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Disputes between and among shareholders or members of closely-held corporations (often referred to as internecine disputes) are almost inevitable during the lifetime of a corporation.  However, through careful planning, clear communication, and well-drafted corporate governance documents, shareholders can minimize, if not altogether avoid, the frequency and magnitude of those disputes.

Corporate Governance Documents

The first step that shareholders should take to address and minimize disputes, and to resolve such disputes when they do arrive, is to have in place a clear and comprehensive Shareholders’ Agreement (or an Operating Agreement in the case of a limited liability company).  The corporation should also have a set of By-Laws.  Those agreements are crucial in closely-held corporations because they govern the relationships between shareholders/members and address various scenarios that could lead to disputes. Key provisions should address:

• voting rights and procedures that clearly define how decisions are made and the voting thresholds required to take corporate action;
• procedures for resolving deadlocks. In closely-held corporations, especially where there are two equal shareholders, a deadlock can occur if shareholders cannot agree on critical business decisions. Deadlock provisions might include a buy-out option, where a shareholder can be forced to sell his shares to the other shareholder.  A deadlock provision can also require the appointment of an independent third party or mediator to break the deadlock;
• anti-dilution provisions that prevent conflicts concerning ownership and control. While corporations may need to finance their growth through equity transactions that may dilute the interests of existing shareholders, anti-dilution provisions can protect shareholders from unfairly having their ownership percentage significantly reduced by future rounds of financing or other shareholder transactions;
• buyout provisions that clearly define the process for buying out a shareholder in the event of death, disability, or bankruptcy;
• exit strategies that contain provisions detailing how shareholders can exit the company, either by sale, buyout, or other means. In a closely-held corporation, shareholder disputes often arise when one party wants to exit the business but cannot do so easily. Exit strategies can include a Right of First Refusal, which allows the corporation or the other shareholders the first option to buy a departing shareholder’s shares before they are sold to an outside party. The Shareholders’ Agreement should also contain a formula or method for valuing shares, especially in the event of a buyout, to prevent disagreements over the value of the business; and
• an efficient mechanism for dispute resolution, such as mediation or arbitration. These alternate dispute resolution mechanisms prevent costly and lengthy public litigation and provide a more predictable and neutral forum for resolving disputes, which can be particularly important in closely-held companies where personal relationships may be involved.

Because corporate law and other regulations may evolve or change over time, it is important to periodically review the Shareholders’ Agreement, By-Laws, and other governing documents with a lawyer or other professional advisor who specializes in corporate governance to ensure they remain up-to-date and effective.

The Roles and Responsibilities of the Shareholders Should Be Clear and Unambiguous

In addition to clearly defining the rights and obligations of the shareholders in the Shareholders’ Agreement and By-Laws, the shareholders should have clearly defined and agreed upon roles and responsibilities.  Having multiple shareholders with similar but not identical business interests can lead to disagreements. When forming the corporation, make sure that each shareholder’s role, financial interest, and expected return align with their skills and goals, which will reduce potential for conflict.  For example, do all shareholders have to agree on the corporate strategy and the decision-making processes to effectuate that strategy?  It may be the shareholders’ intent that only some of them are permitted to be involved in the day-to-day management of the corporation, while other shareholder are passive investors with no say in the corporations’ operations and management.  If such decision-making authority and rights to manage the corporation are not set forth in a Shareholders’ Agreement, they should be memorialized in the corporation’s By-Laws or other governing document.

Compensation

Conflicts can also arise when there is ambiguity regarding compensation for shareholders, especially those involved in the day-to-day operations. Clearly define how salaries, dividends, and other forms of compensation will be handled, and ensure that all shareholders agree on the structure.  A well-structured management framework can prevent misunderstandings and the conflicts that arise from unclear expectations.

For example, when certain shareholders are also employees and others are passive investors, there may be disagreement over how compensation is distributed between salary and profit shares.  The employee/shareholder might argue that they should receive a higher salary or profit share compared to a passive shareholder who does not contribute to the daily operations of the business. Alternatively, passive shareholders may feel that active shareholders are being overpaid for their roles.  A fair compensation structure should be established that compensates active shareholders for their work while also giving passive shareholders a reasonable return on their investment. Shareholder agreements can detail different compensation levels depending on the shareholder’s role and level of involvement.

Establish Robust Corporate Governance Practices

Corporate shareholders should establish strong corporate governance practices that ensures transparency, fairness, and accountability.  This includes: (1) establishing a Board of Directors that have clear responsibilities, and holding regularly scheduled board meetings that are properly noticed and at which minutes are taken to memorialize the discussions and any corporate action taken; (2) holding periodic shareholder meetings to ensure open communication and address any concerns before they become larger issues; and (3) having transparent financial reporting where shareholders receive regular financial updates to prevent confusion and mistrust.

Minority Shareholder Protection

In a closely-held corporation, where ownership is typically concentrated among a small group of individuals, the protection of minority shareholders – i.e., shareholders that hold less than a majority of the corporation’s outstanding shares – is an important consideration.  Common rights that minority shareholders bargain for include veto powers over significant corporate actions, such as a merger or a sale of all or substantially all of the corporation’s assets, or the incurrence of debt in excess of an agreed upon amount; if majority shareholders sell their shares to a third party, the minority shareholders may be granted the right to “tag along” and sell their shares on the same terms as the majority shareholders; a minority buyout provision that gives a minority shareholder the right to sell his shares back to the company or to other shareholders at a fair market value upon certain predefined events occur (e.g., a significant change in the business).  Minority shareholders also bargain for reporting and information rights, which typically include receipt and/or access to certain financial and operational information of the corporation to ensure transparency.

Conclusion

Proactive planning and clear documentation are the best tools for preventing disputes among shareholders of closely-held corporations.  Key measures like a well-drafted shareholders’ agreement, clear corporate governance, defined exit strategies, and regular communication can help mitigate the risk of disputes, maximize the flexibility of the corporation in times of both economic growth and decline and enhance operations.  If disputes do arise, it is important to have processes in place for resolving them, such as mediation or arbitration, rather than allowing them escalate into legal battles. Regularly consulting with corporate lawyers or business advisors can also help ensure that the company is in good standing and its governance structure is appropriate for the shareholders involved.