The Shareholder Agreement – California Corporations

When organizing limited liability companies and corporations, clients often ask business lawyer, such as DPA Law Group, whether they should have a “shareholders agreement.”  To begin, shareholder agreements are among the owners of corporations, as shareholders—not among owners of limited liability companies or LLCs, who, by statute, are known as members.  So while this post addresses a type of agreement among shareholders as owners of a corporation, we typically recommend that LLCs with multiple members consider analogous provisions for inclusion in the LLC’s operating agreement which governs the relationships among the LLC and their members.

Buy-Sell Provisions

Shareholder agreements tend to be particularly important in small, closely held corporations.  This is because the shareholder owning the corporation also work there as service-providers to the corporation.  Because they work together such shareholders tend to want to be able to select their colleagues and company co-owners.  As a result, one of the more central components of the shareholder agreement are provisions that restrict the ability of a shareholder to sell his or her shares to a third party.

To this end a typical shareholder agreement provides that a shareholder cannot transfer or encumber his or her shares without first giving notice to the corporation and the other shareholder.  Providing the required notice triggers an option by the corporation and/or the remaining shareholders to purchase the departing shareholder’s shares at a price determined by a specified valuation mechanism and pursuant to an agreed manner for payment.  For example this could be a sale of the shares at fair market value determined by appraisal, with the purchase price paid in cash at closing or by a combination of cash and a promissory note repaid over time. 

The buy-sell provisions should also address what happens to a shareholder’s shares in the event of his or her disability, retirement, or death.  Typically, the mechanism for determining the purchase price is largely the same across triggering events, although the duration and manner for payment may vary depending on the particular triggering event.  This can include, for example, a longer pay-out time when the triggering invent is voluntary—the shareholder wants to sell or retire, and a shorter pay-out period when the sale arises because of an involuntary event: death or disability. Often corporations purchase "key man" insurance on key shareholders in an amount sufficient to purchase a deceased shareholder's shares from his or her estate with a single payment.

Tag-Along and Drag-Along Rights

Shareholder agreements may also provide protections to minority shareholders.  For example, they can provide a minority shareholder ownership interest cannot be diluted without its consent, and may further provide for “tag-along” rights in a permitted sale of shares by the majority shareholder.  Tag along rights mean that if the controlling shareholder seeks to sell all or part of his or her shares to a third party, the minority shareholders may participate in that sale on a pro-rata basis on the same terms of sale.

Conversely, a shareholder agreement can provide a majority shareholder the right to “drag-along” a minority shareholder in a sale of the corporation, so long as the minority shareholder’s shares are purchased on the same terms and conditions as those of the majority shareholder.  This means that if the majority of holders decide to sell their shares to a third party the minority must go along.

Timing

Shareholder agreements may be entered into at any time.  More often than not, however, it is entered into shortly after the corporation’s formation and is generally (but need not be) among all shareholders.  It is common for new shareholders to join an existing shareholder agreement by either agreeing to be bound by the existing agreement or by all of the shareholders executing an entirely new shareholder agreement.  And corporations with a shareholder agreement frequently will not issue shares to a new shareholder without his or her simultaneously joining an existing shareholder agreement.

Before drafting a shareholder agreement, corporate counsel will generally make an effort to become familiar with the business of the corporation and ascertain any sensitivities that may exist with respect to the corporation’s business and/or among the shareholders.  A shareholder agreement tailored to the business helps the parties establish workable ground rules for their relationship up front, reducing chances of future disputes and disagreements.

By Andrew (Drew) Piunti, drew@dpalawyers.com, ©2016.  DPA Law Group, 1100 Lincoln Ave. #381, San Jose, CA 95125