A shareholder agreement is a contract between the shareholders of a corporation that outlines the rights and responsibilities of each shareholder as well as the obligations of the shareholders to one another and the corporation.
Shareholder agreements, also known as stockholder agreements, are optional but are often used by closely held corporations, which have a limited number of shareholders and concentrated ownership. In these companies, shareholders are often not only investors but are also involved with day-to-day business operations, which may create complex and conflicting relationships.
When properly drafted by an attorney, shareholder agreements can help mitigate the risk of future conflicts and promote the long-term stability and success of the business.
The Potential for Conflicts in Closely Held Corporations
The term corporation may bring to mind a large company that has publicly traded shares, widely dispersed ownership, and professionally administered management. However, most corporations are closely held firms controlled by a small group of shareholders. In closely held corporations, the shareholders may also be directors, officers, and employees of the company. That is, ownership and control are not always clearly separated. And often, the shareholders are family members or have other personal relationships to one another in addition to their business relationship. These overlapping relationships and the profit motive resulting from being an investor in the company may create tensions between shareholders.
Within close corporations, shareholder disputes are one of the most difficult and potentially destructive problems that can occur. These disputes may arise if majority shareholders attempt to squeeze out minority shareholders or otherwise take actions that benefit the majority at the expense of the minority. Minority shareholders may also have interests that diverge from the majority and the overall good of the company.
The corporate charter and bylaws may not adequately address the complex—and conflicting—relationships that may exist in the context of shareholder relationships in a closely held corporation. A shareholder agreement can be used to fill this void and prevent conflicts.
How Shareholder Agreements Work
A well-drafted shareholder agreement provides clear guidelines for the operation and management of a closely held corporation and can help prevent conflicts and uncertainties among shareholders. It can also protect the interests of shareholders and ensure the stability and continuity of the business.
Some of the key provisions in a shareholder agreement address the following issues:
- Clarifying rights and obligations. Shareholder agreements clearly delineate the rights, responsibilities, and obligations of each shareholder, ensuring that everyone understands their role within the corporation. This can prevent misunderstandings and disputes regarding management, decision-making, and profit distribution.
- Protecting shareholder interests. The agreement may include provisions designed to protect the interests of minority shareholders, including rights of first refusal, tag-along rights, or antidilution protections. These provisions assure minority shareholders that the majority will not treat them unfairly.
- Making decisions. By establishing procedures for decision-making and voting rights, shareholder agreements provide a framework for resolving disputes and making key corporate decisions (e.g., an acquisition or a change in strategy). Such a framework promotes stability and efficiency within the corporation, especially in situations in which shareholders have differing opinions or priorities.
- Managing transitions and exits. Shareholder agreements often include provisions for handling changes in ownership, such as buy-sell agreements, that outline the process for buying out a shareholder who wants to sell their shares or who becomes incapacitated. Without a plan to manage transitions and exits, a company may experience costly business disruptions during ownership changes.
- Preserving confidentiality and preventing competition. Shareholder agreements can include confidentiality provisions designed to prevent disclosure of sensitive corporate information to third parties. They may also include restrictive covenants designed to prevent shareholders from engaging in competitive activities that could undermine the corporation’s interests.
- Resolving disputes. A shareholder agreement can provide mechanisms for resolving disputes between shareholders (for example, mediation, arbitration, or buyout).
Shareholder agreements can provide a blueprint for navigating many different—and difficult—scenarios a corporation could face.
Properly Executed Shareholder Agreements Are Valuable Planning Tools
Shareholder agreements, like other types of business contracts, are not one-size-fits-all tools. While well-thought-out shareholder agreements can prevent or provide a means for resolving problems, poorly drafted agreements can create new, unintended problems that could lead to expensive litigation. Their preparation must be undertaken with an eye toward the specific goals your company wants to achieve. For legal assistance drafting a shareholder agreement that aligns with your company’s goals, shareholder personalities, and dynamics, please contact our small business attorneys to schedule a meeting.
