Everything’s Great Today, But … The Importance of a Shareholder/Buy-Sell Agreement

June 01, 2005

Those operating businesses as franchisors have undoubtedly been told of the importance of shielding one’s personal assets from the attacks of creditors by operating such businesses through a corporation or other legal entity which limits the personal liability of its owners. And, while forming a corporation or limited liability company is certainly a wise decision, one most attorneys would advise is fundamental when undertaking a business venture, a step in the process of entity formation that is all too often overlooked is the generally unpleasant process of putting in place a Shareholder Agreement (a/k/a a “Buy-Sell Agreement”).

For one thing, shares of stock or a membership interest in a limited liability company are the personal property of the individual or entity in whose name the ownership interest is listed. In other words, absent an agreement to the contrary, the owner of that interest is free to transfer the interest during their lifetime to whom ever they want and, at death (in the case of individual owners), the interest will transfer to the owner’s heirs, or to whomever the owner has identified that interest to be transferred under his or her will. A Shareholder Agreement can address the transferability issue by putting outright restrictions on transfer during one’s lifetime, providing for a right of first refusal with respect to prospective transfers and dealing with how the ownership interest is transferred upon the death of one of the partners.

Shareholder Agreements are also important for shareholders who hold less than a controlling interest in the business. Absent an agreement to the contrary, most corporate statutes provide that the vote of a majority of the shareholders shall govern in most situations. Therefore, it becomes vital that shareholders in minority positions negotiate terms that, at the very least, give them a vote on crucial decisions affecting the business, such as major contracts, sale of a substantial portion of the company’s assets, or mergers and acquisitions.

Shareholder Agreements can also provide a mechanism for valuing the business in the event of a mandatory buy-out (such as upon death or disability). This can include an agreement among the owners on the initial value of the business, together with a procedure to update the value on an annual basis or agreeing on a process for valuing the business either through a business appraisal or based upon an agreed formula tied to the performance of the company.

Transferability, management and valuation are among the important issues that can be addressed in a Shareholder Agreement, but they are by no means exhaustive of all matters that shareholders can and should consider. Furthermore, the ultimate agreement among the shareholders will vary depending on the type of business venture, the number of shareholders and the relationship among the parties. However, taking the time to discuss these issues today with competent legal counsel should ultimately produce a greater understanding of each shareholder’s intent and minimize the basis for disputes down the road. In addition, periodic review of an existing Shareholder Agreement is worthwhile as a company grows and evolves over time so that the shareholders can consider whether provisions that may have made sense at one point during the life of the company are still appropriate.

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