Showing posts with label Co-Sale. Show all posts
Showing posts with label Co-Sale. Show all posts

Tuesday, December 18, 2012

Why You Need a Shareholders Agreement (Part I)

If you are forming a corporation with a partner, regardless of whether it is with your best friend that you have known since birth or a new business relationship, executing a well-crafted Shareholders Agreement is essential.  Too often, partners mistakenly believe that the corporate By Laws answer all the questions and will adequately set the parameters for the relationship between shareholders.  While the By-laws address day-to-day operations of the corporation, the Shareholder Agreement is where a number of specific rights and obligations of the shareholders are set forth.  Common provisions of a Shareholders Agreement will address such issues as voting rights, restrictions on voluntary and involuntary transfers of stock, buy-out clause, non-competition obligations, death, incapacity or divorce of a shareholder, and limitations on Board of Directors powers.  The next several posts will address the importance of the Shareholders Agreement, some of the common provisions, as well as several issues that are often overlooked in drafting the Agreement.

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         
If the business partners have a Shareholders Agreement, all of the above can be dealt with before they become issues.
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.

Wednesday, February 22, 2012

Why the LLC is a Favorite for Start Ups (Part II)

This post is Part II of a discussion as to why lawyers suggest, and entrepreneurs often prefer, the structure of the limited liability company over other business entities.  While the LLC is relatively new in comparison to the corporation, start-ups more often choose the LLC when forming their business.  Therefore, what is it about the LLC that makes a preferred structure for start-ups?  As explained in the first installment, there are three reasons the LLC has become so prevalent:

          1.  Reason #1: The tax advantages of the LLC versus the corporation;

          2.  Reason #2: The extremely flexible nature of the LLC, allowing wide-latitude in structuring the rights and obligations of the members (i.e., the partners);

          3. Reason #3:  The user friendly nature of an LLC.  

A comparison of the arguable tax advantages of the LLC was the subject of the previous post, while this post focuses on the flexibility of the LLC and the wide-latitude it provides in structuring the rights and obligations of the partners.

Reason #2: The extremely flexible nature of the LLC, allows wide-latitude in structuring the rights and obligations of the members (i.e., the partners).

The document governing the rights and obligations of the members of an LLC is the Operating Agreement.  The key aspect of the Operating Agreement is that it is an extremely flexible document and is limited only by what is expressly prohibited or required by the NY LLCL.  Therefore, the members can utilize the Operating Agreement to structure the economic and control rights to fit the needs of the members and the business.

            A.  Do you want the entity controlled by all the members or a manager?  Under New York law, LLCs are by default deemed member managed, and thus each member has management authority; however, New York law also allows the members to instead choose to have the LLC managed by a manager or a board of managers, and the manager does not need to be a member of the entity.

           B. Do you want all the members to have the same rights?  If not, different classes of members can be created based on voting or economic rights, and in fact some members can be given economic but not voting rights.  Additionally, economic and voting rights need not be based on ownership percentage in the LLC. Contrast this flexibility with an SCorp which prohibits creating different classes of shareholders.  Another alternative is to require super majority or even unanimity for key decisions, leaving the manager to run the day-to-day operations but limiting the authority to protect the rights of minority members when it comes to important substantive issues.

          C.  Do you want to restrict the transfer, pledge or sale of membership interests?  Through the Operating Agreement, the members can elect to include provisions restricting the transfer, pledge or sale of membership interests.  Adding provisions such as a right of first refusal, a co-sale right and a prohibition on the pledge of one's membership interests not only (i) limits the ability of a member to dispose of its interests  without an opportunity for the other members to also monetize, in part, their interests, but also (ii) means the existing members can preclude the admission of a third party who they may decide is not good for the business.

          D. What can be done if I have a dispute with my partner?  The members will have an opportunity when drafting the Operating Agreement to include a Buy/Sell provision addressing the rights of the members if a serious and seemingly unresolvable dispute arises. The Buy/Sell provision should detail the procedure for exercising the right and the methodology employed for valuation of the membership interests. See  In addition, include a clear dispute resolution clause, as you would in any contract, which states the venue for resolving claims both in terms of the type of tribunal (i.e., court, arbitration, mediation) and the actual geographic location (for example, New York County or Nassau County).

         E. What are other examples of what can be included in the Operating Agreement and what are the limitations?  Simply put, the the Operating Agreement can include any provision the members decide to incorporate provided it is not prohibited by the New York Limited Liability Company Law (or is otherwise unlawful).  Therefore, the members may decide to include, among other clauses, (i) a non-compete clause, (ii) confidentiality restrictions, (iii) provisions adjusting the application of certain tax provisions, (iv) provisions relating to the allocation and distribution of profits and losses, (v) grounds for termination of the LLC, expulsion of a member, or addition of new members and (vi) creation of officer positions (such as a President or CFO), to name a few examples of typical Operating Agreement terms. 

       F.  But I have heard that it is harder to raise funds from investors when you have an LLC as opposed to a corporation?  The argument that it is harder to raise funds if you are an LLC as opposed to a corporation does not carry much sway nowadays.  The fact is that it is extremely difficult, even in the best economic environment, to raise financing from third party investors.  If you are fortunate enough to find investors, it is unlikely they would be dissuaded by the fact that the business is an LLC as opposed to a corporation.  Remember, the highly flexible nature of the LLC allows the members to bring in investors with different economic and voting rights, and the LLC is so common place it is rarely a reason investors will be uninterested in your business.   

In sum, the Operating Agreement is a contract among the members of the LLC, and therefore the members have the right to adjust the terms to fit their business needs, reflect the contributions of the members, and make the LLC attractive to potential investors. 

The final installment on this topic will discuss the operational simplicity and ease of use of the LLC. 

Disclaimer:  The discussions in this blog do not constitute legal advise nor create any attorney-client relationship.  You are urged to seek the advice of an experienced lawyer who can provide counsel with respect to your corporate/business law matters.


Wednesday, January 25, 2012

Operating Agreements: Ten Important Provisions

If you are starting a business or have an established business and are bringing in a new partner, you need a written Operating Agreement.  In fact, the New York Limited Liability Company Law (NY LLCL) requires that an LLC have an Operating Agreement, failing which the members of the LLC are subjected to an agreement that is essentially created from the provisions of the NY LLCL. See Limited Liability Company Law 417(a).  Aside from the statutory requirement of a written agreement, you do not want an operating created from the provisions of the New York LLC law because there are discretionary provisions that the members can change, thereby addressing the particular interests of the members.  Below are ten key provisions a business should include or consider including in the Operating Agreement.

1.  Member Managed vs. Manager Managed.  If you do not specifically address whether the LLC is managed by the members or a manager then by default it is deemed managed by the members.  A member managed entity means that each of the members has management rights, and if this is not want the parties desire then it needs to be changed through the Operating Agreement -- indeed, it is unlikely that the majority member wants each member to have control authority.  The simple solution is to state in the Operating Agreement that the entity is manager-managed and then expressly state the name of the manager.

2. Having a Vote on Material Matters.  Even when the LLC is manager managed (by the majority member) the minority member(s) should try to negotiate to retain a right to veto material financial and business decisions.  The manager can still make day-to-day decisions but major issues would require approval of super majority of the members.  Among important (material) issues that typically require super-majority approval are (a) a material change in the business of the company, (b) a merger, sale of the business or significant assets, dissolution, bankruptcy or reorganization (c) transactions in excess of a certain amount, (d) amendments to the Operating Agreement, (e) incurring loans in excess of a defined amount,  (f) entering into transactions with the LLC members or officers, (g) redemption of membership interests, (h) employment or consulting agreements or increases in compensation of employees/consultant in excess of a certain amount, and (i) even admission of new members.  It is not unusual for a minority interest to demand that material issues can only be decided based on approval of a super-majority; therefore, do not assume that because you will own a small (minority) interest you are overreaching in asking for voting rights with respect to material business and financial matters.

3. The Membership Percentage Need Not Dictate Economic and Voting Rights.  If the intention is to allocate profits and losses other than based on the percentage of interests a member owns in the LLC or to create separate classes of voting rights, then define the terms in the operating agreement.  The Operating Agreement can vary the financial rights of members and create different classes of members, giving partners the flexibility to grant interests in the business that are not strictly defined by percentage of ownership. 

4. Tax Provisions.  The members can choose to include (or not to include) several significant tax provisions and elections affecting treatment of contributions of property, capital accounts, allocations and distributions and other tax issues.  These tax provisions should not be overlooked and should be discussed with an accountant as well.

5. Transfer of Membership Interests.  The Operating Agreement should address restrictions on transfer of membership interests, and will often include:

           (a) A right of first refusal giving other members the right to purchase offered interests pro rata based on a member's percentage interest in the LLC.  The right of first refusal prevents a member from selling its shares to a third party without giving the other members an opportunity to purchase the shares.  The right is as much about a chance for members to increase their ownership as it is about excluding the transfer of interests to an undesirable new partner.  If you include a right of first refusal, make sure the operating agreement clearly sets forth the procedure and time periods relating to exercise or waiver of the right.

          (b) Co-sale rights give members the right to sell a percentage of their interests along side a selling member so that a partner cannot liquidate its interests without giving other members an opportunity to sell some of their shares as well.  As with the right of first refusal, be sure to define what is necessary to meet each member's obligations under the co-sale terms.

          (c) An exception for transfers made to related parties since an operating agreement will generally require a member obtain approval of  for any transfer; however, you may not want your partner's son or husband as a partner so before agreeing to such a provision consider if transfer to a related partner is acceptable.

          (d) Although technically not a transfer, a restriction on the pledge or encumbrance of a member's interests.  The restriction prevents an involuntary transfer of a partner's interest to a lender or other lien holder that would otherwise occur if the the member defaults on its obligations to the lien holder.

Note:  The restrictions on transfer of a member's interests in an Operating Agreement boils down to the simple point that you entered into a business relationship with a partner (or partners), and you do not want a partner to hand over its interests to someone you do not know (or worse, do not like).

6.  Buy/Sell Provision.  Business partners can grow apart, their involvement or desire to be involved in the business can change, a partner can fail to meet expectations, or a number of other issues can arise whereby a partner wants to leave the business or the other partners want a partner out of the LLC.  A Buy/Sell provision will avoid the disputes, distractions, and (yes) legal costs that otherwise inevitably will arise during a business divorce.  The Buy/Sell provision should set the terms under which a the LLC or other partner can buyout a partner or a partner can require the LLC to buy its interests.  The structure and mechanisms of a Buy/Sell provision are discussed in prior posts, emphasizing the importance of clear terms as to when the provision can be invoked, how the selling interests to be valued, and the procedure for completing the transaction. See  

7.  Termination.  Include the grounds for termination/dissolution of the LLC.  Under New York law if you are a minority or equal partner in the LLC a court will not grant an application to dissolve the entity simply because you cannot "get along" with your business partner.  In fact, a dysfunctional partnership that still manages to be a successful business generally will not be dissolved by judicial decree under New York law.  Therefore, the Operating Agreement should delineate the circumstances under which dissolution of the LLC can occur, including (without limitation) a defined time period, the occurrence of a certain event, or a vote of a majority (or super-majority) of interests.  Indeed, if you include a buy/sell provision (as discussed above) and one partner wants to end the business while another does not, then there will be an avenue to address the issue through a buyout.

8. Non-Compete.  You may want to include a non-compete clause, and if so it must comply with New York law in terms of geographic scope, time and scope.

9. Dispute Resolution.  The dispute resolution clause should set forth the body that will decide any dispute (i.e., a court or arbitration), the venue (place) the matter will be tried (including not only the geographic location but, for example, in the case of an arbitration the arbitral institution), and perhaps that the losing party will be responsible for the legal fees of the prevailing party.

10. Flexibility.  The Operating Agreement is an extremely flexible document and is limited only by what is expressly prohibited or required by the NY LLCL.  As such, there are a number of other financial and control terms that can be addressed in the Operating Agreement so be sure to take advantage of this flexibility in structuring the rights and obligations of the members when drafting the Operating Agreement.

Disclaimer:  The discussions in this blog do not constitute legal advise nor create any attorney-client relationship.  You are urged to seek the advice of an experienced lawyer who can provide counsel with respect to your corporate/business law matters.