Founders of closely-held businesses are generally enthusiastic about their business’ prospects and allied in the common cause of building a success story. They are often reluctant to think about what happens if later their visions diverge, personal relationships sour, financial situations decline or health deteriorates. An agreement for managing these situations, such as a shareholders agreement, is essential to minimizing the damage to both the company and the individual relationships. Generally, the sooner this agreement is entered into the better. If you have a third-party financing source, they may well require a shareholders agreement.
In a closely-held corporation, there are a small number of shareholders who are very often also directors, employees and/or creditors of the corporation, and may well be related to one another. One shareholder may put in cash or property, and another may contribute sweat equity. These multiple and differing relationships create significant potential for conflict among the shareholders. Shareholders agreements are designed to provide solutions to these conflicts before they occur. In addition, the process of a preparing a shareholder agreement will hopefully flush out any significant differences in business philosophy or personal goals while there is little at stake and everyone is still pulling together, instead of later when there is more to lose and the relationships may have become adversarial.
A shareholders agreement will typically do one or more of the following, with some tailoring to suit the particular company:
- Restrictions on Transfer. Restrict transfer of the shares in order to prevent a new shareholder from participating in the venture without the approval of the original shareholders, although transfers to family members and their trusts are generally allowed.
- Transition and Liquidity. Provide liquidity for the estate of a deceased shareholder, by requiring the company or the surviving shareholders to buy back the deceased’s stock.
- Buy/Sell. Establish procedures (such as rights of first refusal, mandatory repurchases, puts or calls), through which the corporation or the other shareholders may purchase the stock of a shareholder who, for example, is no longer employed by the corporation, is deceased, disabled, divorced, retired, declares bankruptcy, or desires to sell.
- Valuation. Provide a mechanism to set the price of stock being bought by the corporation or other shareholders, or for estate tax purposes. The price can be pegged to book value, a multiple of earnings value, an appraised value, by agreement, or by some combination of these mechanisms.
- Payment Terms. Specify the payment method, such as cash or an installment note over a term of years, if the corporation or other shareholders purchases a shareholder’s stock. Collateral or personal guarantees from the other shareholders may be required.
- Key Man Insurance. Provide for the purchase of key man insurance to fund the corporation’s repurchase of a deceased shareholder’s stock.
- Control. Maintain the founding shareholders’ respective ownership percentages by granting them a first right to purchase stock (preemptive rights), if the company offers stock for sale in the future.
- Corporate Governance. Establish basic corporate policies regarding matters such as the payment of dividends, election of officers and directors, establishment of voting groups, and sale of the company.
- Subchapter S Corporations. Prohibit the shareholders from transferring their stock to persons that would cause the corporation to be disqualified from Subchapter S status; provide for distributions sufficient to pay any taxes passed through to the shareholders; and provide for unanimous shareholder consent to termination of Subchapter S status.
None of these issues are adequately addressed in corporate statutes or organizational documents, if at all. Without at least a basic shareholders agreement, significant changes in the relationships between the shareholders and the company may cause distracting controversy and, at worst, may threaten the existence of the company. If your company has more than one shareholder, regardless of whether the company is newly formed or already existing, a shareholders agreement can be a powerful tool for navigating the company’s future.
 While this article discusses the possible provisions of a shareholders agreement between a corporation and each of its shareholders, each of the concepts can be applied, with appropriate modification, to limited liability companies or partnerships.