Stock is a unique feature of corporations. Shares of stock allow members of the public (or select investors) to have partial ownership of a corporation.
Since shareholders are the investors in a corporation, it’s important that the corporation makes provisions to protect the individual shareholders.
A shareholders’ agreement accomplishes that goal. Let’s discuss what exactly a shareholders’ agreement is, and why you need one for your corporation.
What Is a Shareholders’ Agreement?
A shareholders’ agreement (also occasionally called a stockholders’ agreement) is a document written by the shareholders, for the shareholders. It is an agreement between the shareholders themselves and the corporation — it defines the rights and privileges of the shareholders.
Usually, this agreement is written by the corporation’s first shareholders. Since this group is often small at first, the agreement may need to be amended as the corporation grows.
Do I Need a Shareholders’ Agreement?
Most corporations need a shareholders’ agreement. These agreements are vital in any corporation where the interests of multiple shareholders need to be protected.
For example, let’s imagine that there are two business partners who incorporate together, and they own the corporation’s stock equally. A shareholders’ agreement would help these business partners create a fair operational environment for both parties.
Corporations which plan to sell shares to the general public should also keep a shareholders’ agreement. That said, there may be a few corporations which can function without a written agreement, including corporations where there is only one shareholder (not very common, but they do exist).
Sometimes, a corporation can avoid writing an agreement when one person owns such a dominant majority of the stock that they effectively control the corporation, because that person’s majority makes voting nearly pointless.
Even in these cases, writing a shareholders’ agreement is usually a good idea. Despite advanced business analytics, it’s impossible to predict how a business will grow and change. A shareholders’ agreement can make provisions for unexpected changes in ownership, making any potential transition as seamless as possible.
What Should My Shareholders’ Agreement Include?
Many components of the rights and privileges of stock ownership are already set out by the corporation’s bylaws.
For example, the bylaws will prescribe the corporation’s privileges to issue stock, including how much stock can be issued and what types. The shareholders’ agreement basically dictates the rights and privileges of the shareholders once they own stock in the company.
In this section, we’ll cover the most important aspects of a shareholders’ agreement.
Voting rights and procedures
In a typical corporation, shareholders who buy common shares have the right to vote in the corporation’s annual shareholders’ meeting. Usually, these shareholders elect the directors of the corporation, and as a result, they have some impact on how the corporation is run.
The shareholders’ agreement allows the corporation and its shareholders to decide exactly how the shareholders will elect the directors. These guidelines include provisions for how many members must vote to have a quorum. You’ll also need to prescribe what percentages are required for an initiative or resolution to pass, as well as what happens when a resolution does not have the required votes.
These provisions will allow your annual shareholders’ meetings to run smoothly and efficiently.
Shareholders’ rights to dividends
The primary reason shareholders invest in a corporation’s stock is because there are payoffs in the form of dividends, which are essentially a cut of the corporation’s profits. Each corporation sets a different standard for how and when these dividends are passed to its shareholders.
For one thing, share value stems from the percentage of ownership that accompanies each share, and the percentage of dividends belonging to each shareholder functions similarly. How much each shareholder receives depends on two factors: how much stock they own and what cut of the profits belongs to the shareholders to begin with. The corporation as a business entity gets a cut of its own profits, and so do its shareholders.
The agreement will clearly define how the profits are divided. In addition, the agreement should prescribe how and when the corporation will pass off those profits, and it can also include what happens when the corporation fails to pay the shareholders.
Shareholders’ control over the board of directors
As we discussed earlier, the shareholders of a corporation have voting rights, and one of the primary things the shareholders vote for is the board of directors. As a result, the shareholders’ agreement needs to explain exactly how and to what extent the shareholders can control the board.
These provisions are especially important. They set rules for how many shareholders must vote for new directors in order to elect them, and they also establish the criteria and process for dismissing directors if the shareholders no longer want them on the board.
Transfer and creation of new shares of stock
While setting up stock for the first time, it’s easy to overlook the fact that, someday, the ownership of those stocks will change. People give their shares to family members as inheritances, or they lose interest in the company and want to invest their money elsewhere.
However, when a stock is sold or transferred to another person, this technically changes the ownership of the corporation, and depending on the number of shares transferred, selling stock can profoundly affect the corporation’s ownership.
The same goes for when a corporation wants to issue new shares. If the corporation issues a large number of shares on top of its initial public offering, it dilutes the value of its stock already in play.
The agreement should make several provisions to protect the investments of the current shareholders, including policies such as rights of first refusal. With these rights, if one shareholder wants to sell his or her stocks, the other shareholders have the first chance to buy them (and thus minimize the change in company ownership) before the general public.
Similarly, if the corporation wants to issue more stock, the shareholders’ agreement may require the corporation to offer a percentage of those stocks to its current members first for a fixed price, allowing them the opportunity to maintain their current stake in the corporation.
The exact agreement you establish will depend on your members. Remember, what works for one group of shareholders might not be right for the next. The important thing is that you establish an agreement that is mutually beneficial and protects the rights of everyone involved.
How Do I Set Up a Shareholders’ Agreement?
Writing up your shareholders’ agreement is a very important part of establishing your business. As you can see, there are dozens of details to consider, and you should get input from all of your shareholders.
If you have a small number of shareholders — which is pretty likely if you’re just starting out — you should meet with the shareholders and discuss the components of the agreement in person. With their feedback, you can create an agreement that benefits everyone.
If you have a large number of shareholders, however, a meeting with feedback from all of them could be chaotic and impractical. Here’s what you can do instead: write up a proposed draft ahead of the meeting, which can even be just an outline that covers the major decisions. You can use the draft to facilitate discussion with your shareholders. Then, based on that discussion, you can finalize the agreement.
If you’re just not sure where to start, you can browse sample agreements online. Skimming through these agreements will help you see the language, format, and components of a good shareholders’ agreement.
You may also want to enlist legal help to write an agreement that is both fair and thorough. A corporate lawyer can also help you eliminate any unintentional loopholes or oversights in your agreement, although this can obviously be rather expensive, especially for a young startup without much capital.
Most corporations need to set up a shareholders’ agreement. Doing so will help your corporation run smoothly and protect the interests of all involved. It is not a simple document to create, but thanks to this guide, you’re equipped to create an agreement that works for all parties.