What Happens If You Have a Shareholders’ Agreement … and What Happens If You Don’t?

Key Considerations

By: Steven J. Kuperschmid, Esq., Partner, Ruskin Moscou Faltischek, P.C. (RMF)

We see three kinds of clients relative to shareholders’ agreements, those who:

1. Adopted a thoughtful, well-crafted shareholders’ agreement at inception or early in the business formation. They may not live happily ever after, but they are happier than the next two.
2. Did not create a shareholders’ agreement, but wish they had.
3. Did, but could have sought further expertise to address more effectively shareholder needs.

Who Needs a Shareholders’ Agreement?

So, do you need a shareholders’ agreement? We think, for the most part, yes. Depending on who you are (majority or minority shareholder), your perspective and needs will determine if you need one.

Majority Shareholder: If you are the majority shareholder, you may not need a shareholders’ agreement. You control the election of the Board of Directors that appoints the corporate officers and directs the management and policies of the company. While you may be concerned about minority shareholders transferring their shares, which is a valid concern, on a practical level if anyone else were to acquire minority shares (through a gift, sale or otherwise), the new minority shareholder would not achieve any greater rights than the original transferor.

Minority Shareholder: If you are a minority shareholder, you may have a much greater interest in having a shareholders’ agreement. You could contractually require a board seat, veto rights at the board and shareholder voting levels and restrict the majority from transferring his/her shares, all of which would typically benefit the minority shareholder.

Regardless of Status, Shareholders’ Agreements Hold Certain Benefits for All Parties

In reality, a shareholders’ agreement will typically benefit all parties by providing certainty as to governance, succession, retirement planning and method of resolving disputes. Highlighted below are some key considerations:

1. Economics: Though more limited in variation than limited liability companies, shareholders’ agreements can address economic distributions by addressing dividend policies, employment terms, including salary and bonus. These items can also be managed in stand-alone employment agreements, and if this option is used, it should be coordinated with the shareholders’ agreement.
   
   
2. Voting: Shareholders’ agreements can address who makes certain decisions, the percentage or number of votes required for a quorum (the minimum number of votes required to validly hold a meeting), voting percentages, super voting rights and veto rights.
   
   
3. Transfer Restrictions: Shareholders’ agreements will typically include a right of first refusal, provisions on buy-outs in the event of death, disability, termination of employment, divorce and other triggers. They will provide for a method of valuation, payment, indemnification post-sale and other related matters.
   
   
4. Conflict Resolution: Shareholders’ agreements can help with conflict resolution by providing for mediation or arbitration of disputes. While this can be beneficial, experience shows that the best dispute resolution provisions include shotguns, puts, calls and other devices that encourage or discourage designated behaviors. Proper use of these provisions can equalize relative strengths among the parties and preclude the need to ever resort to a conflict resolution format.
   
   
5. Tax Status and Distributions: Many closely held businesses elect S status and there are many ways to jeopardize S status. Shareholders’ agreements can provide specific covenants restricting shareholders and/or the corporation from allowing any S status disqualifying events. Additionally, agreements can mandate minimum tax distributions so that shareholders need not go out-of-pocket to pay taxes attributable to allocated corporate income.
   
   
6. Exit and Retirement: It is typical for shareholders’ agreements to address exit and retirement parameters, especially where the corporation has an operating business (as opposed to holding assets) and multiple shareholders.
   
   
7. Employment and Restrictive Covenants: Shareholders’ agreements can address terms of employment, non-solicitation, confidentiality and non-competition stipulations. By including these terms in the agreement, parties ensure that they are coordinated which makes them more enforceable, especially in light of new Federal Trade Commission (FTC) rules, though that remains to be determined.

More Specifics on Shareholders’ Agreements: When and How

When to Create: While ideally parties should enter into shareholders’ agreements at or near inception of the business, they can be created at any time if all parties agree. It should be noted that as businesses grow and change, it may be smart to revisit and revise existing agreements. For greatest effect, shareholders’ agreements should also be coordinated with the company’s certificate of incorporation and by-laws.

How to Structure: Every business is unique with specific needs and challenges. Shareholders’ agreements should therefore reflect the specific circumstances of each business and its shareholders. Factors, such as company size, its industry, number of shareholders, as well as their individual relationships, should all inform and influence the structure and content of the agreement. For instance, a startup with a small number of closely connected shareholders may prioritize rapid decision-making and flexibility over the need for mechanisms to ensure transparency in governance — likely more important for a larger business with a diverse shareholder base.

Shareholders’ Agreements Safeguard Interests

From our perspective, we see shareholders’ agreements as important tools for safeguarding the interests of all shareholders and ensuring the smooth operation of the business. By providing clear frameworks for governance, decision-making and dispute resolution, shareholders’ agreements help prevent conflicts and promote stability. The ability to tailor these agreements to the specific needs of a business underscores their importance and effectiveness.

Seek Expert Advice

Given their complexity and need for customization, we advise obtaining expert legal advice when drafting a shareholders’ agreement.

Our law firm can provide tailored advice and support for all your corporate governance needs, ensuring that your shareholders’ agreement effectively protects your interests and facilitates your business’s success.

Contact Us

If you have any questions, contact your PKF O’Connor Davies client service team or:

Steven J. Kuperschmid, Esq.
Partner, Ruskin Moscou Faltischek, P. C.
skuperschmid@rmfpc.com | 516-663-6686

About the Author

Steven J. Kuperschmid serves as Co-Chair of RMF’s Corporate & Securities Department, Chair of the firm’s Cybersecurity and Data Privacy Practice Group and member of the Blockchain Technology and Digital Asset Practice Group. He typically represents entrepreneurs, family businesses and publicly-traded and privately-owned institutional companies, as well as private-equity funds.