A Shareholders’ Agreement (also known as a Stockholders’ Agreement) is an agreement among some or all of a company’s shareholders which modifies shareholder standing and relations through a combination of rights, restrictions and procedures. Shareholders’ Agreements can serve as supplements to a company’s corporate governance documents and often contain provisions that directly impact management of the company.
Parties that desire privacy or confidentiality often choose a Shareholders’ Agreement to document stock ownership rights and obligations because they are not generally required to be publicly filed. A Shareholders’ Agreement is also typically easier to amend than formal corporate governance documents, such as charters or bylaws, which often require supermajority votes to amend. Shareholders’ Agreements are more common in non-publicly-traded companies and closely-held corporations, such as family businesses, private equity investment firms and small-scale joint ventures, than large or publicly-traded companies that are heavily regulated by federal and state securities laws.
Characteristics of Shareholders’ Agreements
Shareholders’ Agreements vary depending on the nature of the company’s business and the shareholders’ specific goals and circumstances. Matters commonly covered by Shareholders’ Agreements include: (1) buy-sell provisions, (2) share transfer restrictions, (3) contributions, (4) board composition and powers, (5) management, (6) voting rights, (7) voting agreements and (8) preemptive rights.
Buy-sell provisions in Shareholders’ Agreements govern when the shareholders of a company have the right (or obligation) to repurchase the shares of a given shareholder who has the corresponding right (or obligation) to sell those shares. Typical triggers for buy-sell provisions include a shareholder’s death, disability, bankruptcy, retirement or other cessation of employment. Most buy-sell provisions: (1) identify the triggering events; (2) state whether the provision is mandatory or optional and if optional, how that option may be exercised or waived; (3) indicate whether the company will redeem the shares or the other shareholders will repurchase them; and (4) describe in detail the repurchase mechanisms and procedures.
If the remaining shareholders are to repurchase the shares, Shareholders’ Agreements usually require each shareholder’s repurchase obligation to be in proportion to that shareholder’s then-current holdings. This avoids any accretion or dilution in ownership interests and ensures that the relative percentages of all shareholders’ interests in the company remain constant.
Share transfer restrictions
Many Shareholders’ Agreements include restrictions on the transfer of shares, particularly in closely-held corporations with few shareholders. Shareholders of a small family-owned business, for example, may agree to restrict share transfers to family members only in order to keep control of the company within the family. Most Shareholders’ Agreements carefully coordinate share transfer restrictions with buy-sell provisions to avoid conflicts when buy-sell provisions are triggered. The most common forms of share transfer restrictions include (1) rights of first refusal, (2) rights of first offer, (3) drag-along rights and (4) tag-along rights.
• Rights of first refusal
Rights of first refusal are triggered when a shareholder receives a third party offer to buy its shares. A right of first refusal gives the company’s existing shareholders the opportunity to purchase those shares at the same price and on the same terms and conditions as the offer from the third party. The selling shareholder must sell to the existing shareholders if they match the third party’s offer. To the extent they do not, or if they decline to exercise their right of first refusal, the selling shareholder is free to sell to the third party.
• Rights of first offer
Rights of first offer are triggered when a shareholder wishes to sell his or her shares but does not yet have an offer from a third-party purchaser. A right of first offer gives the company’s existing shareholders the power to require that the selling shareholder offer those shares to them before offering them to any third party. The selling shareholder is free to sell to a third party if the existing shareholders refuse to purchase the shares or if a third party offers to pay a higher price.
• Drag-along rights
Drag-along rights are triggered when a majority interest in a company is being sold. A drag-along right gives a majority shareholder the power to force minority shareholders to sell their shares at the same price and on the same terms and conditions as the majority shareholder is receiving.
• Tag-along rights
Tag-along rights (also known as piggybacking rights) are also triggered when a majority interest is being sold. In contrast to a drag-along right, however, a tag-along right enables minority shareholders to force the purchaser of the majority interest to buy their shares at the same price and on the same terms and conditions as is being offered to the majority shareholder. Unless the purchaser agrees to do so, the sale of the majority shareholder’s stock cannot be consummated.
Shareholders’ Agreements often state the nature and amount of the initial capital contribution each shareholder made to the company and may also include a capitalization table. Shareholders’ Agreements that require shareholders to make additional capital contributions generally describe that requirement in detail and set forth the consequences for any shareholders who fail to meet that obligation.
Board composition and powers
Shareholders’ Agreements often establish the composition and number of the board of directors. They may give specific shareholders the right to designate nominees for election to the board or to directly appoint shareholders as directors. Similar to corporate bylaws, Shareholders’ Agreements may: (1) set board quorum requirements, (2) establish board voting procedures and requirements (both generally and for specific matters), (3) allow shareholders to remove directors and fill board vacancies and (4) grant shareholders the right to observe board meetings and receive information normally reserved for board members.
Ordinarily, a corporation’s charter or articles of incorporation gives its board of directors broad power to manage the company in both its day-to-day affairs and long-term activities. A Shareholders’ Agreement in a closely-held corporation, in contrast, can limit a board’s power and significantly restrict the scope of its overall authority. These limitations generally cease to be effective when a corporation goes public.1
Corporate governance documents usually give the board responsibility for electing officers of the company. Shareholders’ Agreements, however, may allow shareholders to play a larger role in selecting a company’s officers and key employees. Section 7.32 of the Model Business Corporation Act, adopted in 29 jurisdictions, provides that a Shareholders’ Agreement may: (1) designate who shall be officers of the corporation, (2) fix officers’ terms of office and (3) establish the manner of selecting or removing officers.
Many state corporation statutes require stockholder consent for certain company actions. A Shareholders’ Agreement provides an opportunity to expand those consent rights by, for example, identifying corporate matters requiring a unanimous or supermajority vote or granting one or more entire classes of shares special voting rights on selected questions. In order to maintain confidentiality, shareholders often prefer to adjust their voting rights in a private Shareholders’ Agreement rather than in a publicly-filed corporate charter or bylaws.
Shareholders’ Agreements may provide a mechanism for shareholders to agree on how they will vote on specific matters. Other types of agreements that also serve this purpose include shareholder voting agreements, pooling agreements and shareholder control agreements.2
A preemptive right is an existing shareholder’s right to purchase any newly-issued shares of the company prior to those shares being sold to third parties. Shareholders’ Agreements often confer preemptive rights, which allow existing shareholders to maintain their percentage of equity ownership in the company.
Shareholders’ Agreements often include provisions that govern: (1) share registration, (2) confidentiality, (3) termination of shareholder employment, (4) corporate data access, (5) dispute resolution and (6) corporate dissolution.
Ordinarily, the substantive corporate law of the state in which the subject corporation was organized governs the construction and enforceability of a Shareholders’ Agreement.
• Buy-Sell Provisions
• Transfer Restrictions
• Rights of First Refusal
• Rights of First Offer
• Drag-Along Rights
• Tag-Along Rights
• Board of Directors Composition
• Board of Directors Power
• Voting Rights
• Voting Agreements
• Preemptive Rights
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