Breaking Up is Hard to Do: Why You Need a Shareholders Agreement

It is hard not to pick up a newspaper or a magazine without reading all about all the gory details of the latest divorce involving the rich or famous, and the contents of a prenuptial agreement. While it would seem that the only connection between these celebrity divorces and small business partners, is the latest edition of People Magazine sitting in their waiting room. Most small business partners owners would be wise to learn a lesson from their more rich and famous celebrity counterparts, and prepare the corporate equivalent of a prenuptial agreement – a Shareholders Agreement. Regardless of whether it is a corporation or a partnership, the same considerations apply.

The formation of a business, like a marriage is intended at the outset to be a long term relationship, where the partners agree to subsume their personal goals, link their futures, and remain faithful to each other, till death (or dissolution) do them part for the benefit of the business. There has to be an understanding that the common goal of the partners to make the business successful will require sacrifices for the collective rather than personal good. In other words, at this point of the relationship there is a clear delineation of the duties and responsibilities of each partner, as well as a single vision regarding the future of the company.

We all know that the one constant in business is change. Regardless of how well developed a business plan is, changes both externally (which includes relations with clients and competitors) and internally (relations among the partners and staff) are inevitable. The success of any business is based upon how well the business, and the partners, adapt to these changes. Not surprisingly, the roles, responsibilities, and expectations of the partners will also change. The ability to adapt to these changes tests the strength and commitment of the partners to each other.

As is the case in most marriages, money (capital), or more probably the lack of capital tends to bring out the worst in spouses and partners. In such a setting, personal and family relationships between the partners may become liabilities rather than assets. Statistics confirm that dealing with these changes, on a collective and personal basis is the primary cause of both small business and matrimonial failures within the first five years. A typical Shareholder Agreement will normally outline the duties, responsibilities, expectations, and benefits of each partner, and provide a formula to undo the relationship should the parties agree to divorce.

A typical Shareholder Agreement will set forth restrictions on the transfer of shares, to a third party. Normally it will exempt transfers, back to the corporation, existing shareholders, or members of the shareholders immediate family. This ensures ownership of the business will remain within the circle of the founding partners, and requires an exiting partner to sell his or her interest back to the remaining partner as opposed to "someone new". A procedure will also be established for a transfer of ownership should one of the partners die, which is an important estate planning concern. An important aspect of this is the use of insurance policies to supply the proceeds for a buy out, as opposed to forcing the remaining partner and the business to fund the purchase.

While a Shareholder agreement normally will not specify which shareholder has the right to buy out the other, by establishing a formula that controls the purchase, it indirectly establishes which partner will have the ability to be the purchaser as opposed to the seller. In many cases this same effect is accomplished by a clause that requires a sale of a partners interest upon terminating employment.

The failure to have such an agreement normally leads to very contentious litigation, which from experience is every bit as hostile as he worst divorce action. More importantly, litigation between partners may itself cripple and ultimately destroy the business. Lastly the cost of having your attorney prepare a shareholder agreement will be an insignificant cost if it prevents or limits a dispute.