1. Do Not Confuse the Articles, By-laws and Shareholders Agreement.
Entrepreneurs forming a corporation for the first time may find that they are unclear as to the differences between the Certificate of Incorporation (or Articles of Incorporation), By-laws and the Shareholders Agreement:
A. Certificate of Incorporation: This document (which often have a different name outside of New York, such as Articles of Incorporation), is the only document that must be filed in New York to form a corporation. As with many states, New York provides a simple form requiring only limited information to be included in the Certificate (name of the entity, purpose, county where located, number of authorized shares, and name of registered agent). While you may draft your own form, the simple New York form is all that is required to incorporate. There are siutations where you might draft your own Certificate of Incorporation, as where there are different classes stock, and the Certificate of Incorporation will be more complex. However, the basic Certificate of Incorporation is a bare-bones document that does not address any issues relating to corporate governance, authority of the Board of Directors, or the rights and obligations of the shareholders.
B. By-laws of a Corporation. The By-laws serve the purpose of setting forth important terms relating to the governance of the corporation. Thus, the By-laws establish important aspects for day-to-day operation of the corporation:
(i) Board of Directors: the number of members of the Board of Directors, meetings of the Board, voting, removal, vacancies, and powers of the Board of Directors;
(ii) Shareholders: Annual and Special Meetings of Shareholders, including notice, voting, and general procedures;
(iii) Officers: election/appointment and removal procedures and authority of officers;
(iv) Indemnification: indemnification of Directors, officers, employees of the corporation; and
(v) Miscellaneous: Stock, Maintaining Books and Records, Seal of the Corporation, Amendments to the By Laws.
C. The Shareholders Agreement. The Shareholders Agreement is the document among the Shareholders and the Corporation where a number of specific rights and obligations of the shareholders and the corporation are detailed. The Shareholder Agreement is a contract, and can include essentially any terms that do not violate the New York Business Corporation Law (or any other applicable law). Typical provisions can include voting agreements or rights among the shareholders, restrictions on voluntary transfers of stock (i.e., selling stock to a third-party) and involuntary transfers (death, bankruptcy or divorce of a shareholder), a buy-out clause, non-competition obligations, information rights of shareholders, and limitations on authority of the Board of Directors and dispute mechanisms.
2. Why the Shareholder Agreement is Essential.
The Shareholder Agreement is essential as it clarifies the rights and obligations of the Shareholders between each other as well as certain obligations of the corporation to the shareholders that are not otherwise included in the By-laws. Too often entrepreneurs, to their peril, are willing to rely on the relationship with their friend (now business partner) or believe they lack the negotiating position to ask for certain rights as a condition of an investment or becoming a minority partner in a business. A well-drafted Shareholders Agreement not only helps delineate the rights of the business partners, but it will in most cases resolve any disputes before they arise because the issue will have been addressed in the Agreement.
Below are some typical disputes that will be alleviated with a Shareholders Agreement:
- Deadlock in a 50/50 corporation
- The sale of shares by your business partner to his undesirable friend
- The transfer of shares to the free-loading son of your deceased business partner
- The transfer of shares to your business partner's spouse in a divorce
- A decision by the Board to hire an employee at a ridiculously high salary
3. What are some of the Key Provisions to Include in a Shareholders Agreement?
Important provisions in a Shareholder Agreement will, at a minimum, include:
A. Restrictions on voluntary and involuntary transfers of a shareholder's stock;
(i) Right of First Refusal
(ii) Co-Sale (Tag Along) Rights
B. Resolution mechanism/buy-out clause in case of a deadlock;
C. Voting rights and obligations among shareholders;
D. Limitations on Board of Directors powers; and
E. Several Miscellaneous Rights
(i) Restrictive Covenants
(ii) Drag-Along Obligations in the event of sale of the company
(iii) Information Rights
The next several posts will discuss the above typical clauses of a Shareholders Agreement, including important drafting tips.
Disclaimer: The discussions in this Blog do not constitute legal advice nor create an attorney-client relationship. You are urged to seek the advise of an experienced lawyer who can provide counsel with respect to your corporate/business law matters.