By: Robert C. Hackney
Why would we need a shareholders’ agreement?
Unfortunately, that is like asking an 80 year-old billionaire who is marrying a 30 year old model why he needs a prenuptial agreement.
In the beginning
Every start up begins life as a basic concept in the mind of its creator. Through thought and discussion with colleagues, the concept grows and becomes more focused over time, until it reaches the stage where its creator decides that it could be a viable business opportunity. Usually by the time, it is not just the sole entrepreneur’s baby, but is the result of collaboration among a number of individuals who have invested their time, effort and creative talents to bring it to a full blown business idea, perhaps with a concrete business plan.
At this stage, potential complications may already be brewing for the new start up. Every person who considers himself or herself as a contributor to the idea now has a vested interest in the start-up, and wants to see it succeed. Each person may eventually have a different vision for the new entity, as to it focus, its market, its operational structure, and a plethora of other categories.
Starting a new company is exciting and it is also exhilarating. Everyone is so excited that they sometimes don’t want to slow down or stop for a moment, they must remain in forward motion. Don’t worry, we will take care of the details later. In the rush to get launched, critical factors are often overlooked, and ignoring these factors can quickly shatter the dreams and aspirations of all of the founders. By not paying attention to one basic business concept, they set themselves up for failure, and set the company up for destruction.
Basic Corporate Structure
To begin with, entrepreneurs need to recognize and appreciate the basics of a corporate structure. Without discussing the nuances of the various hybrid entities, and focusing on the corporation, which is where most start-ups begin life, a corporation is owned by its shareholders. These shareholders elect a board of directors, and the board of directors then appoints the company’s officers. Because all start-ups are generally small, these distinct functions usually get muddled, and it is hard to remember who is wearing what hat at what time.
In the strictest sense, and separating each group into their own different box, the function of the board of directors is to set the company’s policy and direction. The function of the company’s officers is to carry on day to day operations, and carry out the policy directives set by the board of directors. The confusion comes when some, if not all, of the players are participants in all three categories. A good shareholders’ agreement addresses the typical problem areas and sets the standards to avoid disaster.
What is it?
So, just what is a shareholders’ agreement? Simply put, it’s a contract that covers all of the intricacies of your particular corporate situation. Corporations are like people, no two of them are the same, so the state corporate law and the standard bylaws won’t cover the individual situation that is unique to your company. You need more, you need a shareholders’ agreement. (By the way, you will see this referred to as a “shareholder agreement,” a “shareholders agreement” or a “shareholders’ agreement,” all of which are in common usage.)
When the company is young, and only has a few shareholders, all of whom are also either officers or directors or both, the shareholder’s agreement is critical. Generally speaking, the larger the shareholder base, the less important the shareholders’ agreement. Think of the shareholders’ agreement as the document that sets forth the rights of the shareholders, and the powers and duties of operational management (officers) and the directors. A shareholders’ agreement may be among all shareholders, or just some of them, depending upon what you are trying to accomplish.
Areas to be covered in a Shareholders’ Agreement
The areas commonly addressed in a shareholders’ agreement include:
a. Determination of what happens when a shareholder dies, retires or becomes incapacitated;
b. Establishment of the number of directors of the company, duties, and agreements to vote for certain persons as members of the board;
c. Set forth any rights of first refusal;
d. Set forth any pre-emptive rights of shareholders;
e. Set forth any other sale restrictions on shares;
f. Create buy-sell provisions upon the triggering of certain events;
g. Creation of Tag Along or Drag Along rights.
Best Reasons to have a Shareholders’ Agreement
The following are some of the best reasons to consider entering into a shareholders’ agreement.
1. More specific rules for management. As we said above, the Supreme Court says that corporations are people, and as I stated before, no two people are alike. Bylaws cover the basic points, but the real customization comes in the shareholders’ agreement. This provides you a way to tailor the rules and regulations to fit your specific needs in your corporation.
2. Protection for minority shareholders. Specific provisions can be inserted that provide more protection for minority shareholders than you normally find in the bylaws. For example, certain major decisions might only be made if a high percentage of shareholders approve such action. Also, rights such a Tag Along Rights might be inserted into a shareholders’ agreement so that if the majority shareholders decide to sell their shares to a new owner, they have to offer the same deal to the minority shareholders.
3. Protection for majority shareholders. Sometimes, given too much power, the tail wants to wag the dog. If minority shareholders have the power to veto certain actions, then it’s the majority shareholders who are not being treated fairly. The insertion of Drag Along Rights can be helpful, in that a few minority shareholders may not be able to hold up a sale of the company or its shares if the majority have the right to “drag them along.” Hold out under this scenario cannot kill a takeover of the company.
4. Transfer Restriction on Shares. Frequently, shareholders in a small company want to know exactly who their other shareholders are, and whether or not they are compatible with the vision and direction of the company. We have all seen the one minority shareholder who has cause more havoc than necessary, and sometimes has destroyed a company just by the power of their negative personality, or their cunning desire to squeeze the majority. We frequently see a “right of first refusal” in a shareholders’ agreement that gives a right to the company and/or the other shareholders to purchase the shares of a shareholder who wants to sell. If the old shareholders are uncomfortable with the possible new shareholder, they can exercise their right and buy the shares on the same terms and conditions as the third party has offered.
5. Buy-Sell Provisions. Most frequently seen in companies with two or three shareholders, the buy-sell provisions are useful particularly when a shareholder retires, dies or becomes incapacitated. A buy-sell is sometimes funded by life insurance. If allows a company to go forward after losing one of its founders without having to take in a new “partner.” There are many horror stories about a 50% owner becoming partners with his former shareholders’ spouse, which ends in litigation or destruction of the business enterprise.
6. Linkage to Employment. In many small companies, the shareholders are also the employees. What happens when an employee leaves? Even if it’s on friendly terms, now the company may be required to pay dividends to the only shareholder who does not work there, and is now contributing nothing to the success of the company. In such circumstances, the company or the other shareholders want the opportunity to buy the departing employee’s shares.
7. Non-Compete. If a shareholder-employee leaves the company, most companies want a mechanism to keep the former employee from competing with his former employer. While provisions like this are also typical in an employment agreement, they seem to carry more weight being included in a shareholders’ agreement, and may alleviate the need for an employment agreement (which may have more restrictions on the company).
8. Method of dealing with disputes and disagreements. My personal experience and belief is that more companies fail due to internal disputes, than fail due to lack of funding, bad products, or lack of sales. A shareholders’ agreement that lays out the way to resolve disputes is the most important aspect of any shareholders’ agreement, and in the case of a 50-50 ownership situation, is a basic requirement of starting any company. There are a variety of methods of dispute resolution.
Remember, your company is unique. There is no formula that fits all companies. There is no silver bullet. This post is to help stimulate thought by thoughtful shareholders and perhaps to provide some potential guidance, but there is no “one size fits all” in the world of shareholders’ agreements. So, if you have already started your company, and you don’t have a shareholders’ agreement, stop what you are doing right now, and get it done. Don’t be the billionaire without a prenuptial agreement.