Update Your Shareholder Agreement Before You Face Costly Litigation

Clients often believe that the company they own with others does not have a shareholders’ agreement when the one that actually exists is “too old” or “outdated.” It can be a shock to learn that the agreement that all the owners signed 30 years ago is still legally in effect. But if it was signed by everyone, and has never been formally amended or rescinded, it is likely still legally binding in New Jersey.

An outdated shareholders’ agreement could have unforeseen, even disastrous consequences. What if the parties agreed in the past to certain things that today they would never even consider? For example, a shareholders’ agreement could give all shareholders the right to be bought out upon demand at current market value. Of course, when that agreement was signed, the company likely had very little, if any, value. It was a startup, so a buy-out provision like this seemed perfectly appropriate at the time. But what if the company is now worth $10 million dollars, meaning a 30% interest would be worth $3 million? Simply by virtue of a minority shareholder making a demand, this company now must come up with $3 million dollars, based upon a 30-year-old agreement, regardless of the cash position of the company?

If you are the 30% owner, this may seem great. But where is the company getting the money? What if buying out the minority owner at this price might cause the company to default on other obligations? For a company that has grown even more – say, it is now worth $100 million -  the consequences of an outdated clause the company has effectively outgrown could be even more dire.

A startup could also have an agreement that expressly allows spouses to work at the company. But what if that was written two marriages ago – again, when everyone got along - and now you cannot even fathom the idea of working with your business partner’s current spouse?

Small business owners should not only make sure they have a shareholders’ or (in the case of an LLC) an operating agreement, but they should update them every so often, much the way the owners might update their wills. When you and your business partners are all on the same page, it might be easier to make modifications that are in the best interest of the company.  When everyone is getting along, it is easier to recognize (using the above buyout example) that the company could never afford to buy any of the owners out and that such a clause could kill the company. At the very least, a lengthy payment schedule could be added as a compromise that provides the same right but won’t bankrupt the company.

But if this issue isn’t even considered until the owners are fighting with each other, voluntary, cooperative change is likely not an option. A 30% owner who is sick of the other owners and the way they do business may not be concerned about the impact his immediate “cash out” will have on the company. Having an automatic right to be bought out at market value, rather than having to engage in minority shareholder dispute litigation, can be extremely valuable. In fact, it could save you hundreds of thousands of dollars in potential legal fees and eliminate the need to prove shareholder oppression or other wrongdoing. But from the majority owner’s – and the company’s – viewpoint, a decades-old clause that was never revisited or even thought about could be disastrous.

As a small-to-mid-sized business owner, you should be making sure your business documents are up to date in the sense that they reflect the will of all the owners and are still practical and workable. If you wait until the shareholder dispute has already materialized, you may not like the way your dated documents read to your current eye. Please do not hesitate to reach out to me at dcroberts@norris-law.com.