Part of the “Launch It Legally: An Attorney’s Guide to Starting Your Business” series
For our fourth installment of “Launch it Legally,” we dive deep into the world of shareholder agreements. Similar to how an operating agreement functions for an LLC, a well-drafted shareholder agreement outlines the rights and obligations of shareholders in a corporation.
What Is a Shareholder Agreement?
True to its name, a shareholder agreement is a legal document entered into among the shareholders of a corporation. Unlike an LLC’s operating agreement, which is entered into between both managers and members, only shareholders (i.e., the owners) sign a shareholder agreement.
The terms in a shareholder agreement are generally more limited than what is included in an operating agreement. This is because corporations have a separate governing document, called bylaws, which outline how the corporation is managed by the board of directors and the officers (read our previous blog post on “key players” for more detail on shareholders, boards of directors, and officers).
Importantly, a shareholder agreement outlines buy/sell provisions in the event a shareholder leaves the company or wants to transfer their shares. The agreement will also discuss matters that require a shareholder’s vote or agreement (which are rare, as a corporation is mostly governed by the board)
A shareholder agreement is most helpful in smaller companies with only a limited number of shareholders.
Does My Business Need a Shareholder Agreement?
It all depends on the state law where your entity is based. In Illinois, no law requires companies to have a shareholder agreement. Other states, however, may require one.
Even in states that do not require these agreements, shareholders are strongly advised to prepare a shareholder agreement upon incorporation. This is the only document outlining key details, such as how much capital each shareholder invested into the company.
Disputes can quickly arise among shareholders, and having a clear agreement to account for these disputes is essential. For example, a shareholder agreement outlines the process to follow if a shareholder wants to exit the company or if shareholders want to expel one of their fellow shareholders.
What Are the Most Important Terms to Include in a Shareholder Agreement?
There is no set structure or form for a shareholder agreement. However, a well-drafted agreement will include the following terms:
- Number of shares issued: The shareholder agreement will clearly state who the shareholders are and, if the company has multiple classes of shares, the number and type of shares they own.
- Rights and duties of shareholders: While the company’s bylaws will outline the roles of the board and the officers, the bylaws do not discuss what decisions shareholders can make for the company. The shareholder agreement should outline what, if any, decisions are reserved for shareholders. Generally, shareholders do not guide or direct an organization operationally, as decision-making is reserved for the board. However, certain large decisions may be reserved for shareholders, especially in smaller companies.
- Buy/sell terms: Perhaps the most important part, and the bulk, of a shareholder agreement is comprised of the buy/sell terms. These determine how a shareholder can exit the company, whether by force-out, death, disability, or voluntary exit. They will also clarify whether a shareholder can transfer shares (usually they cannot transfer without permission or allowing the other shareholders the right of first refusal to purchase the shares).
Buy/sell sections are quite detailed: they outline notice procedures for an exiting shareholder, whether the company or remaining shareholders have a right of first refusal to purchase the exiting shareholder’s interest, and the purchase price and payment terms for the exiting shareholder’s shares. Buy/sell terms in LLC operating agreements are very similar to buy/sell terms in shareholder agreements. Continuing to run an organization without this crucial language can lead to lengthy disputes in the future.
- Restrictive covenants and confidentiality: Most shareholder agreements include standard confidentiality language, and many also include restrictive covenants, such as a non-compete. A non-compete restricts a shareholder from working at or owning a competing company while that shareholder owns shares of the company and for a certain length of time after they no longer own shares.
Shareholder agreements delineate certain basic but crucial aspects of a business’s big-picture operation, while the bylaws provide more detail for the most common operational issues. Even if a shareholder agreement is not required by your state, drafting one that is clear and comprehensive is always a good idea. It can help set your corporation up for success long into the future, and avoid needless legal disputes down the road.