What is a Shareholder Agreement, and Why Do You Need One?
A new client once contacted our firm about an issue he was having with his business. He and his brother had founded a company a few years prior. They organized the company as a corporation (using an online incorporating service), and each brother owned half of the shares. The business grew, and their customers were happy. But the brothers realized, a few years in, that they absolutely couldn’t stand working together.
They argued constantly, and it reached the point where they couldn’t effectively co-manage the business. So one of the brothers (let’s call him Bert) decided he wanted out of the business. He asked the other brother (let’s call him Ernie) to buy out his shares so that the two could part ways. Unsurprisingly, they couldn’t agree on a buyout price for Bert’s shares, and a stalemate ensued.
This miserable situation went on for almost a full year. Then Bert, needing funds to start a new business, sold his half of the company to his uncle, without Ernie’s prior knowledge or permission. Ernie had a difficult relationship with his uncle and had no interest in owning half of the company with him. So he consulted with our firm to see if he could prevent Bert from selling the shares to his uncle.
Unfortunately for Ernie, the answer was no. The brothers never signed a shareholder agreement. And without such an agreement in place, there was nothing to restrict Bert from selling his shares to whomever he wanted.
So what’s a shareholder agreement, and how might it have made a difference?
As the name suggests, a shareholder agreement is a contract between a corporation’s shareholders. Its purpose is to clearly define the rights and obligations of the shareholders, lowering the risk of misunderstandings and disputes between the corporation’s owners.
Shareholder agreements can cover many different topics, but usually touch upon at least the following:
Transferring Shares. The agreement can have language limiting a shareholder’s right to transfer his/her shares to third parties (for example, requiring the transferring shareholder to get the consent of a certain percentage of the remaining shareholders before selling the shares). It may also contain language granting the company and/or other shareholders a right of first refusal to buy the shares of any shareholder who proposes to sell to a third party. Agreements sometimes also contain “shotgun” clauses, where a shareholder can offer to buy the other shareholder’s shares for a specific price per share. The other shareholder can then either accept that offer, or purchase the offering shareholder’s shares for that same price.
Making Decisions. Shareholder agreements commonly contain provisions describing how shareholders can make decisions on behalf of the corporation. This may include details about how shareholders appoint and remove directors, and what actions the corporation can and can’t take without the shareholders’ consent.
Vesting Provisions. Especially in the case of startup companies, a shareholder agreement might subject some or all of the shareholders’ shares to a vesting schedule. These provisions state that a shareholder won’t get the benefit of the shares until certain conditions are met. For example, the language could provide that the company can repurchase the shareholder’s shares if he or she doesn’t stay with the company for a defined period of time (say, 4 years), or if the shareholder doesn’t meet certain performance milestones. Vesting provisions can be very useful in making sure that key employees don’t depart right after accepting their shares in the company.
Death/Incapacity. Shareholder agreements usually also provide for what happens to a shareholder’s shares if that shareholder dies or becomes incapacitated.
Dispute Resolution. The agreement might also prescribe a process for shareholders to resolve conflicts with one another before matters escalate to full-blown litigation (mediation, arbitration, etc.).
Returning to the situation with the feuding brothers, a properly drafted shareholder agreement could have saved them a massive amount of time, expense, and heartache. An agreement with reasonable restrictions on share transfers may have prevented Bert from selling his shares without Ernie’s consent. It could also have laid down a mechanism for fixing the price for Bert’s shares and facilitating an orderly buyout. Instead, in the end Ernie was powerless to stop the sale of Bert’s shares to their uncle, and was stuck co-owing a company with someone he never wanted to do business with.
Shareholders usually buy into companies with optimism and good intentions. Nevertheless, shareholder disputes are extremely common, and can cripple the operations of any unprepared corporation. A well-drafted and carefully conceived shareholder agreement can greatly reduce the risk of shareholder disputes, and help to resolve issues if and when they arise.