Critical Issues In Structuring Shareholders Agreements Of Closely Held Companies

Sunday, June 1, 2008 - 01:00

In many instances the relationship among shareholders of closely held companies draws comparisons to that of a marriage, and as you might expect, the agreement that governs certain aspects of that relationship similarly draws comparisons to that of a prenuptial agreement. In essence, a well-drafted shareholders agreement should provide for a contractual resolution of an assortment of issues before they become problems. Addressing these issues early on (at a time when all shareholders are getting along), often avoids possible litigation later, and in many instances will allow the company to continue its day-to-day operations with minimal disruptions. Although this article generally focuses on shareholders agreements (agreements that govern the relationship among shareholders of corporations), the same issues apply to the agreements for equity holders of limited liability companies and partnerships. Though not an exhaustive list, some of these key issues are (1) voting rights, including minority protections and day-to-day management rights; (2) restrictions on the right to transfer shares; (3) buy-sell rights and applicable purchase price terms; and (4) restrictive covenants (non-compete clauses) applicable to shareholders during and after ownership. While there are several other important provisions that should be included covering distributions, allocations and various tax issues (particularly for limited liability companies and partnerships), this article focuses on only the four areas listed above.

Voting Rights And Management

A basic issue in all closely held companies, where the ownership is not equally held, is that of voting. In general, unless specifically set forth in the shareholders agreement, shareholders controlling more than 50 percent of the shares control the vote. Accordingly, shareholders agreements often provide that certain fundamental decisions should require the unanimous consent of all of the company's shareholders. These fundamental decisions vary from business to business, but often include: (i) sale, liquidation or winding up of the company; (ii) material acquisitions and dispositions; (iii) significant borrowing or lending; (iv) name changes; (v) hiring or firing of employees; (vi) increasing employee compensation or benefits; (vii) opening new offices or branches; (viii) entering into new lines of business; (ix) commencing or settling lawsuits; (x) making material investments; and (xi) issuance of additional equity.

An advisable way to streamline the management process of a closely held corporation is to have the shareholders approve an annual operating budget and capital expenditure budget each year and then vest in a shareholder (if such shareholder is involved in the management of the company) or an officer of the company, the authority to manage the company's day-to-day operations within the approved annual budgets. Once such budgets are approved, shareholder consent will only be needed for actions that fall outside of the approved budgets. Further flexibility can be built in by allowing such shareholder or officer to act within a percentage above or below the agreed-upon budgets.

Restrictions On Transfer And Participation Rights

Unlike a large corporation, a closely held company is likely to have most or all of its shareholders actively involved in the operations of the company. As a result, it is common to place certain restrictions on shareholders' ability to sell their shares. An outright restriction on a shareholder's ability to sell shares is typically unenforceable; therefore, shareholders agreements will usually allow shareholders to sell their shares subject to either a "right of first refusal" or "right of first offer."

A right of first refusal provision requires a selling shareholder to first obtain a bona fide third party offer for his or her shares. Once obtained, the selling shareholder must then provide all non-selling shareholders the right to purchase the shares on the same terms and conditions as the selling shareholder has been offered by such bona fide third party purchaser.

A right of first offer provision requires a selling shareholder to first offer his or her shares to the non-selling shareholders, setting forth a price and terms for the sale. If the non-selling shareholders do not accept such offer, the selling shareholder is then entitled to sell his or her shares to a third party on terms not more favorable than those presented to the non-selling shareholders. If the purpose for having the right of first offer is to discourage shareholders from selling to third parties, the right of first offer should be coupled with a matching right that allows the non-selling shareholders the opportunity to match the final offer made by a third-party purchaser.

It is also common to couple rights of first refusal and rights of first offer with what are commonly referred to as "drag-along rights" and "tag-along rights." A drag-along right (which is typically given to the majority shareholder(s)) gives the selling shareholder (in connection with his or her sale) the right to require the non-selling shareholders to sell all of their shares to the third-party purchaser on the same terms (thus allowing for a sale of 100 percent of the company). A tag-along right (which is typically given to the minority shareholder(s)) gives the non-selling shareholders the right to join in the sale by the selling shareholder, on the same terms (thus preventing a minority shareholder from being left out of a sale by the majority shareholder(s)).

In a company with only two shareholders, it may be advisable to include a provision that triggers a mandatory sale by one of the shareholders in the event there is a fundamental disagreement among the shareholders. Often referred to as a "shotgun" provision, this provision provides that when the shareholders are deadlocked over a fundamental matter concerning the company, either shareholder can trigger a buy-out.

Buy-Sell Rights

In addition to the deadlock scenario discussed above, there are other circumstances in which shareholders of closely held companies may want to provide for a mandatory purchase and sale of shares. Some of these circumstances include (i) termination of a shareholder's employment with the company, with or without cause; (ii) voluntary resignation of a shareholder; (iii) termination of employment by a shareholder with good reason; (iv) death of a shareholder; and (v) disability of a shareholder.

Upon the occurrence of each of the above events, the company and the remaining shareholders will have a strong incentive to purchase the shares of the departing shareholder so that the company does not have shares in the hands of an undesired shareholder. Whether to make the buy-out optional or mandatory in each circumstance is a matter that is negotiated and fact-specific, as is the determination of whether the right to purchase should be given to the remaining shareholders or the company itself.

There are many factors to consider in establishing the purchase price and terms that should apply in each of the above scenarios. In circumstances where the shareholder's employment is terminated without cause, with good reason, or by reason of disability, it is generally most equitable for the departing shareholder to receive fair market value for his or her shares. To determine fair market value, the company can either engage an independent appraiser or incorporate a pre-negotiated formula price. How to structure the payment will often depend on the type of business involved (i.e., service sector or manufacturing-based) and the financial capability of the remaining shareholders or the company, as the case may be.

Where the departing shareholder has been terminated for cause or has voluntarily resigned without good reason, it is customary to provide for a discounted purchase price. However, the circumstances vary from company to company and it may not always be appropriate to have a discounted price for these events.

In the event of the death of a shareholder, it is advisable to tie the purchase price to insurance proceeds. In a company with only two shareholders, it is probable that the most tax-effective approach is for each shareholder to obtain an insurance policy on the other (generally referred to as a cross-purchase). The shareholders agreement should provide for a mandatory obligation on the surviving shareholder to purchase, and the estate of the deceased shareholder to sell, the deceased shareholder's shares for an amount that in most instances will be satisfied by the insurance proceeds. This will result in the surviving shareholder receiving a step up in basis equal to the purchase price when he or she purchases the shares. Where a company has more than two shareholders, the cross-purchase approach is still likely to be the most tax-effective approach, but it can become burdensome and complicated. The alternative approach is to have the company as the beneficiary of the insurance policy, but in many instances it is not as tax-favorable.

Restrictive Covenants

Depending on the nature of the business, shareholders agreements often contain restrictive covenants designed to protect the company by preventing departing shareholders from directly competing with the company after they depart. Restrictive covenants are especially important in service businesses where the opportunity to damage the company through solicitation and servicing of its clients is greater.

The scope and term of the restrictions will depend on the circumstances applicable to each company. However, as a general matter, shareholders should be bound by confidentiality obligations and should be prohibited, at a minimum, from soliciting the clients and employees of the company for so long as such shareholders own shares in the company and for a reasonable period of time thereafter. In certain circumstances, the restrictions should be broadened to prohibit rendering services to clients of the company and potentially to competing with the company, in each case, for a reasonable period of time after a shareholder has ceased to own shares.

Conclusion

This article has attempted to address some of the more customary provisions that should be contained in the shareholders agreements of closely held companies. Memorializing many of these provisions may ultimately avoid conflicts and problems down the road. The issues discussed here are by no means exhaustive, but tend to be those most commonly faced by shareholders of closely held companies. Other matters that often need to be addressed include distributions, allocation of profits and losses and tax consequences. Needless to say, a shareholders agreement, as well as agreements governing limited liability companies and partnerships, are complicated documents. Therefore, equity holders of closely held companies should always discuss their specific circumstances and objectives with their legal, financial and tax advisors before entering into any such agreements.

Brad Schwartzberg is a Partner and Joshua Walker is an Associate in the Corporate Practice Group of Davis & Gilbert LLP.

Please email the authors at bschwartzberg@dglaw.com or jwalker@dglaw.com with questions regarding this article.