I am often asked to help clients prepare the bylaws for their corporation after they have filed the articles of incorporation, obtained an employer identification number and opened the bank account. The discussion usually is directed toward maintaining control of the corporation; how can the client prevent other stockholders from selling or transferring their shares in the corporation to others in the future? Although it is possible to address this issue in the bylaws, the more appropriate vehicle for stock sale restrictions is a buy-sell agreement.
Buy-sell agreements are not required for the formation of a corporation; they are not filed with the State of California. A buy-sell agreement is a contract between the stockholders of a corporation, which contains terms and provisions relating to transfer of stock in the corporation. Buy-sell agreements are typically used to create a market for the sale of unregistered securities (e.g., stock in non-publicly traded corporations) and to provide for the transition of ownership in a corporation in the event of death or withdrawal, which might otherwise jeopardize the operation and management of the corporation.
A buy-sell agreement can be tailored to the needs of the corporation and the stockholders, but most buy-sell agreements contain, among other things, a method for determining the purchase price of a share of the corporation’s stock, restrictions on the ability to voluntarily transfer stock to third parties (such as using the stock as security for a personal debt of the shareholder), a description of the limited circumstances under which a transfer of stock is automatically permitted, the rights of the corporation, other shareholders, and transferees in a stock sale, and the remedies for violation of a buy-sell agreement.
The most common protection in a buy-sell agreement against a change in ownership that might upset the operations of a small business is the grant of a right of first refusal for the purchase and sale of stock that benefits both the corporation and the other stockholders. In other words, if a stockholder solicits and receives an offer from a third party for the purchase and sale of their stock, under the terms of a buy-sell agreement, the selling stockholder must first offer the stock to the corporation under the same terms and conditions as the offer received. And if the corporation rejects the offer, then the selling stockholder would then be required to next offer the stock to the other shareholders under the same terms and conditions as the offer received. Only in the event that both the corporation and the other stockholders reject the offer (or a portion thereof), can the selling shareholder sell their stock (or a portion thereof) to the third party.
Other protections that can be written into a buy-sell agreement include a requirement for mandatory purchase by the corporation or other shareholders in the event of an involuntary stock transfer (like an assignment in bankruptcy or conviction for criminal activity), and the requirement that all transferees must be approved by a vote of the remaining stockholders before they can succeed to all of the rights of a stockholder in the corporation.
If a buy-sell agreement is carefully crafted to anticipate common ownership interruptions, the stockholders of a corporation can minimize the likelihood of a transfer of stock that will jeopardize the future ownership, management, and control of the corporation.
This column is the work product of L+G, LLP, which has offices in Hollister and Salinas. Paul A. Rovella is an attorney with L+G, LLP. You may contact the author at (831) 630-1722 or [email protected] Mail your questions to Paul A. Rovella, It’s the Law, c/o The Free Lance, 350 Sixth St., Suite 102, Hollister, CA 95023.