The Purpose of Shareholder Agreement: Corporate Governance
BIRMINGHAM BUSINESS LAW BLOG
A blog published by Red Mountain Law Group providing
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Posted on October 11, 2012
Corporate governance,(1) at its most basic level, is how a corporation operates. Specifically, who makes what decisions, and usually more importantly, who controls who gets to make those decisions. Almost every corporation has their owners (shareholders, members, partners, etc.) elect a committee (board, management committee, executive committee, etc.), which in turn elects and manages the officers. This organizational structure for a business is contained in by-laws for corporations and within the operating agreements for LLCs. Within these documents, and absent the documents within the underlying code, you will find provisions concerning notices, meeting topics, powers, liabilities, etc. Because businesses do not necessarily want to follow the provisions in the code and because they are allowed to rewrite these provisions, they will put them in the by-laws and operating agreements. As we analyze these provisions, the two areas of concern are things that are important and things that are not important. I start with the latter:
What is not important?
If you are a small company and fighting over certain corporate governance provisions, the company is in trouble. Notice is one of those provisions. If you can’t go through a shareholder or board meeting without fighting over notice provisions, the company is probably in some real trouble. In small companies, you typically arrange a shareholder, board, or other meeting like you would any other meeting, and then waive the notice when you get there. If someone misses the meeting time, it is because the email accidentally went into their junk file, not because it was sent to some address on file and, as a consequence, lost in the mail. There are certain provisions in by-laws, operating agreements, and shareholder agreements that if someone is bickering over, my hunch is that the litigators are coming, if they are not already there.
Corporate governance for the small business should give you structure to follow while providing the flexibility to waive the structure for business to be done. When I am reviewing these provisions, I am looking for the ability to get around them, and this is a good thing. For small businesses, the best boards meet when they can (but not always on a great schedule) and discuss strategic business decisions. Then they all sign an action by written consent that signifies what they need to do from a legal standpoint (usually very little).
I harp on this because clients (and sometimes their attorneys) get lost in this minutia. I have seen people have a back and forth about whether they should hold an annual meeting in March or April. Certain questions, such as this, can and should get worked out over time, but it is not worth the discussion at the outset2. With your shareholder and buy/sell agreements, the important point is to have a general buy/sell provision. A right of first refusal, for example, is essential. However, the decision as to whether you should have 10 or 30 days to exercise the right of first refusal is not essential.
Corporate governance is a fluid process, and if you try to encapsulate all of the possibilities from the outset, you will get bogged down in the details. Oftentimes, the pain associated with redoing your corporate governance documents pushes you to adopt an informal policy that is contradictory to your actual way of doing business. People will adopt policies, get charged a lot of money and then act in a way that is consistent with good corporate governance but inconsistent with the documents they adopted. And having a policy in place that you do not follow is more dangerous than having no policy at all.
What is important?
With respect to corporate governance, the important questions are:
a. Who is on the board?
b. Who controls the board?
c. Who has the right to be on the board?
d. Who can fire who?
e. Who sets compensation?
f. What happens if there is a deadlock?
We tend to sugarcoat these matters. Business partners are often in a new relationship, and no one wants to lead with, “Hey, I love you, but I can fire you on a whim.” However, shareholder and operating agreements are analogous to prenuptial agreements.3 Oftentimes, entrepreneurs get hung up on the ability to be fired, and a lot of emphasis is put on employment agreements. Without downplaying the emotional dynamic of a person’s employment or decreasing the significance that employment agreements play in business, unless you are pro athlete or a tenured teacher, you are probably an employee at will. Most people go through life without much job security (when truly analyzed). My recommendation is to get these questions out on the table, be very explicit about what happens if people start disliking one another, and figure out if that is the appropriate arrangement. If business partners cannot get through that initial difficult conversation, how in the world are they going to collaborate on a successful business?
In both LLCs and corporations, the default decision process is that a majority wins. If you have over 50% of the vote, you have control over the corporation or LLC. Operating and shareholder agreements will try to put some parameters or limitations on this dynamic. In some cases, I believe these restrictions are appropriate. Certain people probably should be guaranteed a board seat. Certain people often should be allowed on the board initially, but with the understanding that they could be voted off. That said, the majority rules dynamic is an important one. If you own more equity than anyone else, shouldn’t you also have the right to do what you want with the company? Often these provisions are used more as a hammer than a productive tool.4
Finally, the last question is important — what about a deadlock? This dynamic is almost exclusive to two owner companies. Some people will adamantly insist that one person have control, and there is some wisdom to this. Every ship needs a captain. However, I personally do not have an issue with 50/50 ownership. If you do have a 50/50 partnership, I think it is critical that you have an agreement that would resolve a dispute. These provisions can and should include a mediated dispute and a put/call buy/sell. More important than actually providing a precise plan to untangle the mess, these provisions (and really all provisions) force parties to play nicely with one another. And this is really a key point for shareholder agreements and operating agreements. When things go sideways, you want to be sure that you can resolve the issue with the least amount of wealth destruction.
Goodrich Law Firm, LLC
1 — Today’s inappropriate pop culture reference on corporate governance and minute keeping comes to us courtesy of The Wire.
2 — I think of these questions as controversy creators. Some questions need to be asked and thought through. Some questions, like “When should we have our annual meeting” when you have not been in business for over a year is such a question. Wait and see. Have language in your by-laws that gives the board flexibility to move it should they want to move it.
3 — With a critical difference of taking love out of the equation, thereby removing the stigma associated with prenups.
4 — The analogy for this case is whether you want your company to run like the House of Representatives, where majority rules, or the Senate, where 60 (or more) percent controls. To a large degree, it is a choice between the lesser of two evils, and while one may be tempted to say neither, disputing owners can make the current Congress, as broken and foolish as it is, look like civilized intelligent human beings.