Shareholder agreements: Ounce of prevention is worth a pound of cure

Editor’s Note: John Crolle is a member of the Business Practice Group of Ward and Smith, P.A.

If you are a shareholder of a closely-held corporation that does not have a shareholder agreement, you may be in for some unpleasant and costly surprises. Most, if not all, of those surprises can be prevented or remedied simply by adopting a carefully considered and well-drafted shareholder agreement in advance.

Hope Springs Eternal

When people choose to go into business together, it is usually because they have similar ideas and goals, complementary skill sets, and/or a shared vision. Generally, a person goes into business only with others with whom the person sincerely believes he or she can work compatibly in running a successful business. However, what happens if you find that you are, in fact, in business with someone who does not share your ideas and goals, does not bring needed skills to the business, or with whom you simply can’t work well? If such possibilities are not considered before they occur, bitter and costly disputes can ensue.

To illustrate some potential situations, assume the following facts: Mark, John, and Tom form the corporation MJT, Inc. ("MJT"), and each owns one-third of the stock of MJT. Prior to forming MJT, Mark, John, and Tom were in graduate school together and they share an idea that they believe can be commercialized to make them a fortune. They know each other well and believe each brings complementary technical expertise to the endeavor. Because they are friends and believe that they all have the same expectations regarding the operation of MJT, they do not enter into a shareholder agreement.

Storm Clouds

Now consider the following scenarios:

• Additional cash is needed. Mark, John, and Tom realize that in order to commercialize their idea, they will need additional development capital in the amount of $500,000, and they arrange to borrow the money from a bank. Since MJT is a new company with limited assets, the bank requires that all three shareholders personally guarantee the loan. Tom, who has far more personal assets than Mark and John, refuses to sign a personal guaranty, and the bank, therefore, refuses to loan the needed capital to MJT.

• The unexpected business partner. Imagine the same facts exist as in the above scenario, except that both John and Tom are reluctant to personally guarantee the loan. Without talking to Mark, John and Tom decide to sell their shares in MJT to Larry. As a result of the sale, Mark is in business with Larry. Since Mark does not want to be in business with Larry, he offers to sell Larry his shares as well, but Larry refuses because he needs Mark’s skills in order to commercialize MJT’s product. Mark then is unable to find another readily available buyer for his shares and now finds himself stuck in a business controlled by Larry.

• A shareholder dies. Mark is killed tragically in a car accident. Not only is the loss of Mark’s technical abilities devastating to MJT, but Mark’s will leaves his shares to his ne’er-do-well brother, Matt, who just lost his job shoveling garbage at the landfill due to poor job performance. Matt has no skills applicable to MJT’s business. Matt sees this as a perfect opportunity to "work for himself," and tells John and Tom that he wants to "help" with the business. To top things off, John and Tom have never gotten along with Matt.

• An impasse. After a few years of keeping the company afloat, John has had enough and strikes a deal with Mark and Tom to sell his shares to them. Mark and Tom are now 50/50 owners of MJT. After John is bought out, demand for MJT’s products takes off, and the company begins to make a profit and accumulate cash. Tom wants to use the cash to launch a new product line. Mark believes that such an investment is unwise and wants to invest the cash in certificates of deposit until the economy becomes more stable. Both are adamant in their positions, and their 50/50 voting interests create an impasse. Each would like to buy the other’s shares, but both refuse to sell. MJT does nothing with its excess cash.

The Solution: A Shareholder Agreement

Each of the scenarios described above could have been prevented or resolved by a carefully-considered and well-drafted shareholder agreement.

• The first scenario could have been avoided by a shareholder agreement that requires all shareholders to execute personal guaranties or face the prospect of the other shareholders buying the shares of a shareholder who refuses to execute a guarantee, at a price much lower than fair market value.

• The second scenario could have been avoided by a requirement in the shareholder agreement that shareholders first must offer to sell their shares to the other shareholders prior to selling them to a third party.

• The third scenario could have been avoided by a shareholder agreement that gives the remaining shareholders the right to purchase a deceased shareholder’s shares, using an agreed-upon valuation method to determine the purchase price.

• The final scenario could have been avoided by a shareholder agreement that contains a buy/sell mechanism that forces one shareholder to sell his shares to the other shareholder, using an agreed-upon valuation method.
Conclusion
The time commitment and legal costs of obtaining a carefully-considered and well-drafted shareholder agreement are minimal when compared to the time and cost of resolving problems at a later date, especially when no shareholder agreement exists. The best time to consider and execute a shareholder agreement is at the beginning of the business relationship, before conflict arises. However, it is never too late for willing business owners to enter into a shareholder agreement that will govern their relationship. As many shareholders without a shareholder agreement find out too late, an ounce of prevention is worth a pound of cure.

This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.