The prior post contained a quick survey of the issues that surround voting power and control of a business with multiple equity owners. Before you read this post, make sure you have read the prior post.
In this post, we will discuss a very important topic to business owners: under what circumstances can you sell your shares of a closely held business? The short answer, not surprisingly, depends on the terms and conditions in your Shareholder Agreement. (Remember that for the purposes of this series, the term “Shareholder Agreement” also refers to partnership agreements as well as operating agreements, which is the document that governs the management of limited liability companies.)
If you have acquired shares of stock of a privately held company through a Regulation D offering, those securities are likely subject to SEC Rule 144, which is a different discussion altogether. That will be the subject of a future post. For now, let’s focus on the restriction that a company typically can include in their Shareholder Agreements. These generally fall into two categories: 1) voluntary transfers and 2) involuntary transfers.
Voluntary Transfers
Typically, Shareholder Agreements for small, closely held businesses prohibit the free transfer of shares to an unrelated third party without the consent of at least a majority of the other shareholders. One of the last things you want to have happen as a business owner is to suddenly be put into business with someone you didn’t select or approve of. For this reason, often shareholders in small businesses can not just sell their shares to anyone at the drop of a hat. There are often two restrictions involved in this circumstance: 1) a company purchase option and a 2) remaining shareholder purchase option.
For example, Aaron is a 20% owner of ABC Company. His co-owners are Bill (who owns 40%) and Carl (who also owns 40%). Together, they own 100% of the business. Darren comes along, a total stranger to the business and offers to purchase Aaron’s shares for a significant premium. Aaron wants to sell his shares at this high price to Darren.
In the above example, it is likely that the ABC Company Shareholder Agreement requires that Aaron communicate a written summary of the terms of Darren’s purchase offer to the Company. The Company then has a limited period of time, expressly defined in the Shareholder Agreement, to either purchase Aaron’s shares on the same terms or decline to match Darren’s offer. Subsequently, the remaining shareholders (Bill and Carl) have a similar period of time, after the Company Purchase Option has expired, to either match Darren’s offer or decline. Only once both options periods have expired can Aaron sell his shares to Darren.
The simple reason that the Company Option and the Remaining Shareholders Option periods exist is control. Those two mechanisms both can keep Aaron’s shares in the original ownership group, without introducing an outsider into the business. As we will see in a future post, there are many difficulties present in trying to force out a shareholder if the Shareholder Agreement has not been set up properly.
One things to keep in mind, is that the provisions of Shareholder Agreements are completely malleable. You can modify these concept or create totally new restrictions entirely, as long as they are in writing. You are only limited by the initial owners’ imagination.
Involuntary Transfers
Involuntary transfers tend to deal with some negative events in a shareholder’s life that can also negatively affect the Company: death, bankruptcy, or incapacity. It is generally the case that any of these three events automatically trigger an offer to sell that shareholder’s shares back to the Company. The value of the transaction will be explored at the end of this post.
In the event of the death of a shareholder, it is advisable for that to automatically trigger a sale to the Company. This makes matters cleaner for the Company going forward, in that the deceased owner’s heirs do not succeed to that owner’s voting rights. This can be problematic for a number of reasons, especially if those heirs know nothing about the business or the industry the business is in.
In the event of the bankruptcy of a shareholder, it is advisable for that event to automatically trigger a sale of shares back to the Company. Once a person declares bankruptcy, a court appointed officer (the Bankruptcy Trustee) has legal authority to administer that person’s assets. This introduces a potentially disruptive force into the management of the Company, which is the main thing we are trying to avoid by carefully crafting our Shareholder Agreement.
Finally, in the event of a shareholder’s incapacity, this should trigger an automatic sale of assets back to the Company for reasons similarly to the two above examples. One thing that you must take care with is how “incapacity” is defined. As you can see from the example below, even the most careful drafting can result in ambiguity.
A sample definition could be as follows:
“Incapacity” shall mean that: (a) the Shareholder has a mental or physical incapacity sufficiently acute that the Company may reasonably anticipate that such Shareholder will be unable to resume the normal performance of the full-time duties of said Shareholder’s employment with the Company within ninety (90) calendar days succeeding the commencement of the Shareholder’s incapacity; or (b) the Shareholder is actually unable to perform the duties of said Shareholder’s employment with the Company for a period of ninety (90) calendar days (whether or not consecutive) in any three hundred sixty (360) day period; or (c) a licensed medical professional has rendered an opinion to the Company that said Shareholder is physically or mentally unable to work or communicate for a period of ninety (90) calendar days (whether or not consecutive) in any three hundred sixty (360) day period.
Involuntary Transfers, II: Morality Issues
A very hot topic in employment contracts these days are morality clauses. What is a morality clause? You can go back to one of the most popular posts ever written on the blog to read more about morality clauses in employment agreements. If a triggering event has occurred which would cause the company to fire an executive who is under contract, the question then becomes whether that triggering event also divests that outgoing executive of their shares of the company.
For example: Do you want an executive who has been indicted and found guilty of fraud (and thus terminated under the morality clause in the executive’s employment contract) to remain as a shareholder of the business? Probably not. The thing to keep in mind here is that this in an issue you have to talk about when drafting your shareholder agreements so that they work hand in hand with any employment contracts.
Valuation of the Shares
In the case of voluntary transfers, the purchase price for shares is set by the third party offeror. In the case of an involuntary transfer, however, that can be a thornier issue, because involuntary situations are not typical arms-length transactions where price is negotiated.
One effective technique to use is to periodically set the price of the company’s shares is by using a stipulated fair market value. This is exactly what is sounds to be. The Shareholder Agreement can require that the shareholders meet once a year and determine - or stipulate - the value of the shares of the company. Then that stipulated fair market value becomes the price for any involuntary transfers that may occur in the following year.
Often, the company will employ the company’s outside accounting firm to provide a valuation, which all the shareholders vote to approve or adjust at the annual meeting. One reason that the stipulated fair market value provision is desirable is that it removes uncertainty. If a shareholder passes away, then the estate is paid X for the deceased shareholder’s shares. It makes an unpleasant situation a bit easier. Removing doubt is one of the hallmarks of good legal drafting.
In the next installment, we will explore restrictive covenants.