Why bylaws are necessary but not enough: Why your corporation needs a shareholders agreement Part 4 of 9

Why bylaws are necessary but not enough: Why your corporation needs a shareholders agreement Part 4 of 9

     Every corporation is governed by statutes and its articles of incorporation (called a certificate of incorporation in some states).  In addition, every corporation needs bylaws. 

     Articles of incorporation are sort of like a corporation’s birth certificate.  They are filed with the state and the act of filing them is what establishes (incorporates) a corporation.  The Articles of incorporation don’t necessarily include a lot of information – at a minimum, they list the name, purpose, and number of authorized shares of stock of the corporation along with a few other ancillary items.  Bylaws set out how the corporation will be governed and provide the basic rules for corporate functions.  Bylaws are specific to a corporation, but typical areas covered by bylaws include procedures for calling and conducting meetings of shareholders and of directors, electing directors, appointing officers and committee members, issuing and transferring of stock certificates, and more.  Although bylaws don’t get filed with the state like the articles of incorporation, they need to be in place immediately after a corporation is incorporated.

     Corporate statutes and a corporation’s articles of incorporation and bylaws cover basic corporate mechanics, procedures, and rights.  However, in any corporation with more than one shareholder, it is beneficial for the shareholders to agree to matters beyond the scope of statutes and charter documents.  (That scope, while crucial, is minimal.)  Shareholders do so with a shareholders agreement. 

 

 Sometimes smaller or newer corporations forgo a shareholders agreement.  This happens because the shareholders assume – incorrectly – that statutes and the corporation’s articles of incorporation and bylaws are all that they need.  It also happens because shareholders assume – incorrectly – that they will always be able to work together to resolve any issues.  Even in the (very, very) rare instance of shareholders who can always get along, some issues are beyond their control. 

 

     Shareholders agreements cover a wide variety of topics, many focusing on the shareholder’s interactions among each other and with the corporation.  They can consist of multiple separate agreements or one, comprehensive agreement covering topics such as:

  • Loyalty to the corporation
  • Voting agreements and arrangements
  • Approval rights
  • Stock transfer, both involuntary and voluntary, including:
    • Rights of first refusal
    • Tag along rights
    • Buy-sell provisions
    • Drag along rights
  • Information rights
  • Dispute resolution mechanisms
  • Registration rights

     What does all of this mean? Loyalty to the corporation can be covered by a variety of restrictions and obligations.  Some of the most common include confidentiality obligations, and restrictions on competition with the corporation and solicitation of its clients and employees – all things that aren’t expressly forbidden without a shareholders agreement that prohibits them.   

     Voting agreements and arrangements include shareholders agreeing to vote their voting interests in favor of a specific proposal, such as for certain directors or certain transactions.  

     Approval rights are commonly built into shareholders agreements because corporate statutes typically provide a bare minimum level of shareholder protection.  Accordingly, shareholders want additional protections such as imposing supermajority or unanimous voting requirements for the corporation to take certain significant actions.  Approval rights can also include expanding the list of actions requiring shareholder consent (thereby limiting the board’s power).  For example, expenditures outside of the approved annual budget or borrowing money over a certain amount may be subject to shareholder approval.     

     Stock transfer restrictions allow shareholders to control who they are in business with.  They can cover involuntary transfers in the event of death, disability, bankruptcy, divorce, or “for cause” termination of a shareholder who is also an employee as well as voluntary transfers (i.e. transfer to a third party).  Buy-sell provisions prevent a situation where shareholders are stuck dealing with ex-spouses, heirs, or disgruntled ex-employees – absent these provisions, shareholders can suddenly end up with their worst enemy as their business partner.  Rights of first refusal prevent a shareholder from voluntarily transferring stock to a third party without first giving the corporation and/or the other shareholders the opportunity to buy the option to buy the stock.  In addition, tag along rights protect minority shareholders by allowing them the right to “tag along” and receive the same terms in an approved sale of stock to a third party.  The counterpart to tag along rights is drag along rights.  In the event of a proposed sale of the corporation, drag along rights protect the majority interest by allowing them to “drag” a minority holdout into the sale and ensure the deal approved by the majority will not be ruined.

     Information rights  set out shareholders’ rights to company information.  Corporate statutes of most states provide some inspection rights to shareholders but shareholders may choose to require that the corporation proactively provide financial statements, business plans or other information on a regular basis. 

     Dispute resolution mechanisms allow for shareholders to agree what they will do in the event that someday they do not agree and end up deadlocked.  The most common options include mediation or arbitration, bringing the matter to a third party with industry experience, and buy-sell provisions.  These provisions help ensure that the corporation survives the deadlock.  Absent such provisions, deadlocked shareholders will be forced to litigate. 

     Registration rights allow certain shareholders to force a privately-held corporation to go public.  They aren’t something that every privately-held corporation needs or wants, but for startups dependent on securing certain kinds of investors, registration rights are key.  

     Not every shareholders agreement needs to cover all the topics outlined here nor are these topics the only ones that can be covered in a shareholders agreement.  However, without a shareholders agreement, few to none of the above rights, obligations or restrictions are imposed on the shareholders of a corporation.  This is why a shareholders agreement is essential – it is easiest and often times the only way to impose control and certainty in the otherwise uncertain corporate world.

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