All shareholders, no matter the size or jurisdiction, are granted some limited rights when investing in a company. However, shareholders in a small business are wise to negotiate and draft contractual protections in addition to these limited rights. Shareholders of a publicly-traded company have the ability to sell their shares if they are unhappy with the trajectory or management of the company, but restrictions on the shares or the lack of a public market makes this type of exit potentially impossible in a smaller company. In lieu of such freedom, it is important for shareholders in privately-held companies to negotiate additional protections for three main reasons:
1. Management
Shareholders in privately-held companies often have high expectations for their involvement in management decisions. A shareholder agreement should provide increased transparency into how the company will be managed. This includes board representation by the shareholders and actions the board cannot take without unanimous, or super-majority, approval of the shareholders. Actions such as increasing an officer’s salary, the percentage of profits to set aside as retained earnings, or the issuance of additional securities to a third party are examples of actions that could be contingent on shareholder approval.
2. Liquidity
Shares in private companies are unregistered securities, which means the shareholders do not have an accessible market to sell their interest in the company if they become dissatisfied with how things are progressing. Thus, shareholder agreements can create an opportunity for liquidity. Certain events can trigger a buyout, such as retirement or termination of employment. Prior to such an event, the company and shareholders can agree upon a calculation of the price per share in order to lessen the opportunity for a downstream argument when it comes time for a purchase or transfer of equity to occur.
3. Transfer Restrictions
Transfer restrictions can protect the core players and allow everyone to weigh in on who may come on board and join the team. Shareholder agreements will typically include restrictions on the ability of a shareholder to sell or otherwise transfer his/her shares without the consent of the other parties. They can also provide the other shareholders an opportunity to purchase the shares before they are sold or transferred to a third party. This right of first refusal helps to ensure that the remaining shareholders don’t get stuck working with a new party they wouldn’t have chosen to do business with.
The lack of liquidity and the frequent combination of the roles of shareholder and manager means that wise shareholders will put together a shareholder agreement at the beginning stages of their business venture. A well-drafted agreement can help guide the management and allow them to focus on the changes that will take place over the lifecycle of a business. If you’re interested in discussing your current shareholder agreement or drafting a shareholder agreement you can contact us at info@bendlawoffice.com, or at (415) 633-6841.
Disclaimer: This article discusses general legal issues and developments. Such materials are for informational purposes only and may not reflect the most current law in your jurisdiction. These informational materials are not intended, and should not be taken, as legal advice on any particular set of facts or circumstances. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction. Bend Law Group, PC expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this article.