One of the most common problems faced by shareholders of closely held corporations is that there is no easy way to sell their shares if they no longer wish to be an owner of the corporation. This is because there is usually no market for partial ownership interests in closely held business entities, especially minority business interests.
Another concern that many shareholders of closely held corporations have is that, if one of the other shareholders transfers their shares, they will end up being co-owners with a third party with whom they do not wish to be co-owners.
One way shareholders address these problems are shareholder agreements, often called buy-sell agreements. These agreements typically provide a method through which a departing shareholder may sell his or her shares to the remaining shareholders or back to the corporation.
Many shareholder agreements provide the other shareholders with a right of first refusal if a shareholder wishes to sell their shares to a third party. This allows the other shareholders or the corporation to match any offer that the departing shareholder has received for their shares. This type of provision protects shareholders from becoming co-owners with at third party against their will.
Many shareholder agreements provide that the remaining shareholders or the corporation must purchase the departing shareholder’s shares if certain situations arise. Those situations often include the death of the shareholder and the termination of the departing shareholder, regardless of whether the termination is voluntary or involuntary.
Most shareholder agreements also provide a method for valuing the departing shareholder’s shares in the event that the shareholder is selling their shares to the remaining shareholders or to the corporation.
Shareholder agreements, therefore, provide protection to both to the remaining and departing shareholders. Shareholder agreements that contain a right of first refusal provide the remaining shareholders with protection against becoming co-owners with a third party against their will.
Shareholder agreements that require that the shares be purchased upon death or termination of employment protect departing shareholders by ensuring that if they die, resign or are terminated, their shares will be purchased. Without such protection, the heirs of a deceased shareholder may end up owning shares that have little value to them. If, like many closely held businesses, the company distributes its profits as salaries and bonuses to shareholder-employees rather than through dividends, the shares are not likely to have much value for the deceased shareholder’s heirs. Similarly, a shareholder-employee who has resigned or been terminated will not receive much value from owning shares in a corporation that typically distributes its profits as salaries.
However, while shareholder agreements do provide protection, they also contain potential traps. For instance, the method for valuing the shares may result in a price that is significantly lower than the shares are actually worth. Shareholder agreements often provide that the shares are to be purchased for book value. Valuing the shares at book value does not take into account the company’s goodwill, which may be its most significant asset. Other valuation methods may provide a much more accurate value.
Another trap for the unwary is language that provides that shares will be purchased in the event that a shareholder-employee is involuntarily terminated. In certain situations, termination of a minority shareholder’s employment may be considered oppression of that shareholder. If the shareholder can prove oppression, courts in many states are authorized to provide that shareholder with certain relief. However, a shareholder who has executed an agreement that provides that their shares will be purchased in the event that they are involuntarily terminated may be deemed to have waived their right to challenge an involuntary termination.
Therefore, while shareholder agreements should be encouraged, they should be carefully reviewed before a shareholder accepts the terms of the agreement.
For more information on shareholder agreements, shareholder disputes or for other corporate law concerns, contact Horowitz Law Offices.