In fundraising negotiations with our small business and emerging growth companies clients we always have one eye on the follow on negotiations that will be necessary for the shareholders agreement. If we are lucky the investor signs the joinder agreement and assents to the terms negotiated in the prior fundraising round. More often than not we meet savvy investors who, in return for their sizeable investment, want to renegotiate key points in the shareholders agreement. These tend to be drawn out affairs that require us to harmonize the terms in the shareholders agreement with those in the certificate of incorporation as well as any other statutory requirements applicable to our client.
Experience has taught us that there are roughly ten items that come up consistently in these negotiations. The following is a checklist of these items. When considering each issue be mindful that they are complex provisions that should always be done with the assistance of a seasoned legal advisor.
Who should be a party to the Shareholders Agreement?
This seems like a simple question but is an often-overlooked preliminary matter. Of course each shareholder should sign the shareholders agreement. But the question that we get most often is whether the company itself should be a party to the shareholders agreement? The answer is yes, especially if the shareholders agreement imposes any obligations on the company.
What is the Company’s Capital Structure?
The company’s capital structure will determine which shares are subject to the shareholders agreement and what rights will be associated with each class of shares. For example, if the company has common stock and preferred stock, the shareholders agreement should clearly outline the rights associated with each class of stock. It should also be made clear in the shareholders agreement if current shareholders will be required to make any additional capital contributions to the company going forward.
How will the Company be governed?
When negotiating the shareholders agreement it should be clear whether the company will have a board of directors, how many directors there will be and whether holders of certain shares will have a right to appoint or remove a member of the board of directors. The appointment and removal procedures should be spelled out clearly in the shareholders agreement. In connection with the appointment of members of the board you should also consider what restrictions there will be placed on the board members.
What matters will require shareholder approval?
The laws of most states require stockholder consents for certain company matters but shareholders agreements are an opportunity to augment those rights. For example, if the board wants the company to take on more debt should shareholder approval be required? If there are matters that require unanimous consent, supermajority voting or if certain classes of shares have special voting rights those issues should be spelled out in the shareholders agreement as well. Some companies may have voting arrangements whereby holders of certain classes of stock vote independently of other shareholders. If such provisions exist they should be included in the shareholders agreement.
Are there any restrictive provisions required?
If a company has certain trade secrets or other confidential information it may want each of its shareholders to agree to keep such information confidential. In addition, you may want to consider including non-compete and non-solicitation requirements in your shareholders agreements in the event some shareholders leave the company. One thing to consider is whether these provisions should apply to all shareholders or just to a certain group of shareholders. Restrictive covenants are advisable for key employees who have a say in the company’s direction but may not make sense for certain minority shareholders.
Are there information and inspection rights to consider?
In negotiating the shareholders agreement you should always consider if the company will be required to provide certain information to shareholders. If the company is required to do so when, how and what kind of information will it make available to its shareholders. Another issue to consider is whether required consents will be given to all shareholders or only to shareholders holding over a certain percentage threshold.
What restrictions and requirements are there for stock transfers?
Companies want to control what shareholders can do with their shares and they accomplish this through transfer restrictions. To that end, when negotiating shareholders agreements we find that it is helpful to have a clear list of which persons or entities qualify as permitted transferees (family trusts, affiliates, other stockholders, etc.). Another question you need to answer is whether shareholders can encumber their shares. If a shareholder wants to buy a car can she pledge your company’s shares as collateral for a loan to finance her car purchase? These are real world issues faced each day and we encourage our clients to have policies in place to deal with them. However, no matter how restrictive you want to be you have to allow some transfers so you will need to think through what consents the company will require when there are stock transfers. Additionally, in the event of a sale by majority shareholders will there be a drag along right whereby the company can force a sale by minority shareholders? Should minority shareholders have a tag along right to participate in any sale by majority shareholders? You should also consider building in right of first refusal and right of first offer provisions requiring shareholders to either first offer their shares in a sale to the company or give the company a right to match any fair market value offer for a shareholder’s shares.
Are stockholders entitled to pre-emptive or registration Rights?
Pre-emptive rights offer certain stockholders the right to purchase a pro rata portion of share ownership in any future share issuance so as not to dilute their ownership. If pre-emptive rights are granted to certain shareholders you should consider if there are any limitations on those rights for an issuance of certain classes of stock and also if some shareholders will be allowed to purchase more than their pro rata share in a future stock issuance. Along with pre-emptive rights you should also consider if shareholders are granted registration rights. Registration rights are sometimes included in a separate registration rights agreement but are sometimes included in shareholders agreements. If registration rights are granted you should consider if there will be piggy back registration rights, if there will be any restrictions on the registration rights and if there is a set survival period for those rights.
Under what circumstances can the shareholders agreement be terminated?
As with most agreements your shareholders agreement will include a termination provision and you should outline which circumstances may lead to a termination. In the event of a termination it is necessary to consider what provisions will survive termination of the shareholders agreement. In most instances requirements for confidentiality often survive the termination of the shareholders agreement.
Are there any other miscellaneous considerations?
While most of the foregoing includes the major issues to consider for many shareholders agreements there are minor issues that should also be considered. For example, what state’s laws should govern the shareholders agreement? If there is a dispute over the shareholders agreement what jurisdiction and venue will be most appropriate for settling the dispute? You may also want to consider arbitration or other alternative dispute mechanisms. You should also consider whether the shareholders agreement offers any rights to third parties and how those rights should be governed. Finally, keep in mind that some provisions of your shareholders agreement will overlap with your certificate of incorporation as well as certain statutory provisions that cannot be altered. It is important that these different documents do not conflict. In all cases best practice is to engage a seasoned legal advisor and double-check your shareholders agreement against your certificate of incorporation and statutory requirements to ensure consistency and statutory compliance across all your documents.
Post by Dennis McCarthy