With the growth of small businesses there has been a sharp increase in the formation of entities such as LLCs, S Corporations, and C Corporations in the records of the Texas Secretary of State.
Our clients seek our help in formation of the right business entity and the correct documentation, but often they are hesitant to have too many agreements in place. The hesitation lies in the fear of offending a shareholder or addressing the worst-case scenarios.
We have listed below some common reasons to have a Shareholder’s Agreement in place when issuing corporate shares to a shareholder. Most of these reasons also apply to operating agreements in a limited liability companies, and partnership agreements in partnerships.
Place Rights and Duties in Writing
A shareholder agreement is a contractual agreement that places all the rights and duties of the parties in place. Texas law does not require shareholder agreements to be filed with any entity, thereby, most shareholder agreements are internal documents. The primary benefit of a shareholder agreement is that it places all the duties in a document. This helps shareholders who are in the pre-incorporation stage and have no other formal document for rights and duties. It also helps shareholders know procedures such as voting procedures, removal of a director or an officer of a company. A careful reading of the shareholder’s agreement can resolve many issues before parties head to an attorney.
Predict and Address the Worst
What if a shareholder files for divorce with his/her spouse, and the corporate shares are subject to community property laws? What if a shareholder files for bankruptcy or the CEO commits fraud on the corporation? What if a shareholder dies and his children claim ownership to the shares? A corporation faces financial fragility if any of the events occur, and the corporate shares are at risk. A shareholder’s agreement addresses each of these possibilities and provides dispute free solutions to shareholders, providing more stability to the corporation and the shareholders.
Provide for Intellectual Property Rights
Many of our clients are start-ups and corporations with patents, copy rights and trademarks. When a corporation holds intellectual property, such as patents or copy rights, the shareholder’s agreement sets forth all the ownership and assignment rights of said property. A carefully drafted shareholder agreement provides the assignment of ownership rights from the patent owner individual to the corporation. This measure protects individuals from selling out the rights to intellectual property, or licensing the rights to the intellectual property.
Most shareholder agreements provide non-compete clauses in the event if one of the shareholders decides to compete with the corporation itself. Contrary to popular belief, Texas courts enforce non-compete clauses as long as they comply with the requirements set forth in the Texas Business and Commerce Code, Section 15. A well written non-compete clause in a shareholder’s agreement prevents and limits competition by time duration, scope, and by geographical location.
Prevent Expensive Litigation
A well-crafted shareholder’s agreement addresses the possibilities of litigation and pre-emptively places agreements between corporation and the shareholder in the event of a dispute. Many shareholder agreements provide for alternate dispute resolutions such as mediation or arbitration. Most agreements agree on the venue of litigation, payment of attorney’s fees, court costs and interest, and sometimes even appellate fees in the event of a lawsuit.
In essence, when forming a business, the shareholders, members, managers or partners must retain an experienced attorney in carefully drafting a well-written agreement.