Saturday, November 22, 2014

The Essentials of a Good Shareholders' Agreement (Part II): Right of First Refusal

I recently received a kind email regarding a post I did some time ago regarding the importance of the Shareholders Agreement:  The comment noted, however, that I had indicated there would be subsequent entries discussing key components of a good Shareholders' Agreement.  In the vein of better late than never, the next several posts will focus on the key provisions of a Shareholders/ Agreement.  The focus of this post is the Right of First Refusal.

1.  Why is a Right of First Refusal Important?

A well-drafted Shareholders' Agreement should include a Right of First Refusal, granting the right of the corporation and/or other shareholders to purchase the shares of a selling shareholder before those shares can be legally sold to a third party.  Absent the right, a selling shareholder can simply sell the shares to a third party -- which in theory does not sound like an issue, but in reality can be a nightmare for the business.  Consider the issues that can arise when a shareholder is not restricted from selling its shares to whomever it wishes on whatever terms:  the shares could be sold to someone you do not want to be in business with at a price that is substantially below the value of the business.  Moreover, what if the selling shareholder is a founder or selling a controlling stake in the corporation -- regardless of the person's character, you may not see the purchaser as the right person to be holding the reigns of the business.  Shareholders in a privately held company invest in a business because of a belief in the founders, and if a founder can just sell its interests to anyone without restriction, the very reason for owning the shares can be at risk.  On the other side of the coin, as a founder, you often take in investments from others not only because of financial needs but also the expertise, reputation or relationships that an investor may bring to the business.  When an investor sells without the restrictions of a Right of First Refusal, the founders should be concerned whether the purchaser is an appropriate partner for the business, and should not overlook the fact that as controlling shareholders the founders will owe a fiduciary duty to this new shareholder. Thus, the Right of First Refusal is essential to protect the interests of both the founders and investors.

2. Who Can Have the Right of First Refusal?

The Right of First Refusal can be granted to the corporation, the shareholders or both.  Often, the corporation will be granted the option to purchase the shares before they are required to be offered to the non-selling shareholders.  Vesting the initial right in the corporation has the following advantages:

                    (i) it allows the corporation to "clean up" the capitalization table; in other words, reduce the number of shareholders and outstanding shares.  By reducing the number of outstanding shares, the other shareholders benefit because their percentage of ownership will increase (i.e., if there are 200 outstanding shares, four shareholders each with 50 shares, they thereby each own 25% of the corporation; if a shareholder sells 50 shares to the corporation, the total outstanding shares drops to 150, and the three remaining shareholders would then each own 33% of the company);
                   (ii) the corporation now has additional shares it can offer to existing or a new investor, without diluting the existing shareholders, and
                  (iii) the corporation can prevent an existing shareholder from increasing its stake to a level that may not be viewed as ideal for the business.

If the Right of First is not given to, or exercised by, the corporation then the existing shareholders will have a right to purchase the shares. Note, that in a more complex structure where there are different classes of stock, holders of a particular series of stock (for example, Class A Preferred Shares) may be granted the Right of First Refusal in priority to, or exclusive of, other classes of stock).  Again, giving the Right to the shareholders allows them to prevent a third-party buyer from becoming a shareholder and affords an opportunity to increase ownership in the business.

3. When is the Right of First Refusal Triggered?

Of course, the Right of First Refusal is triggered upon a "sale" of the shares by an existing shareholder; however, what constitutes a "sale" or triggering event?  Obviously, the Right should arise if a shareholder has an offer from a third party to purchase all or a portion of the shares owned by the selling shareholder.  Other events can also trigger the obligation, such as an involuntary sale that is triggered by the occurrence of an event set forth in the Shareholders Agreement.  These involuntary events can include the death, disability or retirement of a shareholder or for "cause" events like conviction of a crime, fraud, misappropriation, violation of non-compete or confidentiality requirements or breach of material company policies.   In some circumstances, the selling shareholder may hold a particular license, and the suspension or loss of the license would jeopardize the status of the company as a professional services corporation, requiring the sale of the person's shares in the company.  When drafting the Right of First Refusal, consider not only the events that, aside from a voluntary sale, should trigger the right, but also when is a triggering event deemed to occur -- f.e., what constitutes and who determines if a "disability" or a material breach of corporate policies has occurred.

4.   What are the Key Aspects of the Right of First Refusal?

  • First, as noted above, identify who has the right:  the corporation, the shareholders, and which shareholders (if any).
  • Second, detail when the right is triggered:  (i) for a voluntary sale it is typically upon an offer to a third party and (ii) for an involuntary sale, the clause should explain what constitutes an (involuntary) triggering event and who will make the determination that it has occurred.  For example, will a physician make the decision about whether a shareholder has a "disability" and if so how will that physician be selected.
  • Third, provide clear notice provisions:  consider what details must be included in the bona fide third party offer, how long does the corporation/non-selling shareholder have to exercise its rights, and include a clear statement that the failure to exercise within a defined time period constitutes a waiver of the right.
  • Fourth, if the corporation does not purchase any or all of the offered shares, what are the rights of the non-selling shareholders, and if one or more non-selling shareholder does not exercise the right, can the others who exercised the right purchase a greater portion of the offered shares.
  • Fifth, in the case of an involuntary sale, how is the purchase price to be determined:  this is the most difficult aspect of drafting a Right of First Refusal, requiring terms that address who makes the determination (such as an accountant, investment bank or other person with a particular expertise relating to the business) and what formula should be used (such as a multiple of gross or net revenues, net profit, discounted cash flow, book value or a host of other valuation procedures),
  • Sixth, if the right is exercised, what are the terms for closing the sale:  (i) when must the corporation or non-selling shareholders close on the purchase of the shares; and (ii)  is there a defined structure for payment of the purchase price (such as partial payment at closing and the remainder as a loan or are the proceeds of a Buy-Sell Insurance policy available).
  • Seventh, if the third party does not close the sale by a certain time period, must the shares be re-offered to the corporation/non-selling shareholders.
5.   A Word about Buy-Sell Insurance.

A dilemma can arise if the corporation or non-selling shareholders want to exercise the right but do not have the financial ability to do so at the time.  As noted above, one way to address the issue is by including provisions for structuring the purchase through installment payments or a loan, alleviating the issue that arises when the corporation/non-selling shareholders want to exercise the right but lack the funds.  Another mechanism that should strongly be considered is obtaining Buy-Sell Insurance.  With Buy-Sell Insurance, the corporation (and the shareholders, if they obtain a policy as well), can fund the purchase the insurance proceeds of the policy.  The insurance proceeds are used to purchase the shares upon defined events, which are usually death or disability of a shareholder (but can include other events).  In the course of drafting the Shareholders' Agreement, the shareholders should consider the option of purchasing a Buy-Sell Insurance policy.  If the company/shareholders are not in the position to do so, then the Right of First Refusal should include a provision that if a policy is obtained down the road, it will in the first instance be used to fund the purchase of the shares from the departing shareholder.

Needless to say, a well-drafted Right of First Refusal clause is an essential component of the Shareholders Agreement.  As a word of caution, however, make sure the provision addresses the specific interests of the company and the shareholders rather than simply relying on a one-size-fits all approach.  Considering who can exercise the right, when it is deemed triggered, how valuation is determined, and the options for funding the buy-out are crucial when drafting the provisions of a Right of First Refusal.  

Disclaimer:  The discussions in this Blog are for informational purposes and 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.