Do I Need a Stockholders’ Agreement?

There are various scenarios under which you or other stockholders might benefit from having a stockholders' agreement.

While you may have heard of a stockholders' agreement (called a shareholders' agreement in some jurisdictions), not all corporations have them. How will you know whether or not you or your corporation would benefit from having a stockholders' agreement?

If you are the company's only stockholder (called a shareholder in some jurisdictions), you do not need a stockholders' agreement. Stockholders' agreements exist to establish and describe the respective rights of two or more stockholders. Also, having a stockholders' agreement would usually be unnecessary if you are the majority stockholder (owning at least 50% of the company) and the other stockholders have little to no leverage to influence how you can run the corporation or pay them dividends. Common circumstances under which a fellow stockholder would expect (or require) a stockholders' agreement to be in place are the following:

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

In these situations, other stockholders may have leverage to demand a stockholders' agreement. Also, a majority stockholder can use a stockholders' agreement to solidify certain critical rights in favor of such stockholder. Below are some of the standard, important topics that can be addressed in a stockholders' agreement.

Controlling the Board of Directors

Stockholders' agreements can be critical in determining who controls the management of the company. In a corporation, the stockholders elect the members of the board (directors), the directors elect the officers (for example the President, Chief Executive Officer, or Chief Operating Officer), and the officers run the daily operations of the company. It is a common misconception that a corporation's President or CEO is always the most powerful person in the company, but the reality is that the directors who appoint (and remove) these officers have ultimate management authority.

A stockholders' agreement can set the number of directors, which is usually an odd number in order to avoid tie votes. The agreement can also specify which stockholders get to appoint directors to the board, whether individually or as groups of stockholders, and how many directors can be appointed by each. The stockholders' agreement can also determine what percentage vote will be required to pass certain initiatives. In other words, some actions may require a majority vote (greater than 50%) while others could require a supermajority vote (for example, 66 2/3% or greater).

Restricting Stock Transfers

For many legitimate reasons, stockholders 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. Stockholders would much prefer having a say in who else is introduced as an owner of the company. Another reason why stockholders want to limit stock transfers is to prevent any shifts in the company's balance of power that would result from one stockholder transferring shares to another existing owner.

Stockholders' 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 stockholders can transfer shares for trust and estate planning purposes (for example, to their heirs if they die or to a legal entity that is wholly-owned by the stockholder).

Rights of First Refusal

Often a stockholders' agreement will permit an owner to transfer stock, but only if such stockholder first offers to sell the stock to the corporation, the other stockholders, or both (called a right of first refusal or ROFR). In these circumstances, if a stockholder has received an offer to sell shares to any person, the stockholder would first give the corporation and the other stockholders a notice outlining the terms of the offer, including the purchase price. In cases where the corporation is granted a ROFR, the corporation would have the right to buy the stockholders shares on the same terms as those stated in the offer (a redemption). A corporation might find this option desirable, in order to prevent an unknown or unwanted owner from joining the company.

Any shares not redeemed by the corporation within the time frame stated in the stockholders' agreement would then be made available to the remaining stockholders on a proportional basis, based on their then-existing ownership percentages. One or more of these remaining stockholders could elect to buy additional shares from the selling stockholder to either increase such stockholder's 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 the third party.

Anti-Dilution and Preemptive Rights

Preemptive rights are often included in stockholders' agreements to allow stockholders to protect themselves from dilution when a corporation wants to sell additional stock or other securities that are convertible into stock (Additional Stock). 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 a ROFR, the stockholders would have a certain amount of time to exercise their right to purchase their pro rata portion of the Additional Stock, upon the same pricing and other terms stated in the notice. Stockholders who exercise their preemptive rights in full would maintain their percentage ownership of the company, while those 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 is standard for Stockholders' Agreements to include drag-along rights (Drags), tag-along rights (Tags), or both. Drags are important to a stockholder who owns a controlling equity stake in the corporation (typically a majority). If a controlling stockholder wishes to sell all his shares to a third-party buyer (which basically results in a sale of the company), then a Drag provision requires that the minority shareholders sell their shares at the same time. This facilitates the ability of the controlling shareholder to sell the company to a buyer who wants to own 100% of the stock.

Conversely, Tags are important to minority stockholders because they work in the opposite way as Drags. If a controlling stockholder wishes to sell all his shares to a third-party buyer, then a Tag provision gives the minority shareholders the option to sell their shares at the same time for the same sale price. This can be vital to minority shareholders because it gives them the opportunity 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 stockholder. This would deny the minority shareholders the chance to enjoy an ROI and also subject them to a new, perhaps unknown, majority shareholder.

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