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The Wisdom of Forging a Shareholders' Agreement

By Scott Au
May 30, 2012 5:00 AM PT

Tech companies, particularly those just starting to take off, need to consider a myriad of business and legal issues in their vision for the future. Especially in light of the dot-com bubble burst, startup tech companies need to pay particular concern to how shareholders can best protect their interests -- and the interests of the company -- if and when a dispute between shareholders arises.

The Wisdom of Forging a Shareholders' Agreement

This author has received many inquiries from tech companies about business and legal strategies, and a recurring question is "What is the best way to avoid preventable disputes and reduce the risk of litigation?" Though a complete answer will depend on the unique qualities of your business, with a strong legal foundation and a well-drafted shareholders' agreement, tech companies can breathe easier and concentrate their time and money on growing their business and not on preventable litigation.

Employee Stock Options

Many IT companies nowadays are offering profit-sharing arrangements such as employee stock options as part of their overall compensation package in a bid to attract and retain key personnel. IT professionals generally are attracted by the ability to share in the company's profits and growth.

For a startup company, providing stock options avoids the need for an outlay of cash and can provide an incentive program the company can utilize to increase productivity and retain key employees.

While providing stock options is a great tool to obtain and retain top talent, having a well-drafted shareholders' agreement can prevent or limit future disputes. It can also serve to promote a harmonious relationship between the parties and ensure all those involved properly understand their role in the company, their responsibilities, and their entitlements -- thus elevating the quality of the work place.

The Benefits of a Shareholders' Agreement

A shareholders' agreement is a legal contract that binds the shareholders. Following are a few examples of the benefits of a shareholders' agreement:

  • Unlike a company's articles of incorporation, which is a public document, there is no requirement to publicly file a shareholders' agreement. The shareholders' agreement cannot be publicly accessed, and the terms of the agreement therefore will be kept confidential as between the signatories to the agreement.
  • A shareholders' agreement can provide for succession planning in situations such as the death or disability of one of the shareholders.
  • Compared to the cost of shareholder litigation, the minimal legal fees for a shareholders' agreement mean the agreement is worth its weight in gold if it can prevent or restrict expensive litigation in the future.
  • A shareholders' agreement can provide protection to minority shareholders by setting out clearly the parties' responsibilities, rights and duties.
  • A shareholders' agreement provides for a smooth transition process for a leaving shareholder.
  • When the benefits and entitlements of a shareholder are specifically laid out, key employees are more motivated to work for the company with an understanding as to the parties' expectation for remuneration and profit sharing.
  • The shareholders' agreement can bring clarity and smooth transition in otherwise complex business reorganization situations such as a merger or takeover.
  • The shareholders' agreement can help prevent hostile takeovers and unwanted competitors from acquiring the company's shares.

The 'Shotgun' Clause

Having buy-sell, or "shotgun," clauses in your shareholder agreement can dramatically lessen and even prevent the possibility of future litigation. A shotgun clause allows any shareholder to offer shares for sale to one or more shareholders at a stated price.

If the offeree believes the valuation is too high, that shareholder then has the right to purchase the offeror's shares at that the same price. This process ensures that the shareholder starting the process will choose a fair value, and it makes for an easy way to arrive at a fair value of your company's shares without the need for a formal valuation.

In the end, it provides a quick, cost-efficient way to deal with an appropriate exit strategy for a dissatisfied shareholder, or a takeover strategy for the ambitious shareholder.

In the case where there are significant disparities in the various shareholders' financial capacities, the shotgun clause can be custom-tailored to include a time-specific delay to allow the parties a chance to be on equal footing. Once all the shareholders are on a level playing field, the purchase and sale of shares under a shotgun clause can be made more fairly.

Other Important Clauses

A well-drafted shareholders' agreement allows the company to avoid disputes over matters such as the nature of the shareholders' responsibilities and job performance expectations. A noncompetition clause in the shareholders agreement can prevent a leaving shareholder from competing against the company within a certain geographic area and time frame.

If the company provides executive salaries and stock options to key employees, a valuable clause to include would be that an employed shareholder waive all rights to severance pay in the case of a termination. This can avoid the concern of a small startup company having to pay out large severance packages, or the costs of having to litigate the issue in the case of a defunct employee suing the company for possible executive severance pay.

A Shareholders' Agreement Will Lead to Savings

Having the shareholders' intentions properly recorded in the shareholders' agreement can avoid future disputes and expensive and preventable litigation costs. Typical legal fees for shareholders' agreements range from US$2,000 to $5,000. If the shareholders' agreement should prevent litigation, the company would essentially save anywhere from $40,000 to $100,000 or more in legal fees, depending on the complexity of the case and the parties' intention to appeal the matter.

The moral of the story is that whether you are looking to increase productivity and loyalty in your employees, protect your legal liabilities as a shareholder, or control the future direction of the company, a well-drafted shareholders' agreement is well worth its weight in gold, and the return on investment is substantial if it can prevent even a single dispute among shareholders.

Scott Au is a business lawyer at Heydary Hamilton. His practice is focused on corporate and commercial transactions, trademarks and franchising law.

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