Shareholder Agreements Can Avoid Litigation and Promote Harmonious Relations in Close Corporations
 
June 17, 2004
 

Close corporations are the most common vehicle for doing business in the United States and their owners represent the most financially successful group in our society. These corporations are often formed by several individuals to pursue an idea or opportunity. Through hard work and good fortune the businesses often grow far beyond the original expectations of their founders. In time, the close corporation may possess great assets and be a source of significant compensation to the founding shareholders and the individuals who succeed them.

Many close corporations operate without any problems during their existence. Others, however, suffer from disputes among shareholders on matters relating to direction, compensation, work ethic and management. These disputes often lead to litigation between shareholders, which can cause great financial damage to the corporation and impair its future advancement.

By anticipating possible areas of dissention and providing a means of resolving disputes, written agreements can help to avoid the costs of litigation and damage to the company. Agreements generally control over principles of fiduciary duty or other obligations that might exist among shareholders. Where the parties have considered an issue and determined among themselves how it should be handled, courts generally uphold the parties’ intentions provided that they are clearly and unambiguously stated.

Agreements may specify the method used to approve compensation and whether a shareholder employed by the corporation can be terminated without cause. Provisions concerning the sale of employee-owned stock upon the employee’s termination or retirement can avoid disagreements and make for smoother transitions. Issues relating to the discharge of directors, who also have an ownership interest in the company, should also be considered.

These provisions may assist in resolving issues that no shareholder envisions when the corporation is created or when new shareholders are permitted to join the company. The ability to terminate a shareholder who also works as an employee could be very important. Disruption caused by this individual, lack of a valid work ethic or disagreement as to the direction of the company can create conflict that significantly impedes day-to-day operations. To alleviate that conflict, the company may need to terminate the shareholder from his employment. Such termination could be considered wrongful, but provisions in agreements permitting termination without cause are enforceable and can thus alleviate such disputes.

More important is what happens to the shareholder employee if he is terminated. The agreement could incorporate a provision that requires the sale of the individual’s stock. The appropriate means of determining the sales price of the stock deserves important consideration. The stock’s book value would provide the individual with a low value for his shares. Individuals who create a corporation would seek to avoid that result and are likely to require that they receive the fair market value of their shares.

With respect to shareholders who are permitted to join the company thereafter, payment of book value or some alternate method of determining value may be appropriate. These individuals have not made the same investment of time or money in the company’s success and do not, therefore, deserve as significant a payment. Moreover, the stock may have been provided as a fringe benefit to a person sought by the company only for the talent he would bring as an employee.

Agreements can also provide that corporations may discharge shareholders or a director if he loses his employment. This provision may be necessary to remove disruptive individuals and insure that the company continues to move forward smoothly and profitably. The agreements could also determine when an individual can sell his stock back to the company and at what price.

The benefits of written agreements are often greater in family-run businesses. In many cases, the company is formed and run by a number of individuals who share common goals and ideals. They often invest their lives in these businesses and it is only natural that they would like their children to join the business and eventually act as their successors. Admitting such children as shareholders, however, can be a source of tremendous friction. The children of one business owner may not share the same goals and aspirations of the other children who join the company. Provisions concerning the removal of these children from the management of the business may be needed. Such provisions, however, need not be designed to strip a child of his or her financial interest. The child may be permitted to keep his or her stock and earn dividends as a “silent” investor. The child may also be permitted to sell his or her stock to the company at fair market value or an otherwise acceptable price.

Shareholder agreements and the protections that they afford can avoid business disruptions and potentially disastrous litigation expenses. To be effective, however, their provisions should be demonstrably fair both to founding and subsequent members. A well-considered and properly drafted shareholder agreement will help to create a harmonious atmosphere in which employees and shareholders pull together to promote their common interests in making a more stable and profitable company.

For more information, contact Christopher Trombetta by e-mail at christopher.trombetta@hklaw.com, or toll free at 1-888-688-8500.