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13 • 2008

The Ins and Outs of Shareholders Agreements

A Shareholders Agreement is a contract among the shareholders of a corporation. The purpose of a Shareholders Agreement is to ensure harmonious relationships between management and the shareholders by creating orderly procedures to deal with events that could otherwise disrupt the future of the company. By entering into a Shareholders Agreement, the shareholders can exercise control over who may become a shareholder of the Company, among other things.

Some popular provisions include:

Restrictions Against Transfer

A Shareholders Agreement will typically include a provision that prohibits one of the shareholders from selling, transferring, or encumbering shares without the prior written consent of the other shareholders. Of course, where appropriate, exceptions can be crafted for estate planning transfers (e.g., transfers to living trusts), or to immediate members of the shareholder’s family.

Right of First Refusal

Some shareholders inevitably desire to sell their shares, so a Shareholders Agreement can include a right of first refusal that requires a shareholder who wishes to sell to provide the other shareholders with a right to match an offer received from a third party. Rights of first refusal protect the Company and non-selling shareholders from sales of stock to unfriendly parties or competitors.

Buy-Out Rights

The Shareholders Agreement will nearly always include rights of the Company and/or the other shareholders to purchase shares owned by a shareholder in the case of certain “major” events. Most notably, these events include, for example, death, disability, bankruptcy, and marital dissolution. Under some circumstances, a Shareholders Agreement will also include an “expulsion” right that permits a substantial majority of the shareholders to “expel” an undesirable shareholder and acquire his or her shares.

Purchase Price

A Shareholders Agreement will generally include some formula for valuing shares purchased. These formulas vary from fair market value determined by one or more appraisers, to book value, or no value, depending on the situation. For example, if a company “gives” shares to a key employee, the purchase price might be nothing or a very small sum until certain time periods have lapsed or performance goals have been achieved. For founding shareholders, a determination of fair market value might be more appropriate.

Payment of Purchase Price

A Shareholders Agreement can require an “all cash” purchase price, or permit the buyer to use a promissory note. In cases where a promissory note is used, the Agreement can include very specific terms, including the interest rate, term, and collateral for the note, if any. In purchases arising following the death of a shareholder, the Agreement can provide for the use of life insurance obtained by the company or other shareholders.

Buy-Sell Provisions

A Shareholders Agreement will frequently include some mechanism to deal with disputes that may arise among the shareholders. In some cases, the buy-sell provision will permit any shareholder to make an offer to acquire the shares of another shareholder. The shareholder who receives the offer has the right to accept it, or make a counter-offer so long as the price is at least 5% higher. This process continues, back and forth, until one shareholder has accepted the offer, and the sale occurs as specified in the Agreement. This type of provision is sometimes referred to as a “Russian Roulette” provision. Although there are different variations on the mechanism, the existence of this type of provision in an Agreement will frequently deter the escalation of disputes among shareholders, as everyone is well aware that an unresolved dispute could lead to the sale of shares.

Co-Sale Rights

Third parties are frequently willing to pay a premium for a controlling interest in a business, or 100% of the outstanding shares. When a single shareholder or small group of shareholders (frequently including a founder) own an interest too small to attract a third party buyer of the Company’s shares, the Agreement can require that all of the shareholders are obligated to sell if an offer is acceptable to a certain percentage of share ownership, or a “key” shareholder. These provisions can require that the price offered by the third party must exceed a certain threshold before the shareholders have the obligation to sell.