Shareholder Agreements - Part 1: Why Do I Need A Shareholder Agreement?

I have received many phone calls over the years along the following lines: “My partner and I are equal shareholders in our business but he has not been pulling his weight lately and I want to get rid of him.  How do I do that?”

The first question I ask in response is: “Do you have a shareholder agreement?” even though I know full well that I would not have gotten the call if the client had prepared for this situation by signing one.  At that point, the only advice I can offer is for the client to negotiate a corporate divorce and, if that doesn’t work, to hire a litigator and go to court.

I have heard many responses from clients when I bring up the subject of preparing a shareholder agreement for their small business but here are some of the most common:

“We are on the same page so we don’t need one.”

“We have 51% / 49% ownership so we don’t need one.”

“We will get around to it later.  We don’t want to spend the time and money right now.”

“Too expensive.”

While it is true that the negotiation and drafting of a shareholder agreement can take some time and can appear to be costly, my advice is almost always that the money will be well spent if difficulties arise down the road.  Certainly, if the dispute goes to court, the cost of litigation will dwarf whatever a shareholder agreement would have cost while the partners were still on amicable terms, not to mention the cost and disruption to the business while the dispute remains open.

I believe that the main purpose of a shareholder agreement for a closely held, small business is to deal with the situation where the “partnership” stops working, for whatever reason.  In such a situation, typically each “partner’s” primary income comes from the business and his or her biggest asset is the shares of the business. 

Many clients expect that the most common reason that shareholders wish to part ways is because of differences of opinion as to the business of the company.  However, that has not been my experience.  Instead, the sudden death or disability of one shareholder is often the triggering event.  There should be provisions dealing with how the deceased or disabled shareholder’s shares are repurchased, often funded with life or disability insurance.  Similarly, one shareholder may wish to retire or take up a different occupation.  Another, often overlooked, situation is the divorce of one of the shareholders.  That shareholder’s shares of the company may be part of the family assets that are divided between the divorcing spouses and a shareholder agreement can provide an agreed method for valuing the business and can ensure that the shareholder’s spouse does acquire shares in the company as a result of the divorce.

A shareholder agreement can also deal with the situation of a deadlock between shareholders.  There are various mechanisms for removing solving deadlocks, often referred to as buy/sell arrangements.  In brief, buy/sell arrangements specify who can buy out whom, under what conditions, at what price and on what terms.

Whatever the reason causing one shareholder to leave the business, a shareholder agreement is a risk management tool.  I suggest it is better to anticipate a change in the partnership in advance and plan for the possibility than to leave it open and face the possibility of litigation when something unexpected happens.

In addition to dealing with the departure of a shareholder (voluntary or otherwise), there are many other matters that should be considered when preparing a shareholder agreement.  In Part 2, I will describe some of those issues.