By Theodore J. Cohen

August 2016

The decision to start a new business is often followed by the decision to operate in the corporate form.  The equity ownership of the entrepreneurs in the newly formed corporation is most frequently represented by common stock, which is issued in exchange for the capital contributions of each to the corporation.  The shareholders of the newly formed corporation generally devote significant efforts to making their new business a success and concern themselves little with issues related to the transfer of their stock in the corporation or to obtaining fair value for their stock in the event of death or disability.  More often than not, at the outset of a venture, there are no willing buyers for these stock interests and the value of the stock may be minimal.

Fortunately, a significant number of entrepreneurs find their efforts rewarded, with the result that their stock comes to represent ownership of a very valuable asset:  the corporation and its business.  The value is most frequently realized by the shareholders through distributions from the corporation in the form of salaries and dividends and by receiving benefits such as health and life insurance.

Despite the value of the stock interest to the shareholder, the shareholder’s interest in the corporation is likely to be unmarketable.  Moreover, many shareholders of closely held corporations find the thought of any of their fellow shareholders transferring their stock interests to third parties unpalatable, since the shareholders of such corporations are usually a relatively closely knit working group.  In addition, if there are more than two shareholders with equal stock interests each shareholder holds only a minority interest in the corporation.  An owner of such a minority interest who is not an active participate in the business (such as a spouse, disabled shareholder or other person who might inherit the shares) may be unable to realize the value of the ownership interest in the corporation, since this shareholder would not receive a salary and dividends may not be paid.

An agreement among the shareholders is the mechanism that is most frequently employed to address these concerns.  Shareholders agreements almost always cover two primary areas: transferability of shares and purchase by the corporation or by the other shareholders of a shareholder’s stock upon death or disability.  Shareholders agreements may also address myriad other subjects, including voting agreements, designation of particular parties to particular offices of the corporation, designation of salaries and benefits and other matters.

Provisions Related to Transferability of Shares 

Shareholders generally agree that they do not want stock of the corporation to end up in the hands of anyone other than themselves, without their express consent.  This objective is achieved by restricting transferability of the stock, except for transfers to permitted transferees, such as family members, family trusts and other entities controlled by a shareholder.  If a shareholder desires to transfer his or her stock and succeeds in finding a willing buyer, a provision frequently included in shareholders agreements will require the shareholder seeking to dispose of his or her stock first to offer the stock to the other shareholders on the same terms and conditions upon which a sale is proposed to be made to the third party transferee.  The shareholders are then permitted to purchase the transferring shareholders stock in proportion to their existing interests in the corporation, so that an equivalent balance of ownership among the remaining shareholders is maintained.  If the remaining shareholders, as a group, decline to purchase all of the stock offered, the shareholder desiring to dispose of stock is free to consummate the sale to the third party, provided the transferee agrees to be bound by the terms of the shareholders agreement.  This latter condition insures the continuation of the restrictions on transferability.  Such provisions are referred to as a right of first refusal.

Purchase of Shares Upon Death or Disability of a Shareholder

Shareholders agreements frequently provide that upon the death of a shareholder the corporation will be required to purchase the shares of the deceased shareholder.  The purchase price is often determined by mutual agreement of the shareholders on a yearly basis, or may be based upon a multiple of the corporation’s prior year earnings, an average of previous year’s earnings, or upon some other objective indicia of value.  Often the purchase of a deceased shareholder’s stock is funded by life insurance maintained by the corporation on the life of each of the shareholders.  Where no insurance coverage has been obtained to provide funds for such a stock repurchase the deceased shareholder’s stock may be purchased by the corporation out of funds legally available for this purpose, either in a lump sum or over a period of years.  The obligation to purchase the deceased shareholder’s stock may also be imposed upon the surviving shareholders, in which case these shareholders are generally required to purchase the deceased shareholder’s stock in proportion to their existing stock interests in the corporation.

The repurchase of a shareholder’s stock upon long term or permanent disability of a shareholder is also generally provided for in a shareholders agreement.  The obligation to purchase the stock of the disabled shareholder is generally imposed upon the corporation or (if the corporation lacks funds available for the purpose) on the remaining shareholders.  The manner in which disability is defined is a significant issue in this context.  A shareholder should only be required to sell stock upon suffering a long term disability that severely impairs the shareholder’s ability to perform his or her functions on behalf of the corporation.  An appropriate definition of disability can assure this result.

Voting Agreements

Shareholders agreements frequently contain agreements among the shareholders to vote their stock to elect each shareholder as a director and, as a director, to appoint each shareholder as a specified officer of the corporation.  These provisions assure that each of the principals of the corporation will be entitled to act in the capacity intended and protect against two or more shareholders, who together control a majority interest in the corporation, banding together to exclude other minority shareholders from participating in managing the corporation.

Conclusion

Shareholders agreements provide important protections to shareholders who are concerned about (1) keeping unwanted third parties from becoming equity participants in their business, (2) obtaining fair value for their stock upon death or disability, and (3) otherwise assuring their continued participation in managing their corporation.  Shareholders agreements need not be complex documents, nor are they necessarily burdensome to prepare.  Through a shareholders agreement, shareholders of a corporation may articulate in a clear, written statement their intentions with regard to important issues affecting their valuable ownership interests in the corporation.  


© 2016 Cohen/Mainzer LLP. All Rights Reserved.  Attorney Advertisement. This document is not legal advice and you should not rely upon it as a substitute for legal advice based on your particular situtation.  This document may not be accurate, complete or up to date, based on the facts applicable to you, and Cohen/Mainzer makes no representation or warranty that it is. Receipt or use of this article does not create any attorney-client relationship between the user and Cohen/Mainzer.