12 Things That Should Be In a Stockholders Agreement

investors

12 Things That Should Be In a Stockholders Agreement

    1. Management of the Company
      You are 50/50 shareholders of the corporation, but will the management responsibilities also be 50/50, or will one of you be doing all of the work? If the former, I would include a provision that the management of the corporation’s business will be conducted equally, so that if one of you “slacks off,” the other one can buy him out or reduce his ownership of the company. If the latter, I would want you to consider an Employment Agreement between the corporation and the “working” shareholder, so that he can be compensated for his labor out of the business’ income before the “passive” shareholders receives any dividends or other distributions.
    2.  

    3. Capital Contributions
      Will your contributions to the capital of the corporation be 50/50, or will one of you be putting in most of the money? If the latter, I might recommend that the “excess investment” (the amount by which the rich shareholder’s contribution exceeds the poor shareholder’s contribution) be treated as a loan to the corporation, to be paid back by the corporation when there’s available cash to do so.
    4.  

    5. “Tie-Breaking” Voting Provisions
      If you are 50/50 shareholders, how will you handle disagreements? If one of you will be doing the bulk of the work and will be responsible for the day-to-day operation of the business, I would ask you to consider a provision giving the working shareholder an extra vote if a disagreement occurs (solely for the purpose of breaking the tie on that one issue, not as a general matter).
    6.  

    7. “Gross Up” Provisions
      Since in a subchapter S corporation all income, losses and other tax benefits flow through to your personal tax returns, how will you handle “phantom income”? Any money you decide to keep in the corporation’s checking account at year-end will be considered “phantom income” — you will have to pay taxes on it even though the corporation didn’t pay it out to you. If that’s a problem for either of you, consider a clause in the shareholders’ agreement allowing the corporation to reimburse you (or “gross you up”) for the tax liability you incurred on any “phantom income.”
    8.  

    9. “Gross Up” Provisions
      Since in a subchapter S corporation all income, losses and other tax benefits flow through to your personal tax returns, how will you handle “phantom income”? Any money you decide to keep in the corporation’s checking account at year-end will be considered “phantom income” — you will have to pay taxes on it even though the corporation didn’t pay it out to you. If that’s a problem for either of you, consider a clause in the shareholders’ agreement allowing the corporation to reimburse you (or “gross you up”) for the tax liability you incurred on any “phantom income.”
    10.  

    11. A Mediation Clause
      How will you handle disputes that go beyond the “informal discussion” stage? Arbitration clauses are nice but, in my experience, too cumbersome in practice. Consider a simple mediation clause appointing an individual you trust — such as the corporation’s accountant or lawyer — to mediate any dispute between you. He or she will not decide the dispute for you, but will attempt to broker an agreement between you (or, in plain English, “bang your bloody heads together until you see clearly”) so the corporation can move forward.
    12.  

    13. An Agreement to Preserve Your Subchapter “S” Status
      How will you prevent the corporation from accidentally losing its favorable subchapter “S” tax status? There are a number of situations where this could happen. For example, if a shareholder dies without a will and some of his shares end up in the hands of relatives who are not U.S. citizens or “green card” holders, the corporation would lose its subchapter “S” status. There are two provisions you need here. One is a provision by which all shareholders agree not to take any action involving the issuance or transfer of the corporation’s shares without getting the approval of the corporation’s tax attorney or accountant. The other is a “buyout” clause requiring the two of you (or the survivor) to repurchase immediately the shares of any person who receives shares in the corporation if that person is not qualified to hold shares in a subchapter S corporation.
    14.  

    15. A “Golden Rule” Buyout Clause
      If the two of you are locking horns more than occasionally, it’s probably a sign that the two of you were never meant to work together in the first place. A “golden rule” buyout clause allows you (assuming you’re the one who wants to continue in the business) to make an offer to purchase the other’s shares in the corporation for a price you consider fair. Your partner would then have a period of time (usually 30 days) to both accept your offer and agree to be bought out for the price you offered, or turn around and buy out your 50 percent stake in the corporation for the same price you offered him. Hence the name “golden rule” — your offer would be for a price you yourself would be willing to accept.
    16.  

    17. A Buyout Provision In Case One of You Dies
      When a shareholder dies, his shares in the corporation don’t just disappear. They are an asset of his estate and will pass to his heirs by will. If he dies intestate, then the intestate laws of your state will determine who gets his shares. Either way, you end up with the deceased’s relatives as your business partners, and you don’t want that. Make sure your shareholder’s agreement includes a clause allowing you to buy out your partner’s estate when he dies (and vice versa).

      A common mistake: requiring the estate to sell ALL of your deceased partner’s shares to you. Your partner will be upset that his estate won’t be able to participate in the growth of the business after he dies, so consider a provision that would allow you to buy most, but not all, of his shares upon death (75 percent is customary), and convert the remaining shares into “nonvoting” shares so his heirs won’t have the right to tell you how to manage the business.

    18.  

    19. A Buyout Provision In Case One of You Becomes Disabled
      Most people know they need a buyout provision in case a partner dies. It is much more likely, though, that a partner will become disabled at some point. Your shareholder’s agreement should allow you to buy out your disabled partner if that happens. Be sure to define “disability” as follows: If your partner has a policy of disability insurance, the policy definition of “disability” will govern; if he doesn’t, then disability should be determined by a physician licensed to practice medicine in your state.
    20.  

    21. A Buyout Provision for “Involuntary Transfers”
      There are circumstances in which a partner’s shares may be taken away from him without his consent — for example, if he files for bankruptcy. Make sure your shareholder’s agreement allows you to repurchase any shares that were involuntarily transferred from your partner (not ALL of your partner’s shares — that’s a common drafting mistake).
    22.  

    23. A Buyout Provision in Case One of You gets Divorced
      Once upon a time, if a partner divorced his spouse, his shares were not considered part of the marital estate because they were titled in his name. No longer. These days, judges have broad latitude to divide assets acquired during the marriage by either spouse pretty much any way they like to achieve a “fair and equitable” division of assets between the spouses. There’s a good chance your partner’s “ex” may end up owning a considerable number of shares.

      Most people include “dissolution of a marriage” as part of the “involuntary transfer” buyout clause of the shareholder’s agreement, but I think this deserves a special provision all its own. Make sure your partner’s spouse (and your spouse) signs a “Spousal Consent” form agreeing that any shares he or she may receive in a divorce proceeding will be sold under the buyout clause.

    24.  

    25. A “Withdrawing Partner” Buyout Clause
      Lastly, don’t forget to include a clause allowing you to buy your partner’s shares in the corporation if he or she no longer wants to work in the business or is otherwise “not pulling his weight.” The language here gets a bit tricky, but at the very least you should cover the following scenarios:

      A.) a partner announces his intent to retire or withdraw from the business to pursue another job opportunity;
      B.) a partner has an employment agreement with the corporation and the agreement terminates “with or without cause”; and
      C.) a partner fails to report to work for a period of X consecutive days.

No Comments

Post a Comment