Often, by the time a dispute between shareholders reaches me, there has been a breakdown in the expectations that result in litigation to sever the business marriage. Some of these disputes may be inevitable. But most could have been avoided, or at least tempered, by ensuring that the governing documents define what the shareholders expect from each other. So what are the most common causes of fights from what was, or more likely was not, included in a shareholder agreement or bylaws?
Fiduciary Duties:
When setting up your corporation, it is vital to clearly define who is doing what. Is this going to be a full-time gig, or is this a side hustle? Is there a recognition that one shareholder has other ownership interests and business ventures, or is there an expectation that all future business opportunities will be consummated through the corporation? These are discussions that, if not had when the corporation is formed, often lead to allegations of breaches of fiduciary duty later on.
Rarely do shareholders come to the corporate table with the same financial means, same business acumen, and same goals. Some may have the financial backing to get the corporation off the ground. Some may have relationships the corporation will rely on to garner customers. And yet others may have the skill to get the required equipment running. And often, the shareholders are of different ages and with different visions of what their individual future holds.
This is why it is critical to define in the shareholder’s agreement whether shareholders have an exclusive duty to the corporation or may dedicate their efforts to other entities. The shareholder’s agreement should also define whether there is an expectation that any business opportunity that a shareholder learns of should be presented to the corporation before the shareholder consummates the same for themselves. Generally, business opportunities that the corporation has the knowledge, skill, and resources to pursue should be presented to the corporation before a shareholder leverages the same for their personal gain. That said, at times, it makes sense to spell out in the governing documents that no shareholder has an expectation to participate in business opportunities that their co-shareholder learns of just by reason of being joint shareholders.
The point here is to understand the different backgrounds the shareholders bring to the corporate relationship and define the expectations moving forward so that everyone is on the same page about the future.
Capital Contributions:
When money gets tight, or assets need to be bought, corporations may need capital infused. One path is a contribution from shareholders. The shareholder’s agreement should define what vote is needed for the capital call to be approved and what happens if a shareholder does not pay their fair share.
The shareholder’s agreement or bylaws should define what vote is necessary for the capital call to be approved. Is a capital call a decision for the directors or the shareholders? Directors generally have a better sense of when capital is needed, but shareholders are the ones putting in the money. Some corporations are better suited to have directors make this decision because there are passive investors involved. But when the corporation has actively engaged shareholders, it may be a decision vested to the shareholder.
Once that decision is made, the governing documents should also define whether a shareholder who fails to put in their proportionate share is diluted or not. If there is a dilution of interest provision included, a shareholder who refuses or cannot put in their share will be proportionately diluted. The other option is to treat the funds from the shareholders who put in their shares as a loan or alternatively to increase their capital accounts. This should be addressed because the governing documents are so that those who contribute when called on are not taken advantage of by those who do not.
Day-to-Day Management:
Some corporations have actively involved shareholders. Others have a key director that may be extremely knowledgeable in the industry when disputes arise when there is a divergent opinion on who had the authority to make decisions for the corporation.
Often, shareholders’ agreements or bylaws rest control of the day-to-day operations with a board of directors. The board can delegate those duties to an officer (i.e., the president). The reason being is that it can be difficult to make swift decisions if several or multiple shareholders have to be consulted. But if how these decisions are being made is not spelled out, conflicts arise.
The best practice would be to include in the shareholder’s agreement or bylaws what decisions are left to the board and what decisions require a vote of the shareholders (and at what percentage). If it is a big-ticket decision such as selling all or substantially all the assets of the corporation, that may be one delegated to the shareholders – the people who have a financial stake in the corporation. Again, the important point here is to include how such decisions will be made.
Selling Your Shares:
Most closely held corporations include transfer restrictions within either the shareholder’s agreement or bylaws. And this is for obvious reasons. You do not want a shareholder selling stock to any third person. But this can create conflict if you have a shareholder who wants to or needs to sell their stock but has no defined buy-out process or purchase price.
The well-drafted shareholder agreement or bylaws should contain provisions to protect the stock being transferred without first giving the corporation and other shareholders the right to purchase the stock. This effectuates keeping the corporation closely held but also permits the departing shareholder a path forward without resorting to litigation.
And the purchase price when it comes time to sell is also vital. Whether it be a book value calculation, an EBITDA calculation, retaining valuation experts, or some pre-defined amount, having a clear path forward on what the purchase price will alleviate consternation. There is not a one-size-fits-all approach here. For a corporation with a lot of goodwill, an EBITDA calculation or retaining valuation experts likely is more appropriate to capture that goodwill. If it is a service entity, perhaps a book value calculation is more appropriate because the ongoing viability may be tied to one or two key people. If they leave, the goodwill goes with them.
The buy-out provision is important to take the time to get right when forming the corporation because when one shareholder feels trapped as unable to sell, and others feel handcuffed with no clearly defined purchase price, litigation may be the only way to divorce them from each other. Defining the buy-out process when everyone is on the same page when the corporation forms can help save the shareholders from themselves and legal fees when the need comes to sell.
