A shareholder agreement can be an effective way to define and communicate the rights of your company's shareholders, including:
- What voting rights shareholders have
- What actions require shareholder approval
- How profits are distributed among the shareholders
- When shareholders are permitted to sell their shares
Being transparent and ensuring that your shareholders understand their rights and are aware of important restrictions can do a lot to avoid or mitigate potential disagreements down the road.
Determine Voting and Distribution Rights
With respect to voting rights, shareholders typically have the right to elect board members and approve (or veto) major corporate decisions such the sale of the company, changes to shareholder rights and large capital expenditures. It is a good idea to list what corporate actions will require shareholder approval in the shareholder agreement and specify what percentage of the vote will be required for approval. Typically, shareholders act by majority vote. However, for certain major corporate decisions you may consider requiring a higher standard of approval — for instance, a supermajority vote (e.g., 66%).
Most often, each share of a company will carry one vote, and shareholders vote on shareholder matters pro rata (in proportion) to the number of shares they own. However, if you would prefer to concentrate voting control among a smaller number of shareholders, consider capitalizing the company into voting and non-voting shares. Non-voting shares typically carry all of the economic rights of voting shares but do not have the right to cast their vote on issues that require shareholder approval. There are also potential tax benefits to dividing your company into voting and non-voting shares. Doing so may allow you to transfer most of the economic value of the business (i.e., the non-voting shares), and therefore the estate tax liability, out of your estate while retaining voting control by holding onto a small number of voting shares.
A well-designed shareholder agreement should also include a distribution policy that specifies when and how corporate profits will be distributed to the company's shareholders. Your company's distribution policy should take into consideration the intended economic benefits you wish to provide your shareholders in the context of your overall financial objectives for your business and your family. The policy should have sufficient flexibility to allow the company to scale back distributions when the company needs to redeploy cash flow back into the business, and increase distributions when the company has excess profits it doesn't otherwise need to reinvest. In order to protect your business during hard times, you may consider setting a minimum dollar amount of profit that must be generated before the company may distribute profit to its shareholders.
Control Who Owns Your Company
A shareholder agreement can be an effective tool for controlling who becomes a shareholder of your company. Most shareholder agreements contain transfer restrictions that prohibit shareholders from transferring their shares to anyone other than certain "permitted transferees" (that typically include other shareholders and immediate family members) without the company's consent.
You may also consider providing your company with the ability to buy back a shareholder's shares upon certain "triggering events," including death, disability, termination for cause, resignation without cause, or if the shareholder commits certain acts that are criminal in nature or otherwise damage the business.
In order to avoid a protracted negotiation or dispute regarding the price at which the company will buy back shares, the shareholder agreement should include a detailed description of the valuation methodology that will be used to value shares that will be bought as a result of a triggering event. Further, shareholder agreements sometimes give the company the right to buy back a shareholder's shares at a discount to fair market value, depending on the circumstances that triggered the buyout.
It is important to consider how the company will finance the buyout, particularly if it is obligated to buy back a large number of shares. If the company is concerned about taking on significant debt to pay for a buyout, it may consider paying the selling shareholder in installments in the form of a promissory note.
If you are concerned that, in the event of a sale, certain shareholders may hold up the deal, consider including a "drag-along" provision in your shareholder agreement. Drag-along provisions state that if a minimum percentage of the company's shares (e.g., 75%) vote to approve a sale of the company, the shareholders can "drag along" the remaining shareholders into the sale on the same terms.
Give Shareholders a Way Out
In certain circumstances, it may be appropriate to allow shareholders to sell their shares to a third party. This option provides shareholders with a means of exiting the company if they require liquidity when the company is not otherwise willing or able to buy them out.
Rather than providing shareholders with an unrestricted right to sell to a third party, you may consider placing some limitations on this option. For instance, shareholder agreements often include a "right of first refusal" provision that requires the selling shareholder to offer his or her shares to the company and/or the other shareholders before agreeing to sell to a third party. Shareholder agreements may also include a "lock-in" provision by which shareholders agree not to sell their shares for a minimum time period — perhaps a few years. Any sales that occur before the expiration of the minimum time period must be made at a discount to the shares' fair market value. Certain shareholder agreements feature "tag-along" rights, which state that if the company's controlling shareholders are contemplating selling their shares to a third party, they are required to include the other shareholders in the transaction in order to protect minority shareholders from being cut out of the deal.
Keeping Your Shareholders on the Same Page
Placing important provisions governing voting rights, distributions and buy-sell arrangements in your shareholder agreement helps to ensure that you and your shareholders are working from the same set of expectations. As a result, you and your shareholders can focus on overseeing your investment in the company without getting distracted by issues that could have been decided up front and documented in a shareholder agreement.