Stockholder Agreements for Stockholders of Closely Held Corporations

When two or more individuals and/or entities organize a corporation and receive corporate stock in consideration for their capital contributions to the corporation, they should consider entering into an agreement (hereinafter a "Stockholder Agreement") which (i) limits the transferability of the stock, (ii) creates a "market" for the stock upon the occurrence of various "triggering events," and (iii) addresses other miscellaneous issues relating to corporate governance and finance. Similarly, any time circumstances result in a corporation having more than one stockholder (whether by virtue of the corporation issuing stock, gifts of stock, sale of stock or otherwise) the stockholders should consider the benefits of agreeing to the terms of a Stockholder Agreement. This article summarizes some of the issues which stockholders of closely held corporations should consider in developing a Stockholder Agreement.

Because of the interplay of legal, accounting/financial and insurance issues, stockholders will normally need to assemble a

team consisting of a corporate attorney, an accountant and often an insurance expert to properly structure a Stockholder Agreement. Once the corporation's attorney prepares a draft Stockholder Agreement, an individual stockholder may decide to have his or her own legal or financial advisor review the draft to assure that it is consistent with his or her own legal, financial and estate planning needs. A brief outline of the provisions most often found in a Stockholder Agreement follows.

1. Transfer Restrictions. Transfer restrictions will describe the circumstances under which stock transfers may be permitted without triggering the operative provisions of the Stockholder Agreement. For example, transfers to other existing stockholders might be permissible, while transfers to unrelated third parties would be precluded unless the stockholder follows a buy-out procedure specified by the Stockholder Agreement.
2. Buy-Out Rights. The corporation and the "remaining stockholders" are often given rights of first refusal to purchase the stock of a stockholder upon the occurrence of a "triggering event" such as a proposed transfer to a third party; death of a stockholder; disability of a stockholder; termination of employment of a stockholder; stockholder deadlock; stockholder divorce implicating the subject stockholder's ownership of the corporation's stock; dissolution or change in control of a corporate stockholder; and involuntary transfers by operation of law (such as the bankruptcy of a stockholder, in which a trustee in bankruptcy could sell the stock to a third party). These provisions will define key terms such as "disability" and "deadlock" to fit the desires of the corporation's stockholders. These provisions will also contain stock valuation mechanisms to arrive at an appropriate buy-out price following a "triggering event."

   Finally, the Stockholder Agreement will specify the terms and conditions upon which any purchase by the corporation or the stockholders following a triggering event must be made. For example, in the event of the death of a stockholder, the Stockholder Agreement will often create otherwise nonexisting liquidity for the decedent's stock by (i) requiring the corporation to purchase the stock of the deceased stockholder at a price to be determined pursuant to an appraisal, and (ii) providing for payment to be made in cash to the extent of any insurance proceeds payable to the corporation, with the balance financed over a fixed period of years with a specified interest rate on the amount financed.

3. Miscellaneous Provisions. Miscellaneous provisions often found in Stockholder Agreements include the following:
   1. Noncompetition agreements precluding a selling stockholder from competing with the corporation following a triggering event;
   2. Subchapter S provisions precluding a stockholder from taking any action which could invalidate the corporation's Subchapter S election under the Internal Revenue Code. Subchapter S provisions in a Stockholders Agreement may also require the corporation to pay dividends sufficient to defray the stockholders' allocable share of corporate income tax;
   3. "Tag-along" rights allowing a stockholder who owns a minority of the corporation's outstanding shares to participate pro rata in any sale of stock by a majority stockholder or stockholders;
   4. Stockholder "put" options in which a stockholder may require the corporation to purchase his or her shares under specified circumstances, and corporate "call" options in which the corporation may require that the stockholder sell his or her shares to the corporation under specified circumstances; and
   5. Arbitration provisions for resolution of disputes among stockholders.

It is critically important to consummate a Stockholder Agreement at the inception of the business relationship when the financial stakes may not be as high and when unanimity of agreement to the terms of the Stockholders Agreement is most likely.

*George F. Eaton II, Esq. is a partner with Rudman & Winchell. He concentrates his practice in the areas of business planning, corporate and securities law.