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Shareholders’ Agreements in Private Corporations: Take Note of These Often Overlooked Provisions

Posted by: Aaron Bowman

Shareholders should think about more than just the basic provisions when considering entering into or revising a private corporation shareholders’ agreement.  Most private corporation shareholders’ agreements contain restrictions on the transfer of shares and address actions to be taken upon death of a shareholder (such as a required share repurchase or rights to buy by other shareholders).  Below are six situations and provisions that are commonly overlooked and not addressed in shareholders’ agreements. If included, such provisions could help avoid future problems and provide corporate or shareholder protection.  It is important to note that the provisions discussed below can be easily incorporated into an LLC Operating Agreement as well.
  1. The Disengaged Shareholder – Consider addressing the shareholder who either no longer wants to work for the corporation or wants to significantly scale back his or her commitment to the corporation.  In closely held corporations, shareholders are often the only directors and officers running the corporation.  If this issue is not addressed, a shareholder may still receive the benefits of being a shareholder while significantly scaling back the amount of work he or she performs for the corporation.  The remaining shareholders may be left having to shoulder the additional burden of running the corporation while still sharing future profits of the corporation with the disengaged shareholder.  A shareholders’ agreement can address this issue by including provisions that require the sale of that percentage of the shareholder’s shares that corresponds to the percentage decrease in the amount of work performed for the corporation, or a structured repurchase of all of the shareholder’s shares over a certain period of time.
  2. The Disabled Shareholder – While it may seem obvious, shareholders’ agreements often fail to deal with consequences related to a shareholder suffering a disability.  Generally, a disability in this context means that the shareholder incurs a long term condition that prevents the shareholder from performing the services to the corporation that he or she historically performed.  A shareholders’ agreement may provide that the disabled shareholder is required to sell his or her shares to the company after a period of disability that does not get resolved.
  3. Put Right – Since private corporations do not have a public market for their shares, owners/investors may want to be certain that after a certain period of time, they will have the opportunity to sell their shares.  This can be addressed with a “put right” provision providing that after a certain period of time each shareholder or certain shareholders have the right to request that the other shareholder(s) or the corporation purchase their shares in the corporation, and if they refuse to do so, all of the shareholders must work together to engage in a sale of all of the shares or all of the assets of the corporation.  This type of provision tends to be reserved for a controlling shareholder or an equity participant brought in to provide capital to the corporation for a limited period of time.
  4. Drag Along and Tag Along Rights“Drag along” and “tag along” rights can also provide exit opportunities for owners and investors in private corporations and tag along rights may provide a level of protection to minority shareholders.  Generally speaking, a “tag along” right allows shareholders to participate in another shareholder’s sale of shares to a third party under the same terms and conditions of the sale.  A “drag along” provision generally allows shareholders who own a majority of the outstanding shares of a corporation to force the other shareholders to sell their shares in a sale transaction involving a third party.
  5. Provisions Regarding Management. -  It’s important to note that shareholders can agree upon certain corporate governance matters such as who is to serve as directors and officers of the corporation, their terms of office and manner of election or removal.  If allowed by state statute, these types of arrangements provide a means for shareholders to avoid statutory requirements governing these topics.
  6. Non-Competition.  While more commonly seen in the context of employment, severance and purchase and sale agreements, non-competition clauses can be incorporated into shareholders’ agreements providing that after a forced or mandatory buy-out of a shareholder, the shareholder is not allowed to compete with the corporation for a given period of time.  However, enforceability of non-competition clauses can be tricky and enforceability requirements vary by state. 
These are only a few of the issues that should be considered and/or addressed when creating a shareholders’ agreement.  There are many other provisions that can be added to shareholders’ agreements and there are many variations on the specifics of each provision.  Each provision must be carefully implemented and drafted to ensure its enforceability and proper administration.  Furthermore, certain provisions may not be appropriate for the business circumstances of the shareholders and the corporation.  Please feel free to contact us if you are interested in preparing or revising a shareholders’ agreement related to your corporation.

 

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