What is an LLC Shareholder Agreement?
A shareholder agreement is a written contract between shareholders of a corporation or members of a limited liability company that establishes informal, formal, and legal understandings between the shareholders or members. These agreements define the rules for the management of the company and also determine the obligations that shareholders or members have to the entity. LLC Shareholder Agreements generally provide for how profits will be allocated, capital investments, transfer of equity or interests and how new members will be incorporated into the existing structure . The decision on how profits are to be allocated is determined by the shareholders or members. Allocation of profits and losses by the shareholder or members is generally done in accordance with their respective investments in the company in most cases, however this could vary due to initial contributions, past allocation, or contributions made for specific purchases can be factored into other ways to allocate profit and losses. Generally, if not identified in the LLC or operating agreement, profits are allocated in accordance with the percentage of ownership.
Essential Components of a Shareholder Agreement
An LLC shareholder agreement should comprise several vital parts. Each is important for providing a clear breakdown of the company’s inner workings and a cohesive framework for resolving disputes as they arise.
Shareholder Voting Rights
One major issue that should be addressed in an LLC shareholder agreement is shareholder voting rights. There are a variety of different voting rights that may be offered, with the majority of them falling into one of two categories, one or both of which will likely be included in your shareholder agreement. These are listed below along with descriptions of each:
One class of stock, or one class of stock with voting rights. This situation is perhaps the most basic of all the variations (with this being the bare minimum), requiring only that each member is given one vote for every share they own, regardless of how many people are involved in the company.
Multiple classes of stock. There are several different variations within this category, though in each case the idea remains the same: a company issue more than one class of stock, each of which has different benefits and voting power. For example, one class of stock might give 10 votes for every one share held while another will offer only one vote per share.
Company Goals
Another big aspect of LLC shareholder agreements is a review of the goals that are shared by all company members. This encompasses aspects such as why the LLC was formed, the priorities of the company and the general business vision. The importance of placing these issues in the shareholder agreement cannot be overstated, as changes to the agreement could be contested at a later point depending on the mood of a particular shareholder. For this reason, it’s best to have unanimous approval of any changes to company goals that are made after the original agreement is ratified.
Profits and Losses
Closely related to company goals is decisions on loss and profit sharing. In an LLC, profits and losses are typically split evenly among the shareholders. As such, you and the other members will agree to take on an equal share of any losses and gain an equal share of any profits. As an example, if your company has five shareholders and it turns a profit of $10,000 in a given year, every member would receive $2,000.
Termination Procedures
No matter how successful your company becomes, it’s virtually guaranteed that cosmetic changes to your shareholder agreement will be made sooner than later. This includes situations in which a member leaves the state or quits the company. In either case, having realistic and fair termination procedures in place is imperative.
Pleas for more clarity on this issue and all aspects of an LLC shareholder agreement are best directed to an experienced attorney.
Advantages of Having a Shareholder Agreement
The primary benefit of drafting a shareholder agreement for an LLC is the avoidance of conflicts between the owners. As owners of an LLC are typically also working in the business or closely advising the management, they are going to be involved in the daily operations and management of the company and its policies, procedures and decisions. Without ground rules and a framework, disputes are bound to arise. Shareholder agreements provide that framework, as the decisions requiring shareholder approval are specifically laid out in the agreement.
It is impossible to identify all the issues that may commonly arise, however, here are a few of the major ones:
The key terms and procedures covered in an LLC agreement can help to avoid conflict among LLC owners. Such an agreement can also save significant time and money in paying legal fees, accountants and other professionals necessary to resolve a dispute.
Shareholder Agreement vs LLC Operating Agreement
The distinctions between an LLC operating agreement and a shareholder agreement lie in their specific roles within the structure of an LLC and its operations.
An operating agreement defines the company’s owners (shareholders) and officers, and lays out how the company will be operated. It details how profits will be distributed, and outlines what happens if a shareholder leaves the company, retires or dies. Shareholder agreements clearly establish shareholders’ rights and responsibilities, as well as details about how and when both the company and shareholders may buy and sell shares.
In general , it is recommended that an LLC have both an operating agreement and a shareholder agreement because the two documents serve distinct purposes. An operating agreement happens before the shareholders are established as members of the operating entity; the shareholder agreement assumes the establishment of shareholders and sets forth terms between them for buying and selling shares, what happens when a shareholder dies or retires, and so on.
As noted above, a corporation should generally have an operating agreement and a shareholders agreement. Both contracts provide important information to the corporation, its officers and its shareholders.
How to Create an Effective Shareholder Agreement
The creation of an LLC shareholder agreement is the best protection for the viability and success of a limited liability company. As each LLC is unique, so too will be the ultimate shareholders’ agreement that is tailored to meet the needs of that particular entity. While each agreement can and should vary from entity to entity, there are certain elements that every LLC should consider including in their partner’s agreement.
Consider the Following Specific Items:
Are there any state restrictions on transferability of shares?
What are the percentage ownership interests of each member of the LLC?
How will profits be distributed?
Will distributions be made on a monthly, quarterly or annual basis?
What rights do shareholders have to vote (i.e., unanimous decision or majority rules)?
What happens if a shareholder wants to sell their interest in the LLC?
What happens if a shareholder dies or becomes disabled?
What happens if an LLC shareholder leaves the company?
What happens if an LLC shareholder files for bankruptcy?
What happens if the LLC is dissolved?
What are the voting rights of shareholders?
Common Errors
Common Mistakes to Avoid When Drafting an LLC Shareholder Agreement
One of the most common errors businesses make in drafting an LLC shareholder agreement is not having a clear and well-defined purpose for the agreement. A shareholder agreement should be much more than a simple formality. It should be a carefully crafted document tailored to the specific needs and goals of the business. Failing to identify and articulate these needs and goals means you’re destined to have an agreement that is ineffective and unenforceable, leaving you with no "agreement" at all. Avoid this mistake by taking the time to sit down with an experienced attorney to develop a customized shareholder agreement that meets all of the specific requirements of your business.
Another typical error is rushing to complete a shareholder agreement without including all relevant parties in the process . Exotic or unusual provisions that are inserted into shareholder agreements without the consent of all parties can lead to major disputes down the line. The best way to avoid this mistake is to consult with an attorney early on in the process so that everyone’s input can be taken into account when drafting the agreement.
A third common error is using boilerplate language from another shareholder agreement as a template for your own agreement. Corporate laws, which govern shareholder agreements, vary widely from state to state, so it is imperative that each shareholder agreement is drafted to comply with the laws of the jurisdiction in which it is being formed. Using a foreign template can eliminate this important distinction, exposing your LLC to enforcement issues. The only way to avoid this problem entirely is to read the laws of the state in which you’ll be forming your LLC before beginning to draft your shareholder agreement, or to consult with an attorney who can do the reading for you.