Showing posts with label Shareholder Agreement. Show all posts
Showing posts with label Shareholder Agreement. 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.

Monday, July 23, 2012

Business Entities: Structures, Characteristics and Choosing the Right One for Your Business (Part IV)

Below is a link to Part IVof a four-part continuing legal education seminar I recently gave on business structures, characteristics and choosing the right one for your business.

Please see:

Disclaimer:  The discussions in this blog do not constitute legal advice 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, October 19, 2011

Ten Legal Mistakes Made By Start-Ups: I Don't Need an Operating Agreement/Shareholder Agreement

Continuing with the theme of the my October 17 post regarding ten legal mistakes made by start-ups, here is mistake number 2:

Myth #2:  I Don't Need an Operating Agreement/Shareholder Agreement or I can just get one online.

If you have a partner in your business, even if it is your best friend since you were in kindergarten, it is a mistake to believe you do not need an Operating Agreement (for an LLC) or Shareholder Agreement/By Laws (for a Corporation). 

First, under New York law, an LLC is required to have an Operating Agreement.  In the absence of an Operating Agreement, the parties are bound by the default terms of the New York Limited Liability Company Law.  Among the default provisions, the LLC will be deemed to be member-managed, meaning any partner has a right to bind the LLC -- this can be a signficiant problem if you believe you were the only partner who was to have management rights.

Second, the Operating Agreement or Shareholder Agreement will delineate the rights of the members/shareholders thereby (hopefully) avoiding disputes.

Third, I have found that when a partner can point to a provision of an Operating Agreement/Shareholder Agreement the parties can rely on the written agreement to avoid the stress of a possible dispute.

Fourth, the Operating Agreement/Shareholder Agreement needs to be drafted by an experienced corporate/business lawyer who understands the intent of the partners with respect to management and financial matters.  Simply adopting an agreement found online or borrowed from a third party ignores the fact that a pro forma agreement will not capture the intention of the partners regarding key issues, including control, management of the business, financial rights, buy-sell/shotgun clause, and many other issues.

Fifth, the execution of an Operating Agreement/By Laws is an indicia of the intention of the partners to observe the formalities of the business organization, providing an important argument to any claim by a creditor to pierce the protection of the entity and assert claims against the partners individually ("pierce the corporate veil").

Next Installment:  Invention Assignment Agreements/Confidentiality Agreements

Wednesday, October 12, 2011

Shareholder Agreements: Define BuyOut Terms

In a prior posting, I noted the importance of setting forth clear terms for buying out another member (LLC) or shareholder (corporation).  For example, the buyout terms/shotgun clause can be set forth in the Operating Agreement of an LLC (or a separate agreement between certain members) or in a shareholder agreeement of a corporation.  The dispute between father and son of Amercian Chopper fame illustrates the need to clearly delineate the terms of any option.  (Paul Teutul v. Paul M. Teutel, 2010 NY Slip Op 09248 (2nd Dept. Dec 14, 2010))  

The father and son had an agreement that included an option for the Paul, Sr. to purchase the shares of Paul, Jr. "for fair market value, as determined by a procedure to be agreed to by the parties as soon as practicable."  Paul, Sr. sought to exercise the buyout option, which Paul, Jr. opposed enforcement of the option.   The Appellate Court ruled that while the reference in the clause to "the term of 'fair market value' in and of itself may be 'sufficiently precise' ... the plaintiff and the appellant went further and expressly agreed to later agree on a procedure for determining the shares' fair market value."  Significantly, the Court, quoting prior precedent, stated that for a closely held corporation (i.e.small prviately-held business) where ownership is held by a small group of shareholders and shares are not easily sold, the fair market value of the stock "'involves a certain degree of inexact valuation and subjectivity, making the procedure by which fair market value is determined of particular importance.'"

The Court reasoned that, as opposed to cases cited by Paul, Sr. where the parties had agreed on an (albeit flawed) procedure for determining fair market value of the stock, the clause here was simply an agreement "to later agree on a procedure for determining fair market value," and thus was not binding.

THE LESSON: The valuation of the stock/membership interests does not have to be determined at the time of drafting the option (buyout clause), but there must be clear terms as to the procedure for valuing the stock.  One alternative is to identify a 3rd party, like a CPA, as the person who will determine valuation and perhaps agree to share the expenses of the valuation.