payment and payment of the balance over 48 months or more. The buyout agreement should enable the business to survive the departure and buyout of one of the shareholders.

The payment terms are an important part of the price. If the payment is made in a lump sum, the price should be lower than if payments are made over a long period of time.

Forced Buy/Sell

Where two individuals or entities each own 50% of a corporation, a "forced buy/sell" provision can be very useful. Such a provision allows one shareholder to give the other a buyout offer. The recipient of the offer must either accept the offer and be bought out, or turn the offer around and purchase the interest of the first shareholder at the same price and upon the same terms as the first shareholder's offer.

This arrangement assures that the price and terms are fair, since the shareholder making the offer may end up receiving the purchase price rather than paying it.

Using such a provision, shareholders can end an unhappy relationship with a buyout that is fair, even where no circumstances otherwise exist to trigger a right to buy out a shareholder's shares.

Proprietary Information

A thorough shareholder agreement should also cover protection of proprietary information. The agreement should require the shareholders to hold proprietary business information in confidence, protect it from disclosure, and not use it for personal benefit.

Proprietary information can be data, customer lists, customer information, computer programs, methods, or other information that the business regards as its confidential information. Other persons, such as employees and contractors, should also be required to protect proprietary information.

Noncompetition

A shareholder whose stock is purchased by the corporation or other shareholders should be prevented from competing with the corporation.

California law makes most noncompetition agreements unenforceable, but an exception to this law allows an enforceable covenant not to compete where a shareholder's entire interest in a corporation is bought out. The time to cover this issue is at the beginning of the relationship, not when a shareholder is departing, perhaps with firm plans to compete with the business.

Consent of Spouse

In a community property state the agreement also needs the consent of shareholders' spouses so that each spouse agrees to give up his or her community property interest if there is a buyout of stock under the agreement.

Rather than having a spouse sign the agreement, a separate "consent of spouse" is often attached to the agreement for each spouse, stating that the spouse understands the agreement and approves it, waiving any community property rights he or she could have asserted.

Importance of Agreement

Many owners of a business discover too late that a written agreement covering buyout terms is necessary to get stock away from another owner who is violating the co-ownership understanding. Many owners are working hard to build up a business - a percentage of which accrues to an inactive shareholder who is no longer involved in the business. A shareholder agreement or buyout provision offers a means to resolve this problem.