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Eff i Sh h ld A Effective Shareholders Agreements

Crafting Enforceable Provisions on Board Composition, Corporate Opportunities, Voting Rights, Transfer Restrictions and More

T d ’ f l f

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific WEDNES DAY, JUNE 15, 2011

Today’s faculty features: Nancy L. S anborn, Partner, Davis Polk & Wardwell, New Y

• rk
• C. S

tephen Bigler, Director and President, Richards Layton & Finger, Wilmington, Del. Nancy S chmidt Roush, Partner, Lathrop & Gage, Kansas City, Mo.

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Effective Shareholders Agreements

June 15 2011 June 15, 2011

Faculty:

• C. Stephen Bigler

Nancy Roush Nancy L. Sanborn Partner Partner Partner Richards Layton and Finger PA Lathrop & Gage LLP Davis Polk & Wardwell LLP Richards, Layton and Finger, P.A. Lathrop & Gage LLP Davis Polk & Wardwell LLP 302.651.7724 816.460.5820 212.450.4955 bigler@rlf.com nroush@lathropgage.com nancy.sanborn@davispolk.com

Any tax information contained in this presentation is not intended or written to be used, and cannot be used, to avoid penalties that may be asserted under the Internal Revenue Code or to promote, market or recommend any transaction or matter addressed herein.

Purpose and Use of Shareholders Agreements

Our general assumptions:

• P i

t

• Private company
• Multiple shareholders who may be individuals, corporations, investment funds or other entities
• Agreement among shareholders to give some or all of the shareholders certain rights and/or
• bligations that are above and beyond those given shareholders generally under state law

g y g g y

• Discussion will generally address Delaware, Missouri and New York state laws but most of these legal

principles are the same or similar in other states

6

Purpose and Use of Shareholders Agreements

Key provisions to be discussed:

• B

d f di t

• Board of directors
• Corporate opportunities
• Transfer restrictions
• Resolving deadlock

Resolving deadlock

• Special approval (“veto”) rights
• Information rights
• Preemptive rights
• Amendments
• Termination
• Dispute resolution
• Governing law

7

Board of Directors

Shareholders want to ensure that composition of board will be as agreed

• A

t t dd b th i ti d ti ( h h ld d t h i ht t

• Agreement must address both nomination and voting (e.g., shareholders do not have rights to

“designate”, “name” or “appoint” directors)

• Nomination process typically addressed in bylaws
• Bylaws should be consistent with shareholders agreement
• Voting agreement is generally enforceable if in writing and signed by the subject shareholders
• Agreement may address substance (how each shareholder must vote) or a procedure for determining how each

shareholder must vote (e.g., as determined by a particular shareholder or group of shareholders)

• State law (not Delaware) may require limit on term of voting agreement

( ) y g g

• Need sufficient shareholders to be party
• Is one shareholder enough?
• Proxy may be required for specific enforcement of voting obligations

8

Board of Directors (cont.)

Shareholders agreement should address who can remove directors and fill vacancies to ensure that board composition continues as agreed that board composition continues as agreed

• State law may require these rights to be stated in certificate of incorporation or bylaws

Sh h ld t h ld dd h b d iti h ti Shareholders agreement should address how board composition may change over time

• If shareholders transfer shares, at what point do they lose director rights?
• Are director rights transferable to a transferee of shares?
• When should director rights terminate? IPO, earlier or later?

When should director rights terminate? IPO, earlier or later?

9

Board of Directors (cont.)

Directors owe fiduciary duties and confidentiality obligations to the corporation

• Di

t b f d ith d ti t th ti th t fli t ith th i t t f th h h ld

• Director may be faced with duties to the corporation that conflict with the interests of the shareholder

who exercised its right to nominate the director Directors are subject to “corporate opportunities doctrine” Directors are subject to corporate opportunities doctrine

• Del. G.C.L. §122(17) allows Delaware corporation to renounce any interest or expectancy in business
• pportunities prospectively
• Statute requires renunciation in certificate of incorporation or action of board of directors

P i i i h h ld i ffi i l if i i

• Provision in shareholders agreement is sufficient only if corporation is a party
• Enforceability of waivers of corporate opportunities doctrine in other states uncertain

10

Board of Directors (cont.)

Indemnification of directors

• C

tifi t f i ti b l t t ith di t

• Certificate of incorporation or bylaws vs. separate agreements with directors
• Future amendments should not limit or alter indemnification rights retroactively
• Multiple indemnitors may be equally liable unless shareholders agreement (or certificate or

incorporation or bylaws) establishes which indemnitors are primarily vs. secondarily liable p y ) p y y

11

Transfer Restrictions

Enforceability of transfer restrictions in shareholders agreements

• Hi t

i ll t i t li ti h b i lid t t bli li

• Historically, restraints on alienation have been invalid as contrary to public policy
• Now, reasonable restrictions on transfer should be enforceable
• Must be in writing and shareholders must have notice
• Share certificates must be legended for restriction to be binding on transferee
• Certificate of incorporation versus bylaws versus shareholders agreement

12

Transfer Restrictions (cont.)

Unreasonable restrictions on transfer likely to be held unenforceable

• Ab

l t t i t t i ti th t ff ti l hibit t f

• Absolute restraint or restriction that effectively prohibits transfer
• Provision giving corporation or other shareholders right to repurchase shares on terms that deviate

significantly from market

• Prohibited shareholder did not have notice of the restrictions

13

Transfer Restrictions (cont.)

Reasonable restrictions on transfers should be enforceable

• I

l d

• Include:
• To preserve S election or other tax characteristics
• Comply with securities or other laws
• Preserve ownership by professionals, or employees, or family members
• Prevent competitors from acquiring shares to gain access to competitively sensitive information
• Must serve valid corporate purpose, be reasonable and in accord with public policy

14

Transfer Restrictions (cont.)

• Del. G.C.L. § 202(c) specifically identifies 5 categories of enforceable transfer restrictions:
• Obli

t h h ld t ff th ti th h h ld thi d t i ht t h

• Obligate shareholder to offer the corporation, other shareholders or third party right to purchase

shares, to be exercised within reasonable period of time (e.g., ROFR, ROFO)

• Obligate the corporation, other shareholders or third party to purchase shares (e.g., mandatory sale

provisions, tag-along)

• Require the corporation or shareholders to consent to transfer or transferee, or to approve number of

shares owned by any person or group

• Consent cannot be unreasonably withheld
• Require shareholder to transfer shares to the corporation, other shareholders or third party, or cause

Require shareholder to transfer shares to the corporation, other shareholders or third party, or cause automatic transfer of shares (e.g., drag-along)

• Prohibit transfer of shares to, or ownership of shares by, designated persons or classes or groups, if

designation is not “manifestly unreasonable”

15

Transfer Restrictions (cont.)

Shareholders agreement should address possibility of indirect “transfers” of shares

• Ch

i t l f tit h h ld

• Change in control of entity shareholder
• Change in terms or trustee of trust shareholder

16

Transfer Restrictions – Rights to Purchase Shares

Shareholders agreements often give the corporation or certain shareholders rights to purchase shares held by other shareholders purchase shares held by other shareholders

If corporation has right to purchase shares:

• Corporation may not repurchase shares if it has insufficient capital at the relevant time
• Consider granting right to other shareholders if the corporation does not want to or cannot purchase
• Consider granting right to other shareholders if the corporation does not want to, or cannot, purchase
• Reduces corporate assets but proportionately increases all shareholders' ownership percentages
• Enforcement against the corporation vs. multiple shareholders may be easier, particularly if

shareholders have limited assets

• No impact on tax basis of non-selling shareholders
• Redemption has tax dividend treatment for selling shareholder unless certain exceptions met

17

Transfer Restrictions – Rights to Purchase Shares

(cont ) (cont.)

If other shareholders have right to purchase shares:

• If

d t h i if th h h ld d t l t th i

• If mandatory purchase, issues if other shareholders do not comply or cannot pay the price
• If right to purchase, must allocate right/obligation among other shareholders
• Buying shareholders increase their tax basis
• Clear capital gains treatment to seller

Clear capital gains treatment to seller

18

Transfer Restrictions – Rights to Purchase Shares

(cont ) (cont.)

Hybrid

• C

ti h th fi t ti

• Corporation has the first option
• Other shareholders have the second option
• If shareholders have the first obligation, potential constructive dividend

19

Transfer Restrictions – Rights to Purchase Shares

(cont ) (cont.)

Triggering events for rights of the corporation or other shareholders to purchase shares

• Sh

h ld d i t t f h

• Shareholder desires to transfer shares
• Right of refusal ─ must first obtain offer to buy from third party, and corporation and/or other shareholders have

right to match

• Right of first offer ─ must first offer to corporation and/or other shareholders, but then free to sell to third parties if
• n terms that are not more favorable than offered to corporation or other shareholders
• n terms that are not more favorable than offered to corporation or other shareholders
• Termination of employment
• Disability or death
• Other involuntary transfers

y

20

Transfer Restrictions – Rights to Purchase Shares

(cont ) (cont.)

Price and terms for right of purchase by the corporation and other shareholders

• S

t i ( h thi d t ff f i ht f fi t f l) t th i

• Some triggers (such as third party offer for right of first refusal) set the price
• Other triggers (such as termination of employment) require the agreement to set the price or the

means of determining price

• Formulas versus appraisals

pp

• Minority and lack of marketability discounts
• Different purchase price depending on identity of selling shareholder may not be enforceable
• If non-compete agreement is required to preserve the corporation’s value, should include in the

h h ld t ith t ti i f i d ft l f h shareholders agreement with term continuing for a period after sale of shares

21

Transfer Restrictions – Rights to Purchase Shares

(cont ) (cont.)

Price and terms for right of purchase by the corporation and other shareholders

• D t

f l ti

• Date of valuation
• Effective date of purchase
• Considerations regarding tax owed on final K-1 for S corporation
• Self-executing closing

Self executing closing

• Option for buyer to pay by note
• Terms of note

22

Transfer Restrictions – Rights to Purchase Shares

(cont ) (cont.)

Other considerations in drafting provisions granting right to the corporation or other shareholders to purchase shares shareholders to purchase shares

• Consider whether transferee should also be bound by transfer restrictions and other provisions of

shareholders agreement

• Include restrictions on share certificate
• Require transferee to execute joinder as condition to transfer
• Should the option to purchase require purchase of all shares?
• Are rights of other shareholders to purchase shares transferable to affiliates and/or third parties?
• When if at all should transfer restrictions terminate? IPO earlier or later?

When, if at all, should transfer restrictions terminate? IPO, earlier or later?

23

Drag-Along Provisions

Drag-along provisions

• T

i ll d t i j it ifi d i it i ht t ll ti

• Typically used to give majority, or specified minority, right to sell entire company
• Should require participation in sale however structured: sale of stock, merger or sale of assets,

escrow, indemnity

• Avoid issues like appraisal rights and disclosure obligations by specific waiver

pp g g y p

• What is the remedy if any shareholder will not cooperate

24

Tag-Along Provisions

Tag-along provisions

• Gi

th h h ld t it t ti i t i l f h

• Gives other shareholders an opportunity to participate in a sale of shares
• Protects the minority when the majority position will be sold, allowing all participating shareholders to

share in control premium

• Consider exceptions to tag-along rights – e.g., affiliate transfers, estate planning

p g g g g p g

• Timing and procedure for delivering information and final documentation to the shareholders
• Allocation issue if buyer wants less than all shares
• Issues for buyer and triggering shareholder if total shares to be sold not certain

25

Drag-Along and Tag-Along Provisions

Other considerations when drafting drag-along and tag-along provisions in a shareholders agreement: agreement:

• Should address "same price and terms" if different classes of stock
• Should address "same price and terms" if non-cash consideration (e.g., certain shareholders subject

to noncompete)

• Should address whether all shareholders must pay transaction costs (including costs of all or certain

shareholders?) and give representations, provide indemnities, participate in purchase price adjustment, etc.

• Easier to enforce for tag-along vs. drag-along – cannot participate in tag-along sale if don’t comply
• Which shareholders have the benefit of tag-along rights?
• Should drag-along rights only be available for a sale of 100%?
• When should drag-along provisions and tag-along provisions terminate? IPO, earlier or later?

26

Resolving Deadlock

Deadlock may arise if differences of opinion among directors and/or shareholders

• St t

l id d i t t f t di d/ di l ti

• State law may provide remedy: appointment of custodian and/or dissolution
• Alternative mechanisms can be incorporated in shareholders agreement. For example:
• Mandatory arbitration or mediation (binding or nonbinding)
• Buy-sell agreements
• Address how price and terms will be set
• Tie-breaking vote (CEO or independent director(s), depending on the issue) (must be in charter in Delaware)
• Dissolution if disagreement on specified issues
• Drafting should be carefully considered and clear to avoid future manipulation

g y p

27

Special Approval (“Veto”) Rights

May include some or all of the following (and/or others)

• M

lid ti i ti t

• Merger, consolidation, reorganization, etc.
• Liquidation, bankruptcy, etc.
• Authorization or issuance of any shares of [senior] capital stock or any options, warrants or other

rights to acquire [senior] capital stock or any security convertible into or exchangeable for any [senior] g q [ ] p y y g y [ ] capital stock (subject to specified exceptions, such as limited issuances to employees and M&A transactions)

• Declaration or payment of dividends on [junior classes of] capital stock
• Redemption repurchase or other acquisition of capital stock
• Redemption, repurchase or other acquisition of capital stock
• Approval or modification of the annual operating budget, or any expenditure that would exceed [$___]

[__%] of [line item] [total budget]

28

Special Approval (“Veto”) Rights (cont.)

• Acquisitions and dispositions of any assets or business (whether by purchase or sale of assets,

purchase or sale of stock merger or otherwise) with a value of more than $ purchase or sale of stock, merger or otherwise) with a value of more than $ .

• Debt exceeding the budget or specified thresholds
• Investments or guarantees exceeding the budget or specified thresholds
• Transactions with shareholders, officers, directors or other affiliates
• Employee stock options and other management equity compensation arrangements
• Hiring or termination of key employees; employment agreements with annual compensation over $_
• Amendment of certificate of incorporation or bylaws (including by merger, consolidation, combination

l ifi ti th i ) reclassification or otherwise)

• Public offering of [equity] securities (or any public offering that is not a “Qualified Public Offering”)

29

Special Approval (“Veto”) Rights (cont.)

Threshold issue is board vs. shareholder approval rights

• B

di t fid i d ti t th ti d it h h ld b d l i ht

• Because directors owe fiduciary duties to the corporation and its shareholders, board approval rights

may not be as protective of a shareholder’s interests

• Cost, burden and delay if must obtain shareholder approval
• Obligation to obtain shareholder approval may require disclosure of potentially sensitive information

g pp y q p y

30

Special Approval (“Veto”) Rights (cont.)

Additional considerations

• I

l i f l i ht i tifi t f i ti

• Inclusion of approval rights in certificate of incorporation
• Limit on authority of corporation to engage in transaction vs. claim for damages for breach
• Avoid non-objective or vague approval requirements (e.g., right to approve any “material” acquisition
• r divestiture)
• “Simple majority” voting requirement on some matters; “super majority” for others?
• When should special approval rights terminate? IPO, earlier or later?

31

Information Rights

Information rights

• Sh

h ld ’ i ht t i f ti d t t l i li it d l h h ld t

• Shareholders’ rights to access information under state law is limited unless a shareholders agreement
• r other contract specifies rights

Drafting considerations Drafting considerations

• Shareholders agreement should contain confidentiality obligations
• When should information rights terminate – IPO, earlier or later?
• Should rights be eliminated or reduced when share ownership falls below a threshold?

32

Pre-emptive Rights

• State law varies ─ have unless certificate of incorporation states otherwise, vs. do not have unless

included in the certificate of incorporation included in the certificate of incorporation

• Providing for these rights in a shareholders agreement allows variances among shareholders
• If different classes of stock have pre-emptive rights, need to allocate new issuances among the

classes

• Need to address the mechanics and timing of waiving the right (include deemed waiver if do not

respond to notice)

• Need to address right of exercising shareholders to acquire shares that other shareholders have

declined to purchase p

• What if some shareholders do not meet securities laws requirements?
• Drawbacks of pre-emptive rights
• When should pre-emptive rights terminate ─ IPO, earlier or later?

33

Amendments to Shareholders Agreement

Drafting considerations:

• Sh

ld l th i t b ll d f t i d t ?

• Should less than unanimous vote be allowed for certain amendments?
• Must a shareholder consent to amendment "adversely affecting" that shareholder?
• What if adversely affect same to similarly situated shareholders who approve?
• How to describe those circumstances rather than leaving open to interpretation

How to describe those circumstances rather than leaving open to interpretation

• Amendments to transfer restrictions

34

Termination of Shareholders Agreement Provisions

• Important to consider circumstances when specific provisions, and when the entire agreement, should

terminate terminate

• Examples of termination triggers: specified date, change of control, IPO
• Consider whether certain provisions should survive termination

35

Governing Law

• State of incorporation?
• I t

t ti d f t f t t l i

• Interpretation and enforcement of agreement vs. corporate law issues
• Must have some connection to the state to use those laws

36

Forum Selection

• State where incorporated?
• St t

f i l ?

• State of governing law?
• State where most of the owners located?
• Neutral state or mutually inconvenient?
• Is the forum to be permissible or exclusive?

Is the forum to be permissible or exclusive?

37