An issue that comes up regularly when we form a new business entity is restrictions on transfer of the equity shares.  In a nutshell, the founders of the company usually are comfortable with each other, but they do not want new faces at the table if someone in the shareholder group decides to transfer their shares – voluntarily or involuntarily.  How to prevent that without unduly tying up a shareholder’s ability to do estate planning or gifting is an issue we regularly see.  For purposes of this article, we will focus on corporations, but the concepts discussed here can be applied to limited liability companies and partnerships as well.

Involuntary Transfers

A shareholder can lose control of his/her shares by operation of law.  These situations can arise in the context of divorce, insolvency or death.  

  • If a shareholder is involved in a divorce, a spouse could make a claim on the shares you are seeking to control.  This is more likely to happen if the shares represent a significant portion of the marital estate.  
  • If a shareholder becomes insolvent, creditors of that shareholder could seek to attach the shares you are seeking to control.  They are assets of an insolvent person and may be attachable under federal or state bankruptcy laws.
  • If a shareholder dies, the shares pass to his/her estate or by operation of a will.
  • If a shareholder pledges the shares as collateral to secure a debt and then defaults, a creditor could seek to execute on the collateral.

The Shareholder Simply Wants or Needs to Sell His/Her Shares

Things change.  A shareholder who needs money may want to sell some or all of the shares.  If the shareholder is “strong willed,” the corporation needs some controls to prevent or frustrate a sale or transfer from happening.

Solutions

In each of the above situations, unless the corporation’s articles of incorporation, by-laws,  or shareholder agreement prevent a transfer through a legally enforceable mechanism, control of the shares could be lost and suddenly you have a new shareholder.  

A key point here is that there is a long standing (very long standing) policy in common law against absolute prohibitions on “alienation” (sale or transfer).  That means that a court may not enforce a flat prohibition on transfer.  To make restrictions enforceable, we draft documents to anticipate the way a court will react.

In the case of divorce or insolvency, a court usually will try to reach an equitable solution.  We routinely include a provision (in a shareholder agreement or by-laws) that states that if a shareholder is the subject of a divorce or insolvency proceeding, the corporation has the right to buy the shares for fair market value rather than allow the shares to be acquired by a third party.  In other words, we create a mechanic that enables the corporation or other shareholders to buy the shares from the shareholder in advance of a transfer so long as fair market value is paid for the shares.  We make this a right of the corporation or other shareholders, but not an obligation.  You may not have the money or you may not care if the shares get transferred, but the other shareholders can make that decision if the situation arises. The sale price should be paid in cash (or cash plus a promissory note) and will then be available for a court to award to a spouse or creditor.  The corporation or the other shareholders keep control.  We always use an appraisal or a calculation based upon “fair market value” because that is what a court would likely order. 

In the case of a pledge or a willful shareholder ignoring the prohibition on transfer, we recommend that the share certificates have a legend that states that the shares are subject to restrictions on transfer.  That legend puts any buyer or transferee of the shares on notice that the shares cannot be transferred without compliance with the restrictions.  While nothing in commercial litigation is a certainty, the legend, together with well drafted transaction documents, should likely prevent a rogue transfer.

We rarely use an absolute prohibition of transfer in our shareholder agreements.  We generally use a right-of-first-refusal in favor of the corporation and/or the other shareholders to intervene in any proposed restricted sale by a shareholder.  The reason is enforceability.  The right-of-first refusal will likely be upheld by a court. 

What about Estate Planning and Family Gifts

We often provide an exception to restrictions on transfer because shareholders need to do estate planning and may want to move assets to the next generation currently.  These carve-outs have to be tightly drafted to prevent abuse and not all clients want them.  You can always revise the restrictions later as shareholders get older.

What About Death?

Death triggers an “involuntary” transfer.  If shareholders want to prevent the shares from falling into the hands of heirs, they can include a provision in a shareholders’ agreement or the by-laws that enables the corporation or the other shareholders to buy the shares for fair market value from the estate of a deceased shareholder.  If the estate of a shareholder is subject to probate or oversight by a surrogate’s court, the operation of such a provision is not automatic and may be subject to review or modification, especially if an heir or an executor objects.  The best course of action, if everyone gets along and the shareholder group is small, is to discuss the situation in advance.  We all have the same problem – we don’t live forever.

Non-Voting Stock

One strategy that is often employed to move the economic interests represented by shares into the hands of family members, employees and consultants is the creation of a class of non-voting stock.  The non-voting stock can have the same rights as the voting stock with one exception – only the holders of the voting stock can vote on any matter coming before shareholders.  You can have tight restrictions on transfer apply to the voting stock and little or no restrictions applicable to the non-voting stock.  Depending on how the equity is structured, this technique can facilitate estate planning during the lifetime of a shareholder without upsetting control or governance.

Spousal Consent

If there is a desire to strengthen the enforcement of restrictions on transfer, especially in the case of divorce, many states require that a spouse consent to the restriction in advance.  This is never an easy subject and our experience is that most clients elect to “run for it” without the spousal consent.  But, having spouses consent concurrently with the implementation of the restrictions is helpful if there is a matrimonial proceeding in the future. If the value of the shares is material to the marital estate a spouse may have statutory rights to the shares.

Structured Sales

In any scenario where the corporation or the other shareholders have a right to buy shares, we usually recommend a structured sale where 20% of the purchase price is paid up front and the balance is paid over three or five years.  This helps ameliorate the pain of having to buy out a shareholder.  However, it has to be a reasonable buy-out provision or a court may not give it effect.  That is why we like to see a material percentage paid up front and a relatively short promissory note term.

Valuations

There are a number of factors that are relevant when creating a mechanism for valuing stock.  The most important consideration is whether the valuation will be respected by a court.  A slanted or subjective valuation mechanism invites judicial second guessing.  Our recommendation is that the parties obtain one or more appraisals by qualified appraisers.  Formulas may be useful if the business is relatively straightforward and there is an industry standard methodology for assessing value.  We often disallow discounts for lack of control or minority interests. 

Conclusion

This article provides a generic description of the most common issues involving restrictions on transfer of equity shares.  Each situation brings its own circumstances that affect these scenarios.  A little planning can go a very long way, especially if your company is successful.

Jon Gardner and Kelly Guerin focus their practices in the areas of corporate and business law. They can be reached at:

jgardner@kavinokycook.com

kguerin@kavinokycook.com