Hey Shareholders, Should You Get a Shareholders Agreement?

Shareholders agreements are amongst the most important contracts for private company owners. I highly recommend them. When drafted well, they can provide a framework for operating a business with minimal conflict between owners. Additionally, if the shareholders do have a serious conflict, the provisions of the shareholders agreement may help resolve the conflict before things get really expensive and messy (i.e. one shareholder serving a lawsuit on another).

Having said all that, they are expensive contracts to draft because: (a) they require a lot of shareholder input (i.e. it takes time); and (b) they are long, complex documents with variety of provisions that can be included or excluded based on the parties’ negotiations.

No two shareholders agreements are, or should be, alike. They should be drafted specifically to deal with the realities of your business and your fellow owners.

Here are some other general thoughts on shareholders agreements to keep in mind when deciding on whether to put one in place:

1. Shareholders agreements contain best practice language that may not have been challenged in a court. I cannot say for certain whether a court would enforce a number of typical provisions in a shareholders agreement, but I put them in anyway because a court might enforce them and, in any event, some of these provisions can provide negotiating leverage (knowing that it won’t likely go to court). For example, a court might not enforce any provision that allows one shareholder to essentially control another upon the second shareholder’s bankruptcy. This is a typical provision put in many shareholders agreements. In a bankruptcy case, for example, a trustee in bankruptcy might ask a court to not enforce such a control provision and there’s a chance the trustee will win.

2. I draft shareholders agreements with the best information on hand at the time of drafting and with my client’s instructions on how he or she want to run the business. I can’t cover off every possibility with a shareholders agreement. There are some things I cannot contemplate. Additionally, the client makes a lot of decisions with respect to how the shareholders agreement is drafted. In hindsight (or during a dispute) these decisions may turn out to have problematic consequences for the client. We’ll talk more about that below with respect to the infamous Shotgun Clause.

3. Every contract is governed by an implied duty of good faith. I can’t boil down exactly how a court will look at the implied duty of good faith when resolving a dispute. The best advice I can give is all decisions and actions must be made in good faith. Keep in mind, if you use a shareholders agreement as sword to try and skewer the other shareholder, even if you do what is allowed under the shareholders agreement, the court might still say you acted in bad faith.

4. Most shareholders agreement contains provisions to prevent shareholders from transferring shares without consent. Usually it’s the remaining shareholders that have the right to grant or refuse consent to a transfer. A transferee might be able to get around restrictions on transfer if he or she sells the shares to a bona fide purchaser of the shares for value. This means if a third person doesn’t know there is a restriction on the transfer of shares, and the third person gives valuable consideration for the shares, the court will not interfere with the transfer. All that will be left is for the other shareholders to sue the shareholder who sells his or her shares in breach of the shareholders agreement.

5. Buy/Sell provisions (i.e. Shotgun Clauses) are a double-edged sword. In some cases they can be used effectively to resolve a situation where the parties just cannot get along. In other cases, a Shotgun Clause gives one party a sizeable advantage. Let’s look at the case of a company with two shareholders. They are not getting along. In the case where both shareholders can run the business, the shareholder with more financial resources can have a sizeable advantage when using a Shotgun Clause. Where only one of the shareholders can run the business (and the other cannot hire someone to do so), the shareholder that can run the business has a sizeable advantage if a Shotgun Clause is used.

6. I approach shareholders agreements in terms of groups. Shareholders agreements typically contain provisions that allow shareholders to sell shares to related parties (e.g. wife, kids, a family trust, etc.). In that case, I still consider the Principals the operating minds of the business (and the head of their “group”). If a Principal wants to get out of the business (or is forced out), he or she should have to transfer all of the shares of his/her group (not just the shares he or she holds personally). If I don’t draft it this way, there might be instances where, for example, a Shotgun Clause is triggered and the Principal has to give an opportunity to buy the shares to the Principal’s family trust (i.e. the Principal is forcing his own family trust to either buy his shares or sell its shares to him). This doesn’t make sense as it would frustrate the Shotgun Clause’s purpose.

7. I recommend using arbitration as the formal dispute resolution process. Arbitration is usually, but not always, faster and cheaper than the courts. It allows you to pick an expert to adjudicate, rather than a judge (who may not have much expertise in your dispute area). Also, court proceedings are all public. Arbitrations are private, meaning you keep your dispute confidential.