Overview of Shareholder Agreement Issues
The following is an overview of many of the basic questions and issues that should be addressed in a Shareholder Agreement among shareholders of a corporation. Contact Robert B. Baumgartner or Scott Pohlman at 703-621-7173 to discuss these issues in greater detail. Each situation is different, and your situation may involve additional issues that are not addressed below, or some of the issues below may not apply to you.
Functions of Shareholder Agreement. Shareholder Agreements allow the owners of companies to be able to control
- Who will be the shareholders;
- The management of the Company;
- The transfer of shares upon a shareholder’s death, disability, and voluntary or involuntary termination;
- The method for valuation of the shares;
- Restrictions on current shareholder activities (competing and non-competing); and
- Resolving deadlocks in management and voting; and
- To sell the Company based upon the vote of the majority of the shareholders (bring along and tag along rights).
- Restrictions on ex-shareholder’s activities.
Control Transfer of Shares
The Shareholder Agreement can prohibit a Shareholder from transferring his/her shares without the consent of the other shareholders. The percentage of shareholders who have to approve can be 100%, or a lower percentage.
The Shareholder Agreement can specify whether the Company will be taxed as:
- a Sub Chapter S corporation, or
- an Chapter C corporation.
Management of Company
A Shareholder Agreement can provide that:
- The founding shareholders will always be the sole directors or at least on the board;
- Directors may have weighted voting;
- Founding shareholders will be the officers of the Company – can specify titles, but not recommended; and
- The founding directors may be compensated on an agreed percentage.
Purchase of Shares
The Shareholder Agreement will provide for how shares will be purchased upon a trigger event.
- Trigger events include death, disability, termination of employment (voluntary or involuntary) and bankruptcy.
- Will the shares be purchased by the shareholders, or the Company, in respect to each trigger event?
- Is the purchase mandatory or optional for each trigger event?
- How will the shares be valued?
- How will the purchase price be paid?
Valuation of Shares
There are several ways to value shares:
An agreed valuation every year. An agreed valuation may not reflect the valuation on the date of the trigger event. If the shareholders fail or forget to complete the valuation, valuation can be by either of the following methods:
- Formula based upon historic corporate data: Simple and inexpensive, but may not reflect real current value (does not take into consideration the effect of the death of the shareholder on revenue generation, or the effect of recent major positive or negative developments.
- Appraisal: More expensive, but will tend to reflect current valuation by taking into consideration all factors affecting the Company. Three appraisal system is recommended.
- Board Valuation: The valuation can be performed by the Board of Directors after consultation with appropriate professionals. This is simple, but may yield varying results, and is giving discretion to the Board. For small percentage shareholders, the board of directors valuation can be used to simplify process.
- Book Value: Book Value is a simple alternative methodology, but may not reflect fair market value of shares.
You can combine methods of valuation.
Payment of Purchase Price
The Shareholder Agreement will provide for how the purchase price will be paid. There are several options including:
- Lump sum: Used for small buyouts and when the cash flow permits or there are life insurance or disability proceeds.
- Time payments: Normally, 10% is paid at closing, with:
- Balance of purchase price amortized over 3, 5 or 10 years
- Balance accrues interest (IRS rate recommended)
- The time payments can be secured by shareholder guarantees (dangerous), lien on Company assets, or holding transferred shares in escrow.
Purchase upon Death
The following are guidelines for purchasing the deceased person’s interests.
Generally, the purchase is mandatory and, for tax purposes, should be by the remaining shareholders, and not the Company. A purchase is by the other shareholders allows the shareholders to receive a stepped up basis for the purchased shares. This provides a significant tax advantage upon sale of the Company.
Life insurance may used to fund the purchase price. Because any purchase has tax consequences, we recommend you consult with your CPA or tax advisor.
Purchase Upon Disability
Disability of a founding shareholder may constitute a trigger event depending upon how critical the shareholder’s involvement is to the Company.
Disability for passive investors is usually not a trigger event. For active participants in the business:
- How disabled should a person be before being bought out?
- Can the effect of the disability be limited through reasonable accommodations?
- How long should the disability continue before constituting a trigger event (normally between 6 and 12 months)?
- Should the buyout be mandatory or optional?
- If optional, should the Company and disabled shareholder have an option to require the buyout?
Purchase upon voluntary termination
If a founding shareholder elects to leave the Company:
- Does the Company have a mandatory or optional buyout?
- Should a vesting percentage be used?
- A vesting percentage is multiplied against the value of the shares to “penalize” the person from leaving.
- For example:
- Year one = 0%
- Year two – 20%
- Year three – 40%
- Year four – 60%
- Year five and after – 80%
Vesting percentages should discourage the shareholder from leaving, but give him a means to leave and capture some of the value he added. The Company will not have insurance to pay the purchase price, so the payment schedule will adversely affect cash flow. A longer payout schedule may be in order to protect the Company’s cash flow.
Termination of Shareholder for Cause
The Shareholder Agreement will often allow the Company to terminate a shareholder “for cause”.
"For Cause" should be carefully drafted to be limited to major bad acts that harm the Company (theft, fraud, felony or moral turpitude convictions that will harm the Company, abandonment).
The terminated shareholder may be “penalized” by reducing the buyout to:
- A fixed price – $500.
- A percentage reduction (share value times vesting percentage times penalty percentage (50%). Any damages caused by Shareholder should be offset against the calculated purchase price.
Term of Payout
Should any payout be over a longer period of time if over a certain amount to protect Company cash flow. Payouts are usually over a 3, 5 or 10 year period.
Should the filing of a bankruptcy by a shareholder be a trigger event? If so, should the buy out obligation of the Company be a mandatory or optional. . And, you also have the same issues to address concerning – valuation of the shares and period of payment.
How to Address Guarantees by Withdrawing Shareholder
The Shareholder Agreement should address what obligations the Company and remaining shareholders will have to obtain a release of the selling shareholder. The obligations may be different depending upon the nature of the trigger event that caused the buyout.
Initial Capital Contributions. The Shareholder Agreement should specify the amount of the initial capital contributions of the shareholders.
Additional Capital Contributions. The Shareholder Agreement should also address what obligations the shareholders have to make additional capital contributions if needed of the operation or expansion of the Company. Options include:
- No further obligation. However, if any shareholder makes an additional capital contribution:
- It will be repaid before distributions to other shareholders. This may be a problem if the Company is taxed as an S Corp. or
- It may result in an adjustment of the ownership interests based upon the relative percentage of each shareholder’s total capital account.
- The obligation may be mandatory if approved by a super majority of the other shareholders.
- The failure of a shareholder to make the capital contribution will result in a penalty (no further distributions, or adjustments to ownership percentage, etc.)
Loans by Shareholders.
The Shareholder Agreement should provide for whether shareholders have a right to make loans to the Company ( if approved by a majority or super majority of the shareholders or directors) and, if so, the terms of such loans (interest rate, security, etc.).
Tag Along/Right of First Refusal Rights.
The agreement can provide that if the majority of the shareholders find a buyer of their stock interests, the other shareholders will:
- Have a right of to match the offer (sometimes called a right of first refusal) or, in the alternative, require that their shares be purchased also (they “tag along” with the transaction.
This type of provision allows the majority of the shareholders to sell their shares in certain circumstances to third parties (and not be held hostage by minority shareholders. The remaining shareholders are protected because they can either buy those shares at the proposed sales price if they think selling is a mistake and the Company has a bright future, or alternatively cash out by selling to the prospective purchase.
A major question is – what percentage of the majority shareholders have to agree to the sale to invoke the Bring Along Rights – 51%, 66%, 75% or higher?
Bring Along Rights.
If the majority of the shareholders want to sell their shares to a third party, i.e., the majority shareholders want to cash out because they think the time is right to sell – but the purchaser will only buy their stock if the purchaser can acquire ALL the outstanding shares.
The majority shareholders can require the minority shareholders to sell their shares. This means the majority shareholders can “bring along” the minority shareholders. A major question is – what percentage of the majority shareholders have to agree to the sale to invoke the Bring Along Rights – 51%, 66%, 75% or higher?
For 50/50 ownership
Resolving Deadlocks. Deadlocks can be the death of a Company. Options to resolve deadlocks include:
- Flip of coin or “rock, paper, scissors” to resolve minor disputes (under a threshold of value, i.e., $5,000)
- Appointment of a trusted advisor to arbitrate issues.
- Arbitration with the AAA to resolve major issues.
- Push Pull.
- One shareholder offers to purchase shares of other shareholder. Other shareholder can accept offer, or purchase offering shareholder’s shares for same purchase price.
The Shareholder Agreement may include restrictive covenants including:
- Covenant not to compete (restricts the person from competing in the Company’s industry for a period of time);
- Covenant not to Solicit Clients – prevents the person from performing work for Company clients for a period of time;
- Covenant not to Solicit Employees – prevents the person from taking Company employees to his new venture;
- Confidentiality – Protects use and disclosure of Company IP and trade secrets.
Remedies for Disputes involving the Shareholder Agreement. The Shareholder Agreement can provide for whether disputes will be resolved through mediation, arbitration or through the court system. Contact Fairfax, VA business law attorneys for help with your case today.
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