Rights Amongst Shareholders on Sale of Corporations

The rights and obligations of shareholders in a privately held or closely held corporation can be detailed and arranged ahead of time through the use of a shareholders’ agreement. Privately held and closely held corporations are corporations owned fully by shareholders that unlike publicly held corporations, typically do not sell or trade their stock in the company on a public stock market.

Further, a privately held or closely held corporations’ shareholders usually do not trade or sell their stock in the company unless they are opting to sell out their ownership in the business.

Several months ago in Business Breakup: A Look into Buy-Sell Agreements, I detailed the scenario where one shareholder is looking to sell their ownership share or the company is looking to force the sale of a shareholder’s interest. In this article I will focus on the use of Shareholder Agreements to protect the rights and interests of shareholders in closely held corporations when the company is looking to sell the majority of its interests to another company.

What is a Shareholder Agreement?

A Shareholder Agreement, as the name suggests, and in its simplest form is an agreement among a company’s shareholders describing the rights and obligations between the shareholders. It provides the foundation for how the shareholders interact with each other.

While every corporation’s shareholder agreement will look different to fit the needs and business decisions of that corporation, a typical shareholder agreement contains the following provisions:

  • Share Vesting Schedules
  • Pre-emptive Rights
  • Restrictions on Transfers of Shares
  • Drag-Along and Tag-Along Rights
  • Rights to Appoint Directors
  • Dispute Resolutions

The Shareholder Agreement can prohibit the sale of a shareholder’s interest in a privately held or closely held corporation without first allowing the other shareholders an opportunity to purchase the shares. This provision can be included in a Shareholder Agreement under a Pre-emptive rights clause or a separate Buy-Sell Agreement. Tag Along and Drag Along Provisions will protect the respective shareholders’ interests when the corporation sells a substantial portion of its shares such as to an angel investor.

What is a Tag Along Provision?

A Tag Along provision is used to protect the interests of minority shareholders. For example, in the event shareholders holding a majority of the shares issued by a corporation decide to sell those shares to another company or someone outside the corporation, a tag along provision can require the minority shareholders’ shares to also be sold to the purchaser as well. Similarly, someone buying into the corporation as a minority investor can take advantage of a Tag Along provision.

What is a Drag Along Provision?

While a Tag Along provision protects minority shareholders and investors, a Drag Along provision will protect the majority shareholders’ interest. In this scenario, the majority shareholder(s) who finds someone looking to purchase the entire corporation can force the sale of the minority shareholders’ interests as well. Commonly, this provision works alongside a pre-emptive rights provision or buy-sell agreement, in order to give the minority shareholders an opportunity to purchase the entire venture.

Shareholder Agreements can be incredibly complex contracts and only a few provisions were highlighted in this article. We strongly recommend that you consult with your own personal attorney when entering or deciding your corporation needs a Shareholder Agreement.

Joseph Rust is an Associate Attorney with the Sullivan & Ward Professional Corporation. He can be reached at (515) 247-4721 or JRust@Sullivan-Ward.com.