While Minnesota law lays a foundation of shareholder rights and responsibilities, these rules will often be incomplete or partially at odds with the needs of many closely held corporations. One of the best places to more clearly define the rights and responsibilities of shareholders is in a shareholder agreement.
A shareholder agreement is separate and distinct from articles of incorporation or bylaws. An agreement binds only those shareholders who choose to sign it, although, in a closely held corporation, this may well be all the shareholders. It is often easier to amend than articles or bylaws, and it is not required to be filed with the Secretary of State.
A properly drafted agreement binds both the current and future shareholders. It ensures that each shareholder, particularly minority shareholders, are treated fairly and that individuals cannot unduly benefit from their position within the company.
Among the many issues a shareholder agreement may address, some are considered particularly standard because of their importance. Some of these critical issues include share transfers, share pricing, minority shareholder rights, and salary setting,
SHARE TRANSFER RESTRICTIONS & BUY-SELL AGREEMENTS
Members of closely held business entities have good reason to be concerned about who owns shares in the company. Unlike a large corporation, shareholders tend to play a much more active role in the company, often serving as employees (see “Shareholder as Employee“). Thus, shareholder agreements often contain several clauses limiting the free transfer of shares without approval from the other shareholders.
One way this is commonly achieved is by granting a “right of first refusal.” Under a right of first refusal, the corporation or existing shareholders must be given the option of buying the shares before they may be sold to an outside party. A failure to make an offer to the existing parties would render any sale to a third party void. Additionally, all shareholders often must sign off to any transfer, including gifting the shares, before it may be valid.
Similarly, a shareholder agreement will often give the company or existing shareholders the right to purchase any shares that have an encumbrance or lien against them that are being acted upon. The lien holder still gets the market value of the shares and ownership in the corporation remains in acceptable hands.
Additional provisions govern shares upon the death of the shareholder, generally obligating the other shareholders (a “cross-purchase”) or the company (a “redemption”) to purchase the shares from the estate. In cases of redemption, the agreement usually requires the company to maintain a life insurance policy for each shareholder to ensure sufficient proceeds to purchase the shares. Such a provision is a benefit for minority shareholders, as their potential heirs will likely struggle to find a purchaser for a minority interest in a closely held corporation, but could still incur substantial tax burdens.
To lower the cost and time of facilitating any transfer that does occur, it is best for a shareholder agreement to outline the required closing process and documents, so that parties concentrate primarily on the terms of the transfer, not the vehicle.
BINDING THE TRANSFEREE
In cases where shares are transferred to an outside party, the shareholder agreement should include language that binds the new parties to follow the agreement. Minnesota, like many other states, does require that any transferee of the shares receive notice of the existence of a shareholder agreement to which they will be bound. This is often done by placing the notice on the back of the share certificate.
Pricing shares can be a daunting task. In a large, publicly traded company, the frequency of trades helps ensure that the “market price” is an accurate valuation of the company. With closely held corporations, agreeing to a purchase price at the time of purchase, particularly if it is a mandatory transfer, may be nearly impossible. Agreeing to a price or method of pricing in the shareholder agreement helps remedy this, as each current shareholder comes to the table as both potential future buyer and seller.
There are several ways to value shares, including setting a fixed price, using the book value, and calculating the present value of future expected earnings. Each method comes with its own advantages and drawbacks. The important thing is that it be clearly articulated and leave little room for doubt. As long as the IRS considers the share price agreement to be reasonable and fairly negotiated, it will adopt the method laid out in the agreement for purposes calculating estate taxes.
HEIGHTENED MINORITY SHAREHOLDER RIGHTS
While the law ensures them a minimal level of rights, minority shareholders may ultimately have little say over many final decisions, as they do not control a majority of the outstanding shares. If other shareholders are agreeable, the agreement may contain provisions granting additional rights and protections.
One such protection is the granting of preemptive rights, which give current shareholders a first chance to buy newly issued shares up to the point of maintaining their current ownership interest. This ensures that one’s interest in a company is not diluted when new shares are issued.
Another additional protection would be to increase the required majority vote needed to take certain material actions beyond the usual simple majority. Similarly, provisions may guarantee minority shareholders possessing a certain percentage the right to elect at least one director to the board of directors.
In the common scenario of shareholders also serving as employees of the company, it may be important to set those salaries in a shareholder agreement. At the very least, it would be wise to lay out parameters for shareholders who also draw salaries from the business. This ensures that a managing shareholder does not pay herself a lucrative salary, leaving little to be dispersed to the actual shareholders.