Shareholder Buyout Agreements for Corporations

Shareholders are owners in a corporation—just like members of a limited liability company (LLC) or partners in a partnership. While shareholders don't necessarily have the ability to manage the corporation's daily operations, they still have a stake in the corporation and a vested interest in the business's success.

Shareholders are cautious about who they let into their company. It's inevitable that one or more shareholders will eventually look to sell their stock, or an event will happen to trigger the sale. When this sale happens, it's important to have rules and procedures in place for the stock transfer. To protect their interests and control who can buy into the company, shareholders should have a shareholder buyout—also called a "buy-sell"—agreement

This article discusses shareholder buyout agreements for corporations. For a more detailed discussion, see our article on buy-sell agreements for small businesses.

What Is a Shareholder Buyout (Buy-Sell) Agreement?

A shareholder buyout agreement is very similar to an LLC owner buyout agreement or a partnership buyout agreement. This agreement is a binding contract among a corporation's shareholders that lays out the rules and procedures for what happens when a stockholder wants to sell their shares.

For a corporation, typically, a shareholder buyout agreement controls the following decisions:

• whether a departing shareholder must be bought out
• who can buy a departing shareholder's stock (this can include outsiders or be limited to other shareholders)
• what price will be paid for a shareholder's interest (stock) in the corporation, and
• what other events will trigger a buyout.

A buyout agreement can be its own document or it can be included as a provision in the shareholders' agreement, also known as a "stockholders' agreement."

Why Do You Need a Shareholder Buyout Agreement?

It's inevitable that sooner or later your business will change. Chances are, one of your stockholders will eventually want to leave the company (and take their investment with them) before the rest of the shareholders are ready for their departure.

When one shareholder leaves—or dies, divorces, or goes bankrupt—and there's no agreement, who decides whether the remaining owners have to buy out the departing shareholder, and for how much? Shareholders who anticipate and plan for these circumstances by creating a buyout agreement can avoid personal and professional discord.

Protecting the Remaining Shareholders' Voting Power

In a corporation, stockholders vote on major company decisions, such as asset sales and acquisitions and board director appointments. Typically, a stockholder's voting power is determined by how many shares they have.

For example, suppose Mako, Korra, and Lin are the three shareholders in a corporation with 1,000 outstanding shares. Mako owns 500 shares, Korra owns 300, and Lin owns 200. In this example, the voting power would be distributed as follows:

• Mako would have 40% of the voting power
• Korra would have 30% of the voting power, and
• Lin would have 20% of the voting power.

So, a stockholder who owns a considerable amount of shares can sway a vote. When this powerful stockholder decides to sell their shares, the recipient of these shares inherits the voting power too. Because they'll be greatly affected by this shift in power, the remaining shareholders are motivated to take control over at least some of the terms of this stock sale.

Absent an Agreement, State Law Will Apply

If you don't have a buyout agreement, then you'll be forced to follow your state's default rules for corporations. And there's a good chance you might not agree with them.

For example, suppose a stockholder wants to sell their shares—which make up 60% of the corporation's total shares—to an outsider (someone who's not a shareholder). Your state's laws might allow the stockholder to sell their shares without the approval of the majority of the other shareholders. But you'd probably prefer the stockholder to get shareholder approval for the sale, or, even better, require the stockholder to sell their shares back to the corporation or to other stockholders.

To avoid having your state's laws decide the fate of your company, you need to create a buyout agreement for your corporation.

What Events Are Covered Under a Shareholder Buyout Agreement?

Typically, the events that trigger the buyout of a shareholder's interest under a buyout agreement are:

• the retirement or resignation of a shareholder
• an attractive offer from an outsider to purchase a shareholder's interest in the corporation
• a divorce settlement in which a shareholder's ex-spouse stands to receive all or part of a shareholder's stock in the corporation
• the foreclosure of a debt secured by a shareholder's stock
• the personal bankruptcy of a shareholder, and
• the disability, death, or incapacity of a shareholder.

Generally, these events will require a shareholder buyout. In other words, if one of these events happens, the affected shareholder will be required to sell their share or their share will be taken from them (such as when they die or their stock is seized to settle a debt).

Specify the timing of the buyout. When you list the events that trigger a buyout, you should also specify when the buyout happens. For certain events, timing is crucial. For example, if a stockholder is going through a divorce or filing for bankruptcy, you'll want the buyout to happen before the divorce is settled or the bankruptcy is filed. Otherwise, you won't have much control over what happens to their shares.

Require notice from the shareholder. You should also include a clause that requires a shareholder to give the other shareholders notice if any of these events are impending so you can plan accordingly. For example, you should require a shareholder to give notice if they plan to use their stock as collateral for a loan or purchase. If you know about this transaction before it happens, you can initiate a buyout early so you can avoid a messy foreclosure.

Who Can Buy the Departing Stockholder's Shares?

So, a stockholder wants to sell their corporate shares, or circumstances have caused them to lose their shares. But who gets their shares: the corporation, the shareholders, or an outsider?

In your buyout agreement, you should specify to whom the departing stockholder can sell their shares.

The Corporation or Shareholders Have the Right of First Refusal

Many shareholder buyout agreements will opt for a right of first refusal (ROFR) clause. This clause requires the departing stockholder to first offer their stock to the other shareholders or to the corporation itself before they can sell it to an outsider.

Then the shareholders or company can decide whether they want to buy the stock or pass on (refuse) it. If the shareholders and corporation don't want to buy the stock, then the stockholder can sell their shares to someone outside the company.

The ROFR gives the shareholders and the company the ability to keep the shares in-house if they choose to. If a lot of shares are at stake, your inclusion of this clause becomes particularly important.

The Obligation of the Remaining Shareholders and Corporation

If you require the departing stockholder to sell their share back to the other shareholders or to the corporation, then you should decide whether the other shareholders or the corporation are required to buy the stock. Requiring the shareholders or corporation to purchase the stock has its benefits and drawbacks for both sides.

Pros and cons for the departing stockholder. An advantage of requiring the stock purchase is that the departing stockholder will have an automatic buyer. A disadvantage is that an outside offer might be more appealing than what the other shareholders can or will offer.

Pros and cons for the remaining stockholders. A mandated transaction makes for a quicker and cleaner transition. But this requirement puts added pressure on the shareholders or corporation to come up with the money to buy the shares—a potentially significant cost.

How Much Should the Shares Be Worth?

Generally, it's harder to value a corporate share—as opposed to an LLC owner's membership interest or a partner's partnership share. Unless your corporation is public and the share price is already known, you'll need to decide on a way to value your corporation's shares. The price of a share is linked to a business's worth (value).

Some corporations look at comparable public companies to come to a fair number. Others calculate their company's book value and divide that number by the number of outstanding shares to determine a share's value.

Because measuring a share's value can be difficult, some corporations opt to hire a valuation specialist with corporate expertise. If you opt to hire an expert, make sure that the person you choose is an uninterested third party that the shareholders agree to. For example, your buyout agreement should require the specialist to have certain credentials—such as a certification from a specific accredited organization.

Paying a lump sum vs. installment payments. Sometimes a shareholder's stock can be worth more than what the other shareholders can currently pay. Even if you think affordability won't be an issue, it's wise for your agreement to allow for payment installments. For instance, you should give the purchasing shareholders the option to pay either a lump sum or a down payment with incremental payments over time (say, five years).

Tax implications of a shareholder buyout. If a departing stockholder sells their shares, then corporate officers and directors will likely need to make the appropriate tax adjustments for the corporation. You should include a clause in your buyout agreement that says who's responsible for filing the appropriate tax forms and notifying the required tax authorities. For more tax guidance, read how corporations are taxed. You should also consider talking to an accountant or tax lawyer. They can help you understand your obligations and how your buyout terms affect your personal and business taxes.

How Do You Create a Buyout Agreement?

As mentioned earlier, a buyout agreement can consist of several clauses in your written shareholders' agreement or it can be a separate agreement that stands on its own. If you have experience drafting corporate documents, you might be able to write one yourself without assistance or with the use of a self-help resource.

If you'd like to try to draft one on your own but are looking for a little help, one good tool to use is Business Buyout Agreements: Plan Now for All Types of Business Transactions, by Anthony Mancuso and Bethany K. Laurence (Nolo). This book contains an agreement with fill-in-the-blank buyout clauses and instructions on how to incorporate them into your other corporate documents.

Consulting a Business Attorney

If you and the other shareholders can't agree or the buyout terms you want are complex, consider consulting with a business lawyer. An attorney can help you negotiate with the other owners, advise you on the best terms for your business, and draft a buyout agreement for you.