Shareholders’ Agreements: Basic Considerations for Majority and Minority Shareholders in Closely Held Corporations
A shareholders’ agreement, also called a stockholders’ agreement, can be beneficial to both majority and minority shareholders of a corporation. A shareholders’ agreement is an agreement among the shareholders of a corporation that contains governing provisions related to how a corporation should be operated and managed while also outlining specific shareholder rights and obligations. Although certain provisions in a shareholders’ agreement can be duplicative of those typically set forth in the articles of incorporation, a shareholders’ agreement can be used to provide clarity and additional privileges and protections for the shareholders. This article explores various considerations to consider for either a majority or minority shareholder of a corporation whose shareholders have adopted or intend to adopt a shareholders’ agreement.
This article is primarily intended for private companies, and is neither intended to be exhaustive of the considerations that shareholders should consider when contemplating a shareholders’ agreement nor cover all of the potential provisions a shareholders’ agreement may contain. Shareholders and potential shareholders should consult with a legal professional to discuss other options, rights, and protections that could be included in a shareholders’ agreement in addition to the considerations discussed in this article.
- Management Rights – A shareholders’ agreement can change the operations and management rights, limitations, and other provisions set forth in the corporation’s articles of incorporation. Majority shareholders could use the shareholders’ agreement to expand the powers of the corporation’s board of directors and its officers while also outlining certain decision-making abilities that will not require the consent or action of the corporation’s shareholders. Additionally, a shareholders’ agreement can govern the replacement of directors or officers upon their death, disability, early retirement, or their involuntary removal from office.
- Drag-Along Rights – Majority shareholders typically like to incorporate a drag-along provision in their shareholders’ agreement which requires minority shareholders to sell their shares in the corporation upon the majority shareholder selling their controlling interest to a third party. This provision will often provide minority shareholders with the same terms and conditions as the majority shareholder is receiving for their shares. Drag-along provisions offer majority shareholders the ability to sell their controlling shares to a potential buyer without encumbering the potential buyer with minority shareholders that may be disgruntled by the change in control or who may not share the same vision for the corporation.
- Right of First Refusal – A right of first refusal clause (often abbreviated as ROFR) details how the corporation or the other shareholders have the right to acquire the shares of a selling shareholder prior to such shares being offered to a third party. Such clause will typically provide a notice period, a period to exercise the option to purchase, and may require disclosure of third party offers to allow the corporation or other shareholders to match such offer. This clause may be important for any majority shareholder seeking to retain their majority ownership and control the entry of any potential investors seeking to become shareholders of the corporation.
- Restrictions on Transfers – Another method of controlling entry into the corporation from prospective investors is the use of transfer restriction clauses. Such clauses typically require consent from the other shareholders or the board of directors when any shareholder is seeking to transfer ownership of their shares to another person. Typical exceptions to restrictions on transfers include transfers to trusts owned by the transferring shareholder or transfers upon death. Restrictions on transfers may be paired with a right of first refusal or a mandatory buyback by the corporation or other shareholders if consent is denied for a proposed transfer of shares. Restrictions on transfers are especially important when the corporation has made an S-corporation election and doesn’t want to risk jeopardizing such tax election by an improper transfer to a disqualifying shareholder.
- Triggering Transfer Events – Majority shareholders may have concerns regarding the transferability of a minority shareholder’s shares upon such shareholder’s death or disability. A shareholders’ agreement can provide other shareholders or the corporation with the option to acquire such shares prior to being sold or transferred (via a will, adjudication by a court, or other transfer or inheritance function) to a third party. A shareholders’ agreement could also give the same right to acquire shares for other specific transfer triggering events such as a shareholder’s criminal misconduct, financial impairment, retirement, or termination of employment with the corporation.
- Restrictive Covenants – Majority shareholders may have concerns regarding a minority shareholder’s ability to keep trade secrets confidential or potential to engage in activities detrimental or harmful to the corporation. A shareholders’ agreement can be used to place certain limitations on shareholder activities that are or could become detrimental to the corporation. Shareholders’ agreements can implement a detailed duty of confidentiality upon shareholders to ensure trade secrets are protected. Additionally, shareholders’ agreements may contain restrictive covenants (such as non-solicitation clauses) to limit shareholder activities that could be harmful to the business of the corporation. Restrictive covenants within a shareholders’ agreement could also limit a shareholder’s ability to undertake certain opportunities that are seen as harmful or competitive to the corporation. Additionally, restrictive covenants set forth in a shareholders’ agreement could provide for a specific survival period following a shareholder’s termination of ownership in the corporation.
- Voting Rights – Minority shareholders could seek to deviate voting right requirements from a default rule of a simple majority (more than 50%) for specific business activities or appointment of directors or officers. To help curve a majority shareholders’ control of a corporation, a shareholders’ agreement could require consent from a supermajority (for example, 67% or more) for certain major business activities such as the sale of substantially all the assets of the corporation, a merger or acquisition event, amending the corporation’s articles of incorporation, going public, or issuance of new shares. Minority shareholders can also sometimes negotiate, despite a lack of voting power, for rights to appoint one or more directors to the board of directors.
- Pre-Emptive Rights – A major concern of minority shareholders is the potential dilution of their ownership interest in a corporation upon the issuance of new shares to third parties. Shareholders’ agreements that contain pre-emptive rights allow current shareholders the right to acquire newly issued shares prior to the corporation offering such new shares to potential investors. This ensures current shareholders the opportunity to participate in new share issuances to avoid dilution of their ownership interest in the corporation.
- Tag-Along Rights – Differing slightly to the drag-along provision described above, a tag-along provision allows minority shareholders the right to sell their shares on the same terms and conditions as those being offered to the majority shareholder by a potential buyer. Tag-along provisions provide minority shareholders with the protection of receiving the same value for their shares as the majority shareholder receives. This right leverages the majority shareholder’s liquidity and ability to receive top dollar for shares in the corporation, without worrying about a minority discount, lack of control discount, lack of marketability, and other minority considerations. Additionally, minority shareholders can be offered the ability to exit the corporation upon a change in control if they are unsure or are not aligned with the future plans a potential buyer has for the corporation.
- Share Valuation – Shareholders’ agreements often set a formula to calculate share prices at any given time, especially upon the sale of the corporation. Shareholders often desire or require annual or periodic share price calculations by the corporation. This ensures the shareholders have a better idea of the value of their ownership interest in the corporation and helps to avoid surprises upon being forced into an involuntary sale (for example, through a forced buyback by the corporation, or a sale to a third party through a drag-along provision, etc.).
- Inspection Rights – Typically, most state laws provide a shareholder of a corporation with a general right to inspect the books and records of that corporation. Nonetheless, a shareholders’ agreement can be used to more specifically detail the rights, duties, and limitations of inspecting the corporation’s books and records. Minority shareholders should pay special attention to any limitations or exclusion an inspection provision may contain within a shareholders’ agreement, including minority shareholders’ ability to communicate with the officers or other employees of the corporation or access to specific financial statements of the corporation.
- Deadlock Purchase – A corporations with equal voting powers among its shareholders may find itself in a decision-making deadlock, especially when a 50/50 voting split is possible, or if a decision requires unanimity. A shareholders’ agreement can layout deadlock breaking provisions to avoid deadlocks, litigation, or disputes among shareholders. One method of breaking a deadlock is providing for a deadlock purchase right whereby a shareholder can exercise their right to either sell their shares or force the sale of the other shareholder’s shares. Typically, notification requirements, option rights, and the purchase price are established within the terms of the deadlock provision to avoid additional disputes over price. Such provisions can save the corporation a lot of time and money by avoiding litigation among its shareholders and offering a quicker solution to continue business operations.
- Joinder Agreements – Typically, shareholders’ agreements will have an accompanying Joinder Agreement, whereby new shareholders will “join” the existing shareholders’ agreement. This saves the existing shareholders and corporation both time and money by avoiding the hassle of re-negotiating the shareholders’ agreement and executing a new agreement every time a new shareholder is added to the corporation’s stock ledger.
Drafting a sound and practical shareholders’ agreement for your corporation can help mitigate the risk of future disputes among shareholders by outlining expectations at the onset of ownership or before a problem arises. Additionally, shareholders are able to negotiate certain rights and protections not otherwise provided under statutory laws. The assistance of an experienced legal professional can help navigate the negotiations between minority and majority shareholders that will often have contrasting interests in the terms and conditions that should be included in a shareholders’ agreement. Whether you are a minority or majority shareholder, consider consulting with a legal professional to discuss the various options, rights, and protections, in addition to those considerations already discussed above, that could be offered in a shareholders’ agreement and that would best suit your ownership interest and corporation. If you are considering an investment in a corporation, find a legal professional to assist in the review of any existing shareholders’ agreement to fully understand your rights and obligations prior to becoming a shareholder.