The Potential of Shareholder Agreements: Protecting Equity Owners, Preserving Value and Preventing Disputes

Parties holding equity in a specific business entity enter into shareholder agreements to advance important business and legal interests.  For example, a group of shareholders may agree to vote in favor of a specific outcome should the equity of the company in question be asked to approve a certain strategic financing deal.  Or, if a third party acquiror offers to buy the shares of one equity owner, others, as parties to a stockholder agreement with such holder, may require the outside investor to purchase their shares as well. 

Well-thought out agreements among all or a portion of a company’s stockholders will  typically address the following questions:

Ownership & Share Structure

• company support:  will the equity issuer be a party to the contemplated shareholder agreement?;

• stockholder parties:   will some or all of the company’s equity owners be parties to the agreement?
• share amounts:  how many shares of the company are owned by each party to the agreement?; 
• new stockholders:  will new equity investors be required to execute the agreement in question as a condition to receiving shares?

• company capital structure:  if the company has issued multiple classes of equity, does the agreement cover just one class, some of such classes or all of them?;

• common stock vs. preferred stock:  if the company has issued any preferred stock, which stockholder types will execute the contract:  only common stockholders, only preferred stockholders or holders of both common and preferred stock?;
• preferred share terms:  does the agreement contain preferred stock-related terms (conversion ratios; liquidation preferences; protective provisions)?;  
• voting rights:  does the agreement contain equity voting rights-related terms?; 
• dividends:  does the agreement contain any dividend-related terms? and
• dividend requirements:  is the company required to issue dividends under certain circumstances?

Governance & Control

• board appointments:  does the agreement grant board-appointment rights to any specific stockholder or group of stockholders?;
• veto rights:  under the agreement, do equity owners have the right to veto any material corporate decisions (to be acquired by a third party; to enter into a material financing transaction)?;
• officer appointments:  for each class of equity issued, does it have the right to appoint or veto the appointment of specific corporate officers?; and
• stockholder meetings:  do equity investors party to the agreement have any rights in respect of stockholder meetings (attendance formalities; proxy-related terms; notice requirements; quorum rules)?

Transfer Restrictions

• rights of first refusal (ROFR):  are existing shareholders under the agreement permitted to buy shares before they are offered to prospective investors?;
• rights of first offer (ROFO):  are sellers of the company’s shares required to first offer such shares to existing shareholders?;
• consent requirements:  are the company’s shareholders empowered to approve certain transfers of its shares?; and
• lock-up provisions:  are any company’s stockholders prevented from selling shares for a certain time period?

Minority & Investor Protections

• minority stockholder protections:  do any votes on material corporate decisions require the support of a supermajority of the company’s shares?;
• tag-along rights:  are minority shareholders permitted to join a sale if a majority of the shares are voted in support of an acquisition transaction?;
• information rights:  are any stockholders entitled to receive any information from the company (audited and/or unaudited financial statements; budgetary plans; books and records inspection rights); and
• anti-dilution protections:  (are any stockholder protected from dilution to the extent the company issues additional shares to other investors?). 

Majority & Exit Rights

• drag-along rights :  are majority shareholders permitted to compel minority shareholders to participate in company sale transactions?;

• initial public offering or sale provisions:  are there specific formalities and/or approvals required for exit transactions?

Employment & Founder-Specific Provisions

• vesting schedules:  are shares for any stockholder earned over time (or upon the satisfaction of certain corporate milestones)?;

• non-competition and/or non-solicitation restrictions:  are any holders subject to workplace-related restrictive covenants?;

• confidentiality:  are executives obligated to comply with market-standard confidentiality-related obligations?; and

• termination consequences:  how does the equity issuer repurchase unvested shares in connection with a founder or employee separation?

Funding & Future Issuances

• preemptive rights:  are existing shareholders entitled to buy new shares to maintain their respective ownership percentages in the company?;
• capital call obligations:  are security holders required to contribute capital pon the occurrence of any pre-specified events? 
• debt approval thresholds:  are stockholder permitted to veto company decisions regarding incurring debt?; 

Buy-Sell Provisions

• trigger events:  what events will activate buy-sell obligations (death, retirement, divorce and/or the existence of a dispute)?;
• buy-sell mechanisms:   how will the buy-sell process work (right of first refusal, “shotgun” clause or mandatory buy-sell)?; and
• valuation issues:  how will the shares subject to the buy-sell process be valued (pre-specified fixed amount, formula utilizing a financial metric like annual revenues or a third party business valuation)? 

Consult a New York Business Lawyer About Your Stockholder-related Interests

To be of value to the parties that execute shareholder agreements, such instruments should address corporate-related eventualities in a holistic manner.  These often include “positive” outcomes like the equity issuer attracting new private investors, conducting an initial public offering or being acquired by third party buyer for a hefty premium.  To be comprehensive, such contracts may also contain terms which cover unwanted developments like financial distress or business setbacks.  A stockholder agreement drafted with care will protect the equity owners party thereto whether the issuer in question is encountering extreme operational turbulence or achieving record profitability.  To discuss your ideas for the terms you think should be included as part of the shareholder agreement for your next equity investment, please contact Castle Garden Law at (929) 429-6797.