The Shareholders’ Agreement – a critical piece of the puzzle

These types of agreements provide for the orderly transfer of, and fair compensation for, interests in a company. In many circumstances, owners will agree upon the terms of a fellow owner’s exit; however, if they cannot agree, the Shareholders’ Agreement will control. When owners embark on a business venture, they may do so with the goals of making the business profitable and then ultimately selling it to a third party. However, other events could preempt these goals, and a company should have a built-in process for dealing with the unexpected.

The best time to develop a Shareholders’ Agreement is at the beginning of the business relationship when everyone is communicating well. Because it is hard to predict who will leave first, everyone is inclined to negotiate the agreement as if they could be either the departing owner, or the continuing owner, leading to a more balanced agreement.

Shareholders’ Agreements typically begin by restricting all share transfers. A transfer may be narrowly defined to include only sales, or may be more broadly defined to include other transfers, such as gifts, encumbrances and judicial transfers.

Next, the agreement identifies permitted transfers, such as transfers to trusts for estate planning purposes or transfers to other owners. The document may also identify events that trigger the operation of the agreement (so-called “triggering events”). Triggering events typically include voluntary transfers (e.g., owner wants to transfer to third party), death, disability and involuntary transfers (e.g., bankruptcy or divorce). Triggering events may also be retirement, termination of employment, and in some cases shareholder stalemates.

In Washington and Oregon, absolute prohibitions on transfer are not allowed, but reasonable restrictions are permissible. These restrictions normally provide that when an owner wants to transfer shares, the company must purchase the shares (this favors the departing owner) or may – at its option – purchase the shares (this flexible approach favors the company and remaining owners). Optional purchases can be structured as cascading options, with the first option in the other owners (a cross-purchase) and the second option in the company (a redemption). A mandatory purchase approach is often used when an owner dies, while the option approach is more popular with other triggering events (e.g., divorce, creditor issues, etc.).

The agreement also prescribes a method to determine the sales/purchase price of the shares to be transferred. Although the owners may set a price (and regularly update it) or develop a formula, the commonly employed approach is to obtain a third-party valuation that considers all applicable factors and discounts. Additionally, the agreement may detail payment terms, such as a specific down payment with the remainder paid over time.

Although much of a Shareholders’ Agreement is focused on ownership transfers, the agreement may cover a variety of other matters, such as security for the deferred purchase price, release of personal liability for company obligations, distributions in the buy-out year (especially with entities classified as partnerships or S-Corporations) and noncompetition provisions.

While the terms of Shareholders’ Agreements may be complex, the purpose of the agreement is simple – to provide for a smooth ownership transition both for expected and unexpected events.

Bill Dudley is a shareholder with Landerholm P.S., a Vancouver law firm. His practice focuses on business representation, including transactions, taxation, succession planning and estate planning for business owners. He can be reached at 360.696.3312 or bill.dudley@landerholm.com.

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