Does My Corporation Need a Shareholders’ Agreement?

When starting a corporation, it's important to have key foundational documents in place to make sure your corporation will be run successfully now and in the future. One such document is called a shareholders' agreement (also called a "stockholders' agreement). While not every corporation has one, this document is critical in determining a shareholder's rights and obligations both to the corporation and to other shareholders.

When your corporation issues shares, you should have the share recipient sign a shareholders' agreement.

What Is a Shareholders' Agreement?

A shareholders' agreement is an agreement made among a corporation's shareholders (called "stockholders" in some jurisdictions) about how the company will be run and what rights and obligations the shareholders have to the corporation and each other.

A shareholders' agreement will typically cover:

• the board of directors, including how the board is elected, controlled, and removed
• restrictions and other policies around stock transfers
• shareholders' voting rights
• how shares are valued and priced
• share distributions (dividends)
• dissolution procedures, and
• other general provisions.

Corporations will commonly have a shareholders' agreement in addition to its articles of incorporation and bylaws. Your corporation might also have a buyout (buy-sell) agreement that details what happens to the corporation's shares when a shareholder dies, retires, or wants to sell their shares.

The bulk of your corporation's shareholders' agreement should remain the same as you issue shares. However, the identifying information of this agreement will differ depending on who's receiving the stock, how many shares are being issued, and for how much.

Do You Need a Shareholders' Agreement?

If you're the company's only shareholder, you don't necessarily need a shareholders' agreement. In general, shareholders' agreements exist to establish and describe the respective rights of two or more shareholders. Also, having a shareholders' agreement would usually be unnecessary if you're the majority stockholder (owning at least 50% of the company) and the other shareholders have little to no leverage to influence how you can run the corporation or pay them dividends.

Just as corporate bylaws are useful in communicating how a corporation is run to internal and external players, a shareholders' agreement can also be beneficial to have in place. You might be more likely to attract investors with a shareholders' agreement. In addition, putting a shareholders' agreement in place at the beginning can make expansion easier as your company changes and grows.

A fellow shareholder might expect (or require) a shareholders' agreement under the following common circumstances:

• You and another shareholder are starting the company together, and you both are contributing valuable talent or assets to the company.
• The shareholder plays a critical role in the company's management or success.
• The shareholder has contributed cash or assets to the company and wants to protect their return on investment (ROI).
• No one shareholder owns a majority of the company's stock.

In these situations, other shareholders can have leverage to demand a shareholders' agreement. Also, a majority stockholder can use this agreement to solidify certain critical rights in their favor.

Key Terms and Provisions of a Shareholders' Agreement

Below are some standard, important topics that can be addressed in a shareholders' agreement.

Controlling the Board of Directors

Shareholders' agreements can be critical in determining who controls the company and its operations. In a corporation, the management structure works as follows:

• the stockholders elect the members of the board (directors)
• the directors elect the officers—for example, the president, chief executive officer (CEO), or chief operating officer, and
• the officers run the daily operations of the company.

It's a common misconception that a corporation's president or CEO is always the most powerful person in the company; the reality is that the directors who appoint (and remove) these officers have ultimate management authority. It's important to have an agreement in place that lays out the chain of command and how each player can obtain, keep, and lose their power.

Setting the number of directors. A shareholder's agreement can establish how many directors a corporation can have. Typically, a corporation will have an odd number of directors to avoid tie votes.

Appointing directors. The agreement can also specify which shareholders get to appoint directors to the board—whether individually or as groups of stockholders—and how many directors can be appointed by each. For example, if your corporation issues common stock and preferred stock, your shareholders' agreement might say that only holders of common stock can vote for directors.

Establishing how votes pass. The shareholders' agreement can also determine what percentage votes will be required for the board of directors to pass certain initiatives. In other words, some actions might require a majority vote of the directors (for instance, three out of five directors) while others could require a unanimous vote. For example, your agreement might require the approval of two out of three of your corporation's directors to hire an officer but require a unanimous vote to dissolve the corporation.

Restricting Stock Transfers

For many legitimate reasons, shareholders usually want to prevent other stockholders from transferring or selling shares. Primarily, people don't want to let new stockholders into the company if they don't know them. Shareholders would much prefer having a say in who else is introduced as an owner of the company.

Another reason why shareholders want to limit stock transfers is to prevent any shifts in the company's balance of power that would result from one shareholder transferring shares to another existing owner.

For instance, suppose there are five shareholders in a corporation that own the following percentages of stock:

• Shareholder A owns 40%
• Shareholders B and C each own 20%, and
• Shareholders D and E each own 10%.

Under this scenario, any initiative voted on by the shareholders (such as electing or removing a director or approving a major asset sale) can be passed by a simple majority of the shareholders. Under their current distribution, no single shareholder can pass an initiative without securing at least one other shareholder's vote (depending on their stake). But now suppose Shareholder A wants to sell all of their shares to Shareholder B. Now Shareholder B would have 60% of the company's shares and would be able to pass any vote by themselves. It would be in the interest of the other shareholders to prevent this scenario so they don't lose all of their voting power.

Shareholders' agreements are typically structured so that all stock transfers are prohibited unless the proposed assignment falls into a specific exception. The most common exception is that shareholders can transfer shares for trust and estate planning purposes (for example, to their heirs when they die or to a legal entity that's wholly owned by the stockholder.

Rights of First Refusal

Often a shareholders' agreement will allow an owner to transfer stock, but only if the shareholder first offers to sell the stock to the corporation, the other stockholders, or both. This arrangement is called a "right of first refusal" (ROFR).

If your shareholders' agreement includes a ROFR clause, then any shareholder who wants to sell their shares must first give the corporation or other shareholders the opportunity to buy the shares. If the shareholder has received an offer from an outside buyer, the shareholder must give the corporation and other shareholders notice of the offer. The notice must include the terms of the offer, including the purchase price.

Typically, in a situation where an ROFR applies, a shareholder looking to sell their stock must make their shares available in the following order:

• first to the corporation
• second to the other shareholders, and
• third to an outside party

In cases where the corporation is granted an ROFR, the corporation would have the right to buy the shareholder's shares on the same terms as those stated in the offer (a redemption). A corporation might find this option desirable, to prevent an unknown or unwanted owner from joining the company.

If the corporation doesn't redeem some or all of the shares within the time frame established in the shareholders' agreement, then the other shareholders can claim the shares. These shares would become available to the remaining shareholders based on their then-existing ownership percentages.

One or more of these remaining shareholders could elect to buy additional shares from the selling shareholder to either increase their ownership stake in the company or prevent a new owner from entering the company. Any remaining shares not redeemed by the company or purchased by the other shareholders could then be transferred to a third party.

Anti-Dilution and Preemptive Rights

Preemptive rights are often included in shareholders' agreements to allow shareholders to protect themselves from dilution when a corporation wants to sell either additional stock or other securities that are convertible into stock. Preemptive rights are sometimes called "anti-dilution rights" or "subscription rights."

When the corporation desires to sell additional stock to any person, preemptive rights require that the corporation first notify the existing stockholders of the terms of the issuance, including the purchase price. As with an ROFR, the shareholders would have a specified amount of time to exercise their right to purchase their pro rata portion of the additional stock. The shareholders would have the option to purchase the stock on the same pricing and other terms stated in the notice.

Shareholders who exercise their preemptive rights in full would maintain their percentage ownership of the company. Shareholders who either decline the offer or elect to purchase less than their pro rata portion of the additional securities would see their ownership percentage decrease.

Drag-Along Rights and Tag-Along Rights

It's standard for shareholders' agreements to include drag-along rights (sometimes referred to as "drags"), tag-along rights (sometimes referred to as "tags"), or both.

Drag-along rights. Drags are important to a shareholder who owns a controlling equity stake in the corporation (typically a majority). If a controlling stockholder wishes to sell all of their shares to a third-party buyer (which effectively results in a sale of the company), then a drag-along provision requires that the minority shareholders sell their shares at the same time. This provision facilitates the ability of the controlling shareholder to sell the company to a buyer who wants to own 100% of the corporation's stock.

Tag-along rights. Conversely, tags are important to minority shareholders because they work in the opposite way as drag-along rights. If a controlling stockholder wishes to sell all of their shares to a third-party buyer, then a tag-along provision gives the minority shareholders the option to sell their shares at the same time for the same sale price. This provision can be vital to minority shareholders because it allows them to take advantage of what might be a rare opportunity to sell their shares and earn an ROI.

Without a tag provision, a third-party buyer who merely wants a controlling stake in the company could conceivably purchase shares solely from the controlling shareholder. This move would deny the minority shareholders the chance to enjoy an ROI and also subject them to a new, perhaps unknown, majority shareholder.

Miscellaneous Provisions

As with all contracts, a shareholders' agreement will include miscellaneous, boilerplate provisions. These provisions will typically cover:

• when the agreement can be terminated
• if and when the contract can be amended
• how disputes will be resolved (such as through arbitration)
• warranties and representations
• the effect of waivers of part of the agreement
• severability of the contract, and
• what state's laws will be used to interpret the contract (called a "governing law" provision).

Your agreement will also include basic information about the parties involved and the transaction taking place. For example, the shareholders' agreement will likely include the name of the person receiving the shares, the corporation issuing the shares, the date, the number of shares being issued, and the price.

Getting Help With Your Shareholders' Agreement

Your corporation's shareholders agreement, like its other formation documents, is critical in determining the future trajectory of your company. It's important to draft this agreement effectively to account for your corporation's current state and its future growth and changes. You'll want to make sure that your shareholders' agreement fits your corporation while planning for any scenario that your corporation might come across sooner or later.

You can find many shareholders' agreement templates online for free. The U.S. Securities and Exchange Commission (SEC) usually has a few examples of simple and comprehensive shareholders' agreements that you can apply to your company. Many corporations can come up with these agreements on their own or with the help of free resources. But if you have questions specific to your corporation, you should talk to a local business attorney. They can review your pre-drafted or shareholders' agreement or create one for you.