A few years ago, I worked on a case, where one shareholder was buying out her partner of over 30 years. The two of them, who were best friends when they started the business, had a falling-out, which made the buy-out very difficult. While they had a shareholder agreement, it lacked many important provisions, including how any buy-out price would be determined. After a huge legal bill, and numerous shouting matches, they finally arrived at buy-out terms. Unfortunately, much of this could have been avoided if they had an effective shareholder agreement in place.
If you’re getting into a business venture with someone, even if it is a spouse or a family member, you should draft an effective shareholder agreement. The best time to draft an agreement is when you first start the venture when you still like each other and can negotiate fairly with each other. Shareholder agreements are important for a variety of reasons:
1.) Business partnerships don’t always last forever
At the beginning of a business relationship, just like at the beginning of a marriage, everything is perfect. Things, however, sometimes go awry, and partners have a falling-out. Trying to agree to business terms when you have already fallen out is almost impossible. It is easier to formalize in an agreement, the approach that will be taken if the relationship does go south at the outset of the business. Don’t risk waiting until differences of opinion are unreconcilable.
2.) Offer protection for minority shareholders
In some businesses, not all shareholders are created equal. A shareholders’ agreement can provide protection for minority shareholders by requiring certain decisions (e.g. business acquisitions, issuing new stock, entering into debt, etc.) to have unanimous consent. This gives a voice to minority shareholders and protects them in certain key decisions.
3.) Protects against share transfers
A Shareholder Agreement can provide a vehicle that would provide the remaining shareholders first right of refusal if a shareholder wants to sell his/her shares in a business or if a shareholder passes away. This can be a useful option, particularly for small businesses that may wish for the initial shareholders to retain the shares, rather than allow external investors or owners to step into the business.
4.) Potential to link ownership to employment
Often shares in a closely-held business are held by owners who are also key employees of the business. If they were to resign or leave the business, for whatever reason, you would more than likely want them to sell their shares. Otherwise they could remain entitled to receive dividends generated by the labor of the remaining partners. A Shareholder Agreement can provide a mechanism whereby a person’s ownership is linked to their employment so that if they were to terminate employment, they must offer their shares up for sale. If the provision is not in the shareholder agreement, there is no requirement for them to sell their shares if they cease to be employed by the business.
A Shareholders’ Agreement can go further and set different valuation mechanisms depending on the circumstances under which a shareholder’s relationship with the company ends (e.g. disability, death, etc.)
5.) Restrictions/Covenants on competition
If a shareholder seeks to leave the company, the remaining shareholders may wish to restrict him/her from setting up or working in a competing business. These restrictions can be stricter than may exist in any employment contract and can be very valuable in protecting the interests of the company moving forward.
6.) Dispute resolution
If a dispute occurs, there can be specific provisions for dealing with disputes outlined in the agreement. These may include the use of mediators or arbitrators.
These are just a few ways a Shareholder Agreement can be important and useful for a company to protect individual shareholders. Any agreement should be reviewed periodically to ensure that it still represents the wishes of the shareholders and to address any new issues that may arise.
Kenneth R. Cerini, CPA, CFP, FABFA
Ken is the Managing Partner of Cerini & Associates, LLP and is the executive responsible for the administration of our not-for-profit and educational provider practice groups. In addition to his extensive audit experience, Ken has been directly involved in providing consulting services for nonprofits and educational facilities of all sizes throughout New York State in such areas as cost reporting, financial analysis, Medicaid compliance, government audit representation, rate maximization, board training, budgeting and forecasting, and more.