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Shareholder
Agreements
Voting
and Management Agreements
A.
Shareholders have always been able to agree how they will
vote their stock.
1. An
agreement by holders of a majority of the shares to vote
as the majority of them votes.
2. Not like a
voting trust where shares are transferred to a trustee
who votes.
a)
Voting trusts are no longer limited in duration in
Illinois and Delaware to 10 years.
3. Illinois
and Delaware statutes specifically authorize these
agreements.
a)
Delaware and Illinois recognize agreements outside the
statute.
B.
Subjects covered in management agreements.
1.
Voting and control.
a)
Who the shareholders will elect as directors and how
many.
b) More
than majority vote requirements, often unanimous vote
being required.
c) Quorum
requirements and notice requirements.
i)
Even if unanimous voting is required a shareholder
can be outvoted if he is not present at a meeting.
This will not happen if the presence of everyone is
required for a quorum.
ii) If
everyone's presence is required for a quorum but
only a majority vote is required, a shareholder can
prevent action by staying away from the meeting.
Sometimes there are provisions to deal with
this.
d)
Requiring the approval of certain persons on certain
issues. This can also be done by creating separate
classes of stock in the articles that have different
voting rights on different issues.
2. Officers
and jobs.
a)
Who will be the officers and who will get what jobs
and titles.
b)
Sometimes salaries and bonuses, fringe benefits and
expenses are specified, sometimes they are just
required to be equal or bear a set relationship to
each other.
c) Who will
exercise what function.
d) Limits
on hiring and payment of employees and contractors or
specifying who can hire.
e) Limits
on contracts over a certain amount or extending in
excess of a certain time.
f) Limits
on debt, giving security, sales or purchases of assets
outside the ordinary course of business, sale of the
business, changing the business, deals with officers
and directors.
g) Grounds
for termination.
h)
Disability
i)
Often salary continuation for a set period is
specified and sometimes disability insurance is
carried for payments after that.
ii) Not
showing up for work
3. Other
management provisions.
a)
Provision against competing with the
corporation.
i)
During share ownership.
ii)
After share ownership.
b)
Sometimes competition is specifically allowed, i.e.,
when a competitor is brought in to turn the business
around.
i)
This is dangerous because conflicting fiduciary
duties may exist and it may be difficult to agree
how to handle them in the agreement.
ii)
Sometimes an agreement provides that if a
shareholder resigns all positions with the
corporation and no longer votes he can compete.
c) Who owns
intellectual property used by or developed for the
business.
d)
Accounting matters.
i)
Fiscal year.
ii)
Accounting methods or changes in them.
iii)
Choice of accountants.
iv)
Whether or not there will be an annual audit or
some other level of review.
v) Whose
signature is required on checks and
contracts.
vi)
Where the books and records and checkbook will be
kept.
e) Sale of
company.
i)
Giving one shareholder a right to negotiate a sale
and a right to require the others to sell and
specifying whether or not they will get the same
price.
ii)
Requiring minority stock to be bought at the same
price in case the majority sells.
iii)
Requiring the company to register certain
shareholders' shares if it goes public.
iv)
Giving certain shareholders veto powers.
f)
Dividends and distributions.
g) S
Corporation status:
i)
Agreement to be an S corporation.
ii)
Prohibiting any transfer or other act that would
terminate the status.
iii) S
corporation shareholders declare their share of
corporate income on their tax returns. This does
not mean they get anything from the corporation.
Sometimes the agreement provides for dividends
sufficient to pay taxes (which may be at a
different percentage for each
shareholder).
4. Provision
for binding subsequent shareholders.
a)
Legend on certificates.
b)
Prohibition against transfer unless they agree to
become bound.
5. Provisions
for breaking deadlock.
a)
Arbitration.
b)
Mediation before court action resorted to.
c) Giving a
shareholder an option to require
dissolution.
i)
Put limits on it - such as a waiting period.
d) One
shareholder (or any shareholder) has an option to name
a price at which the others must either buy or
sell.
i)
This can be manipulated by a shareholder who has
money when the others do not.
ii) You
must specify all the details of the closing to make
it enforceable, just like any other option
contract.
e) A
shareholder's right to be bought out (a corporate
right to buy out a shareholder doesn't work in cases
of deadlock).
6. Minority
protection provisions.
a)
Voting rights on certain things.
b)
Preemptive rights.
c) Job, pay
and benefits.
d)
Dividends.
e) Right to
be bought out.
f) Right to
sell if majority does and at same price.
g)
Restriction on majority rights to deal with itself and
compete.
h) Access
to information.
i) Refer to
the section of the site titled Protection
of Minority Owners of Corporations, Partnerships and
Limited Liability Companies for more
information.
7. Things to
beware of:
a)
Fiduciary duties. Agreements by less than all of the
shareholders cannot provide for something that would
violate their fiduciary duties to the corporation or
other shareholders.
b)
Directors agreements as to management do not have any
solid basis in law and have often been held
void.
Buy-Sell
Agreements
A.
Other names.
1. Stock
redemption agreement.
2. Stock
purchase agreement.
3.
Shareholders agreement.
B.
What they do.
1.
Provide for sale and purchase of a stockholder's shares
by the corporation or other shareholders in certain
instances.
a)
Death.
b)
Disability - more likely than death prior to age
65.
c)
Termination of employment or retirement.
d) Desire
to sell.
e)
Deadlocks.
f)
Bankruptcy or an assignment for the benefit of
creditors.
g)
Divorce.
h) Do you
allow or prohibit transfers from a shareholder to his
family members or controlled entities or from one
shareholder to another?
2. Restrict
sale to outsiders - a small corporation is like a
partnership.
a)
While a partnership agreement or limited liability
company operating agreement may prohibit admission of
an outsider, sale of shares of stock cannot be
prohibited.
b)
Reasonable restrictions on sale are
allowed.
C.
Reasons for use.
1. To
prevent outsiders from becoming shareholders.
2. To fix the
value of stock for estate tax purposes.
a)
Death purchase must be mandatory.
b) The
agreement must bind the shareholder during
life.
c) If
family members are involved it must also be a bona
fide business arrangement with terms comparable to
those that would result from an arms-length
transaction.
3. To provide
funding - liquidity - for an estate.
a)
Closely held corporation stocks have no effective
market other than a sale of the entire company or a
sale to other shareholders.
b) Most
small business owners have most of their assets in
their business.
i)
It creates the estate tax which it ordinarily
cannot pay - it must be converted to cash.
4. To provide
a market for a shareholder who wants to sell.
5. To provide
for succession to key employees or family members on
retirement or death.
6. To prevent
loss of Subchapter S status by sale to a non-consenting
shareholder or a non-qualifying shareholder or to too
many shareholders.
7. To prevent
transfer to ineligible shareholders in a professional
service or similar corporation.
8. To prevent
transfer to a competitor.
9. To insure
compliance with the securities law which require
registration or an exemption.
a)
Company may require evidence that registration is not
required including an opinion of counsel.
D.
Types.
1.
Mechanics can be:
a) In
certificate of incorporation.
b) In
bylaws.
c)
Agreement between any number of stockholders or
between them and corporation.
2.
Specifically allowed by Illinois and Delaware statute
are:
a)
Rights of first refusal in the corporation or other
shareholders.
b)
Obligation of the corporation and other shareholders
to purchase.
c)
Requirements that the corporation or any class of
shareholders consent to a transfer or the
transferee.
d)
Prohibition on transfer to certain designated persons
or classes of persons.
3. The
restrictions cannot be absolute - must be
reasonable.
a)
Mandatory buy-sell.
i)
On death.
b) An
option to buy-call.
i)
If the corporation or other shareholders so desire
they can purchase - rare.
ii) Upon
a shareholder's retirement or death the corporation
or other shareholders can purchase.
iii) If
shareholder wishes to sell, he must sell to
corporation or other shareholders at a
pre-determined price if they wish to purchase or at
least offer the shares to them at the price he has
been offered.
c) An
option to sell-put.
i)
Hard on the buyer.
d) Right of
first refusal.
i)
If an offer from an outsider is received, the
corporation or other shareholders have the right to
match it.
e) No
transfer without consent of corporation or other
shareholders.
i)
Doubtful enforceability.
aa)
Sec. 6.55 allows this - is reasonableness
required?
f)
Prohibition on transfer to certain classes.
i)
Or allowing transfer only to certain
classes.
g) One
shareholder can name a price at which the other or
others must either buy or sell.
h) The
shareholders each place a price in a sealed envelope.
The one who bids the highest gets to buy the other out
at the other's price.
i) A
majority holder will not sell unless a similar offer
is made to the minority holders - or unless they got
some lesser offer.
4. Redemption
- corporation is the buyer.
a)
Technically the simplest and the easiest to
administer.
i)
There is only one buyer and one seller.
b) The
corporation has the money.
c) May not
be advisable for tax reasons.
i)
Redemption must be total or substantially
disproportionate or it is taxed as a dividend at
ordinary income rates.
aa)
Cannot be used unless entire interest is to be
redeemed.
ii)
Ownership of some family members is attributed to
others so a total buy-out of one turns out to be
only partial and taxable at ordinary rates.
iii)
These problems do not arise in S corporations,
partnership or limited liability companies, LLC's
taxed as partnerships. But S corporations can be
converted to C corporations and their earnings and
profits earned during prior C corporation years
will be taxed as dividends when they come
out.
d) May not
be permissible under certain corporation acts unless
corporation has sufficient "surplus".
i)
Make sure the shareholders are obligated to
purchase or contribute funds to the corporation if
the corporation cannot purchase.
ii) If
the corporation can buy only some of the shares
have the shareholder buy first - otherwise the
redemption by the corporation is only partial and
can be a dividend.
5.
Cross-purchase - other shareholders are the buyers.
a)
Technically complicated, especially if insurance is
used.
i)
There are a lot of different buyers and a lot of
difference insurance policies.
ii) A
trust can be used as a purchasing entity and as
beneficiary of the policies.
b) The
shareholders may not have the money and corporate
funds are not available to them except at ordinary
income rates.
6.
Combination.
7. Advantages
and disadvantages of redemption and cross-purchase
types.
a)
Cross-purchase.
i)
Purchasing shareholders receive an increased
basis.
ii) Less
insurance is needed to fund the agreement because
the insurance is not owned by the company and is
not included in its value.
iii)
There is no risk that amounts paid for the stock
will be treated as dividends.
iv) A
purchase can cause a shift in control from one
shareholder group to another, unless you provide
for intra-group purchases.
v) More
insurance policies are required.
vi) The
burden of premiums falls more heavily on the
younger shareholders who have and pay for policies
on the lives of the older shareholders.
vii)
More complicated and more expensive.
b)
Redemption.
i)
Simpler.
ii) The
corporation may be the only buyer able to purchase
the stock.
iii)
Risk of dividend treatment - almost impossible to
use redemption agreements with family
corporations.
iv) A
partial redemption to the extent needed to pay
estate tax can escape dividend
treatment.
v)
Remaining shareholders do not get any increased
basis.
vi)
Restrictions on ability of corporation to redeem by
corporation acts or loan agreements.
E.
Issues.
1. May
want to combine with other agreements.
a)
Covenant not to compete.
b)
Employment agreement.
c) Stock
options or stock as employee compensation.
2.
Price.
a)
Book value.
b) Multiple
of book value, earnings, sales, etc.
i)
Last 3 years averaged with most recent years given
more weight.
c) Agreed
price with periodic updates.
i)
The updates do not take place.
ii) Fall
back on the last agreed value for a while and then
some other method.
d)
Appraisal of assets or stock.
e)
Adjustment of book value by appraisal of specific
assets or market values where available.
f)
Arbitration.
g)
Insurance proceeds.
i)
What do you do with excess proceeds.
ii) What
if the proceeds are not enough.
h) Industry
standards for pricing.
i) One
shareholder names a price at which the other can
either buy or sell.
j) There
may be different prices for different
events.
i)
The price if an employee retires may be higher than
if he is fired or leaves without consent.
3. Funding.
a)
Accumulation in advance by corporation.
b)
Corporate or shareholder bank borrowings.
c) Deferred
payment.
i)
Downpayment.
ii)
Duration of payments.
iii)
Interest rate.
aa)
Related entity and person regulations.
bb)
Installment sale regulations.
iv)
Security.
aa)
Escrow.
bb)
Mortgage and UCC.
cc)
Seller holds certificate for Buyer.
d)
Insurance.
i)
One or more of the shareholders may be or become
uninsurable.
4. Notice must
be on certificates or else an outsider buys free of
restrictions on sale.
a) It
must be conspicuous.
5. Under some
close corporation acts the validity of some types of
restrictions are clearer so if they are important make a
close corporation election.
6. When the
corporation has an option can the selling shareholder
vote on the option if he or she is a director?
7. Corporate
insiders and majority shareholders have a fiduciary duty
and duties under the securities laws to make full
disclosure to minority shareholders who are selling to
them or the corporation at least where the buy-sell is
not mandatory.
8. What do you
do with assets the seller leases to the
corporation?
a)
They can be included in the buy-sell.
9. Require as
a condition to transfer that new shareholders become
parties.
10.
Specifically bind heirs, administrators, executors,
personal representatives, pledgees, mortgagees, etc. as
well as assigns. Some cases have narrowly construed these
clauses.
11.
Specifically cover involuntary transfers such as in
divorce, foreclosure or bankruptcy. Some courts have said
these are not covered by simple "no transfer"
language.
12. These
agreements are probably specifically enforceable, but
specifically provide for it and provide for injunctions
against threatened violations.
13. Make the
corporation a party to cross-purchase agreements so it
can enforce them.
14. Include
after acquired shares and successor entities.
15. If you
have a NOL beware. A buy out can trigger a sufficient
change in ownership to prevent or reduce further use of
the NOL.
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