Transfer Restrictions in Shareholder Agreements
Corporations are creatures of statute, contrary to LLCs, which are creatures of a contract. I have written extensively about the need for a carefully crafted LLC agreement, but have not written much about the need for shareholders in a closely held corporation to have a carefully crafted shareholder agreement.
Shares of stock are generally freely transferable. However, in a closely held corporation, the shareholders frequently want to control who can be a shareholder. One of the fundamental purposes of a shareholder agreement is to provide the shareholders control over who can and cannot be a shareholder. A sound shareholder agreement typically begins with an outright prohibition on transfer. Once a general prohibition on any transfer is in place, a shareholder agreement typically carves out exceptions for voluntary and involuntary transfers.
Shareholder agreements must state the conditions in which a voluntary transfer of shares is permitted. For example, many shareholder agreements permit transfers between shareholders. Transfers between shareholders usually make sense because no new owner is being introduced to the company. In addition, transfers of shares for estate planning purposes to a trust or entity controlled by a shareholder are typically allowed.
When a shareholder wants to sell to a third party, there are many possibilities: some allow sales after compliance with a right of first refusal process, some provide for an option to purchase by an existing shareholder for appraised value and some provide for a sale to certain “permitted” buyers.
Often, involuntary transfers occur in the event of certain “triggering events” such as termination of employment, bankruptcy, disability, and death. Disability and death are the most common forms of involuntary transfer addressed in shareholder agreements. Upon the permanent disability of a shareholder, some shareholder agreements give the other members or the company the option or obligation to purchase the subject shares for a pre-determined formula or appraised price. Upon the death of a shareholder, most shareholder agreements state a purchase price and purchase terms for the company to purchase all shares owned by the deceased shareholder. Disability and Life insurance are often used to fund the payment of the purchase price upon disability or death.
A carefully drafted shareholder agreement can add value to the company and protect the shareholders. Every closely held corporation needs to concern their shareholder agreement on a regular basis. Circumstances change regularly and a shareholder agreement should be updated regularly. Remember, if you can foresee it, you have a duty to plan for it.
For more Washington business entity law considerations, refer to this blog every Wednesday at 12 PM, noon.