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.

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: http://vimeo.com/44119420









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

Ten Legal Mistakes Made By Start-Ups: Failing to Select Competent Counsel (#10)

The previous posts have detailed nine common legal mistakes made by start-ups.  While there are certainly other issues facing entrepreneurs starting new businesses, mistake number ten focuses on the failure to retain experienced professional advisers.  It may sound (a bit) self-serving for a business lawyer to raise the issue of engaging experienced legal counsel, but the reality is that the serious mistakes often made by start-ups can easily be avoided by engaging competent legal, tax and perhaps other professional advisers.

Myth #10:  "I don't need a lawyer or other professional adviser at the start-up stage as they are costly, and I can get all the information and documents I need on the Internet."     

When starting a business, entrepreneurs need to focus on numerous business issues and often are operating on a shoestring budget.  However, the potential liability arsing from the failure to obtain competent legal and tax counsel fair outweighs the perceived cost savings from a do-it-yourself strategy.  Here are some examples:

1.  Choosing the Proper Business Structure.  The first post in this series explained the risk of failing to choose the proper corporate structure for your business, stressing the importance of engaging professionals that can advice as to proper tax planning and the formation of the best legal structure to protect your business.

2. Drafting the Operating Agreement/Shareholder Agreement.  The second post in this series explained why it is a serious mistake to not adopt a Operating Agreement (for an LLC), Shareholder Agreement/By Laws (for a Corporation) or a Partnership Agreement (for a Partnership) or to simply use one found on the Internet.  In addition to the fact that New York LLC law requires the adoption of an Operating Agreement, these agreements set forth the financial and management rights and obligations of the partners and therefore should address the interests of the partners.  Mistakes include adopting 50-50 management control without realizing it, failing to detail buyout rights and mechanisms, and mistakenly choosing a member-managed entity instead of a manger-managed entity, to name just a few common issues.

3. Failing to Address Intellectual Property Issues.  The monumental mistake of failing to protect intellectual property rights from the outset is addressed in the third post, noting that experienced corporate counsel that understands your business can ensure this common error is avoided.  You need to make sure not to miss your opportunity to timely file patent applications, that you properly protect trademarks, you do not allow employees to claim rights in intellectual property, and focus on the legal issues relating to your website (including properly drafted website policies).

4. Employment Issues.  If you are hiring even an at will employee or a consultant, the fourth post details the importance of at least requiring the employee/consultant to sign a Confidentiality and Invention Assignment Agreement.  Properly drafted, the agreement can ensure that not only your proprietary information remains protected but also that the business owns any inventions/intellectual property created by the employee/consultant.  You don't want to find out later, for example, that a former employee is claiming rights in a key software program.

5. Don't Just Give Away Equity.  The fifth post in the series discusses the need for founders to consider carefully the ramifications of using equity in the business as currency.  Even the cash-strapped start-up should discuss with legal counsel the pros and cons of using equity as currency, and if the decision is to proceed then the issuance of the equity for products or services, then it should be properly documented.

6. Tax Issues/Section 83(b) Election.  Just as experienced legal counsel is a must, as discussed in the sixth post there is no substitute for good tax advice from an accountant well-versed in working with start-ups.  Among the issues is making sure shares vest over a period of time and that persons receiving restricted shares understand the importance of the the Section 83(b) Election to reduce tax liability.

7. Vendor/Customer Agreements.  The seventh post in this series discusses the problem that small businesses often think that they don't need contracts with their customers or that a very simple order form is sufficient.  However, many costly issues can arise without a properly drafted customer agreement.

8. Bringing in New Business Partners.  As explained in the eighth post on common start up mistakes, don't bring in a new business partner without proper legal documentation.  Start-ups understandably feel the pressure to attract new partners who can offer financing, professional services, or even play an advisory role.  However, the desire to attract such a partner may lead you to put aside execution of documents detailing the rights and obligations of the partner.  The additional legal costs, or simply feeling that asking the potential partner to sign an agreement will scare the partner off, are not reasons to delay obtaining experienced legal assistance -- the time and legal costs to resolve a potential dispute with the partner will far outweigh the cost of properly documenting the rights and obligations from the outset.  

9. Don't Violate the Securities Laws.  The ninth post in this series outlines the civil and potential criminal exposure from violating the securities laws with respect to the offer and sale of securities in your company.  The bottom line is that even innocent mistakes and "friends and family" investments can lead to corporate and individual liability under federal and state securities laws.  Therefore, you absolutely should consult legal and tax counsel when the company is initially considering offering any equity interests or debt in the company to third parties.    

 10. Experienced Legal, Tax and Perhaps other Advisers, is a Must.  OK, you are convinced about the need to engage legal and tax advice, now make another smart decision and engage advisers who have extensive experience working with new businesses.  Just like it is a mistake to ask your general practitioner/internist to perform brain surgery, don't assume your lawyer is qualified to assist with the myriad legal and tax issues facing start-ups.  Engage a seasoned business lawyer and a experienced tax adviser as these trusted advisers will assist in proper structuring of your business, prevent unnecessary disputes, protect your key business assets, avoid potential liabilities, ensure a good tax strategy, and help you plot a course for well-structured business operations.   

Ten Legal Mistakes Made by Start-Ups: Bringing in a Partner Without a Proper Agreement (#8)

Often start-ups are so excited about bringing in a partner who can offer financing, desperately needed services, or play an advisory role/provide professional advice that the start-up brushes aside the need for a proper agreement detailing the rights and obligations of the new partner.

Myth #8:  "This is a start-up and we should be happy to have this new partner so let's not worry scare the partner off by demanding a formal agreement."  

If you are involved with a start-up you certainly understand the pressure to attract partners who can offer financing, professional services, or even play an advisory role.   All too often, however, this anxious desire to attract such a partner will lead founders to opt to put aside the need to document the rights and obligations of the partner; it may be because of the desire to avoid additional legal costs or simply feeling that asking the potential partner to sign an agreement will scare the partner off.  So instead the founder decides to have a simple handshake and issue the new partner shares or membership interests representing a percentage in the business.  In no uncertain terms, this is a serious mistake for a number of reasons, including the following:

    1.  If this is an LLC, do you have an Operating Agreement?  If this is a corporation, do you have detailed by laws/shareholder agreement?  If this is a partnership, do you have a partnership agreement?  If the answer is no, then the new partner has financial and voting interests based on the interests granted in the entity; and any rights and obligations are otherwise governed by the relative state LLC, Corporate or Partnership law.  Do you know what the governing law says as far as the financial and management rights of members (LLC)/shareholders (corporation)/partners (partnership)?  If not, you may be very surprised later if a dispute arises, at which point it will be too late. 

  2.  What if the new partner fails to do what was promised, dies or becomes disabled?  You could have avoided this issue by having the interests vest over time (see http://mybizlawyer.blogspot.com/2011/10/ten-legal-mistakes-made-by-start-ups_28.html) and/or giving the entity and other partners a buyout right (see http://mybizlawyer.blogspot.com/2011/10/shareholder-agreements-define-buyout.html).  If you do not attend to this issue, you could be stuck with a non-performing partner and perhaps hanging your hopes on the expensive and time consuming process of proving an oral agreement in court.

  3.  The partner decides to sell or transfer its interests to a third party you don't know or don't like (or both).  Can the partner do this?  It depends what the governing law says, but if you had a clear statement of the rights of the partners and a right of first refusal there would be no issue.

  4.  The new partner just signed a contract binding the entity, one which you would not have approved.  In New York, an LLC is deemed to be member-managed unless the Operating Agreement states otherwise, and a s a result each member has the authority to bind the entity.  Solution, an Operating Agreement setting forth that the entity is manger-managed, naming the manager, and thereby removing the authority the new member to bind the entity.  (See http://mybizlawyer.blogspot.com/2011/09/management-of-llc-member-or-manager.html).  Also, LLC and Corporations (but not SCorps) are very flexible structures allowing for the creation of different classes of partners, and therefore you can create a class that has only financial rights and no management/voting rights.

  5.  You just learned the new partner is starting a competing business or offering services to a competitor and is also trying to solicit your employees, customers, and business partners.  If the partner is using trade secrets you still can take seek legal recourse, but again proving the claim is costly and regardless does not address some of the other concerns, like solicitation of your employees.  While enforcing a non-competition agreement can be challenging and requires careful consideration before drafting, you should include confidentiality and non-solicitation provisions in the operating agreement/shareholder agreement/partnership agreement.

  6.  The partner developed services, an application or created products that include certain intellectual property rights and now claims ownership of those products/services or of the underlying intellectual property.  In fact, the partner is filing patent claims and then plans on licensing the rights to third parties.  You could have avoided any issue with an  invention agreement agreement assigning the rights to the inventions and intellectual property to the business.  (See  http://mybizlawyer.blogspot.com/2011/10/ten-legal-mistakes-made-by-start-ups_24.html).                      

  7.  You have a dispute with the new partner, who files a groundless lawsuit in Buffalo, and the other members and the business are located in Long Island.  You realize the added burden of litigating a dispute in a court hundreds of miles from where the business is based, and while the your  lawyer explains there may be grounds for a motion arguing Buffalo is not a convenient forum for the dispute, the motion will create additional litigation costs.  You could have avoided this issue with a venue clause stating all disputes are to be filed in Nassau County, for example.  It also may have been beneficial to include a provision awarding attorney fees to the prevailing party, giving the partner pause before filing baseless claims.  

While the above is in some ways a recap of prior issues that have been discussed in this blog, the take away here should be that even a start-up has a right to demand a new partner sign an agreement clearly delineating the rights and obligations of the members of the entity.  If the new partner refuses or wants you to believe a handshake is enough, you should be very suspicious.  There is simply no substitute for a well-drafted agreement to avoid the myriad legal issues that can arise between business partners. 

Disclaimer:  The above is for discussion purposes only and does not constitute legal advice nor create any attorney-client relationship.  There is no substitute for legal advice from an experienced business/corporate lawyer.

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

    

Right of First Refusal: A Practical Pointer

A right of first refusal is an important provision that should be included in a variety of transactions/contracts -- for example, in By Laws/Operating Agreement, giving the corporation the right to buy the shares of a selling shareholder or giving a shareholder the right to buy shares offered by the corporation; or giving partners in a joint venture the right to buy assets the JV wants to sell.  An expereienced business lawyer will help you understand the importance of a properly drafted right of first refusal and the risks of failing to include well defined terms relating to the rights. See http://www.berkmanlawfirm.com/

The key to a properly drafted right of first refusal is detailing the process for exercising the right.  Make sure the right of first refusal addresses the following:

   1.  The party who has the right must be given written notice of the bona fide third party offer;
   2.  If you are the party that has the right, you want a reasonable time period to exercise the right;
   3.  If you are the selling party you want to limit the time frame for the party holding the right of first refusal to respond because if it is too long it could scare off potential third parties;
   4.  The mechanism for exercising the right should include a written exercise within a defined period following notice of the 3rd part offer, the exercise should be accompanied by a deposit amount, and there needs to be a time frame for the closing; and
   5.  If the 3rd party offer fails to close, you want the right to of first refusal to apply to any future offers.

Again, make sure the terms of any right of first refusal includes clear parameters for notice and exercise of the right.