Succession, continuity shareholder agreements

The owners of closely held corporations and limited liability companies (LLCs) are often the company founders and executive leadership who share a strategic vision for the company’s mission and growth.

The owners of closely held corporations and limited liability companies (LLCs) are often the company founders and executive leadership who share a strategic vision for the company’s mission and growth. Owner stability and continuity are critical but can be disrupted if an owner dies, becomes incapacitated, retires, or voluntarily transfers his ownership to a third party or it is transferred involuntarily. These occurrences introduce business continuity and succession issues by creating the potential for unknown costs, fractured ownership, and differing corporate visions. While LLC operating agreements can address these situations by restricting a member’s ability to transfer ownership interests, corporations generally must rely on contractual arrangements, namely a shareholder agreement (sometimes referred to a buy/sell agreement) to achieve the same objective. Although this article addresses shareholder agreements, the concepts below may be similarly applied to LLCs.

What is a shareholder agreement?

A shareholder agreement is a contractual agreement amongst shareholders and the corporation that predetermines who will buy the shareholder’s shares in the event of certain occurrences, usually well in advance of knowing which shareholder will be bought out. As noted above, common triggers include a shareholder’s death, incapacity, or retirement as well as voluntary and involuntary share transfers by the shareholder. A voluntary transfer involves the shareholder willingly selling their shares to a third party whereas an involuntary transfer to a third party may occur as part of an existing shareholder’s bankruptcy or divorce proceedings. The agreement also outlines the purchaser, purchase price, and payout method. Deliberate drafting and an appropriate valuation agreed upon by all stakeholders are critical to implement an effective shareholder agreement. It is also advisable to have the shareholders’ spouses consent to Shareholder Agreement’s terms.

Drafting considerations

Shareholder agreements should be thoughtfully drafted to address the nuances of each situation. While there is no universal approach, several key aspects should be considered so that the agreement achieves the desired objective. As discussed below, these issues can be interconnected.

An important decision is whether the purchaser will be the other shareholders or the corporation. The optimal answer varies based on factors such as the number of shareholders, the source of funding, and associated tax implications, and may differ between the various triggering events. For example, if the catalyst is a shareholder’s death, the surviving shareholders can fund the purchase by purchasing life insurance on one another. For other triggers, the efficiency of having the company serve as the buyer should be considered along with the associated depletion in the company’s funds and the company’s inability to classify the buyout payment as a deductible expense for tax purposes.

The type of triggering event may also impact whether to make the purchase a mandatory obligation or discretionary decision for the buyer. Although a shareholder’s voluntary transfer can create a fractured ownership situation, it may make sense to structure the purchase as a discretionary decision to provide the corporation or other shareholders a right of first refusal allowing the opportunity to assess the risks of the potential third party buyer and decide at the time of buyout who is the best buyer based on the circumstances at the time. Conversely, involuntary transfers are often a good candidate for mandatory purchases. Under the involuntary transfers noted above, the shareholder’s ownership interests (and voting rights) may be transferred to the shareholder’s former spouse or bankruptcy creditors who may subsequently sell the shares to another third party. Mandating the purchase in these situations avoids the uncertainty associated with disinterested parties joining the shareholder ranks and mitigates the risk of disputes with other parties claiming rights to the shares. The purchase price for mandatory purchases should be fairly calculated in lieu of a nominal price to withstand fairness related inquiries and scrutiny by a divorce court or bankruptcy court.

The existing shareholder composition can also impact whether a purchase is mandatory or discretionary. For example, shareholders approaching retirement may not be agreeable to an obligation to purchase the shares of departing shareholders. Additionally, identical treatment for all shareholders is not required. It is possible to structure the agreement to require minority shareholders to purchase the shares of departing majority holders while making the inverse discretionary at the option of the majority shareholder, or to vest rights of purchase in just the founders.

The factors examined above are not meant to be an all-inclusive list of decisions when crafting a shareholder agreement as other aspects should also be considered in the drafting process. Because each company’s concerns and objectives are unique, it is important to engage legal, financial, and tax advisers in an open discussion of the business’s particularities and strategic objectives. Although shareholder agreements can’t prevent ownership change, a properly drafted agreement allows corporations to proactively manage shareholder succession with minimal disruption.