Shareholder Agreements

By Daniel B. Evans
Copyright © 1995 Daniel B. Evans. All rights reserved.

Agreements among the shareholders of a corporation can take a number of different forms, and it is important to consider all possible options.

PERMITTED TRANSFERS. An agreement can prohibit all transfers, or it can permit gifts to certain family members, outright or in trust, and during lifetime or at death. (Permissible recipients can be limited to the founders, their issue, and the spouses of issue, so that stock does not pass to parties unrelated to the original shareholders.)

REDEMPTION OR CROSS-PURCHASE. An agreement can require (or allow):

Redemption of stock by the corporation;
Cross-purchases by the other shareholders; or
Both an option to the corporation to redeem and an option to the shareholders to purchase any stock not redeemed.

MANDATORY OR OPTIONAL SALES. When a death or other triggering event occurs, the rights of the parties will fall into one of three possible patterns:

Mandatory buy-sell. The shareholder is required to sell and the corporation (or other shareholders) is required to buy.
Call option. The shareholder is required to sell if the corporation (or the other shareholders) decide to buy, but they are not required to buy.
Put option. The shareholder can decide whether or not to require the corporation (or the other shareholders) to buy, but they cannot require the shareholder to sell.

EVENTS REQUIRING SALES OR OFFERS. An agreement can provide for sales or redemptions of stock in any or all of the following cases:

Voluntary offers to sell to a third party. (The rights of the corporation or shareholders to purchase stock before it can be sold to another person is sometimes called a “right of first refusal.”)
Bankruptcy, insolvency, or involuntary attachments. So that stock does not wind up in the hands of creditors or trustees for creditors.
Death of the shareholder.
Disability of the shareholder, making him or her unable to work for the corporation.
Termination of employment with the corporation (other than by death or disability).

An agreement can deal with different situations in different ways. For example, an agreement could give the corporation the option to purchase stock in the event of an insolvency or third party offer, but could also give a shareholder the right to require the redemption of stock in the event of death or disability.

PURCHASE PRICE. The purchase price for shares to be sold or redeemed can be determined in a number of different ways:

Third party offer. When the corporation or other shareholders have a right of first refusal, the option price is usually the price offered by the third party.
Independent appraisal. An independent third party can be hired to appraise the stock of the company and set the purchase price.
Book value formula. The audited financial statements of the corporation can be used as the basis for the purchase price, and there may be adjustments for the appraised value of real estate and tangible assets, discounts of inventory or receivables, or a predetermined value for “goodwill.”
Earnings formula. The current year’s earnings, or an average of two or three recent years, can be multiplied by a predetermined “capitalization factor” (or price/earnings ratio) to determine a value for the corporation.
Periodic agreements. The shareholders can agree to set a value themselves, and review that value periodically. (This works best of all of the shareholders are equally likely to buy or sell stock, so that no shareholder will have a reason to undervalue or overvalue the stock.)

OTHER TERMS. An agreement can also provide for:

Installment sales of stock, so that the corporation or purchase shareholders can pay the purchase price in installments, with interest. The unpaid purchase price is usually evidenced by a note, and there is usually a security interest in the stock sold.
Escrow of certificates, so that the certificates are held by a third party, who enforces the agreement.
Arbitration of any disputes.