Reading... Articles of Incorporation and Shareholder Agreements: What's the Difference?

Articles of Incorporation and Shareholder Agreements: What's the Difference?

There are two constitutional documents required when setting up a corporation in any U.S. state:

Articles of incorporation, which is the primary document and typically regulates the corporation’s activities including its powers and objectives
Corporate bylaws, which regulate the company in relation to its internal management and affairs. This includes board meeting procedures and entitlements to dividends.

A third document that can be drawn up in a corporation is the shareholder agreement, which is not compulsory under state law.

When you set up a business as a corporation for the first time, it is a requirement for most states that you file the corporation's articles of incorporation. This document represents a charter that confirms your corporation’s existence in the state where your corporation is based. It is submitted in the form of a single document at your Secretary of State's office and includes the basic operating features of your corporation. Once you have filed the document and it has been approved, you have legally created your corporation as a valid registered business in the state.

The following information has to be included in the document:

The name and address of your corporation
Its corporate reason for existence, which normally includes the term "to lawfully engage in an activity"
Your corporation’s registered agent, who has been given the authority to receive service of process for the corporation
Information about your corporation’s stock, which should include share numbers of which your corporation has the authority to issue, designation of share classes, and each share’s value

Normally, the articles of incorporation will identify by name the incorporators of your corporation who have initiated the process of incorporation and are usually responsible for the signing of the articles of incorporation before the document is filed with the state. If the articles of incorporation have named the director(s), they may need to sign the articles of incorporation document before it can be submitted.

Filing Fee

When your articles of incorporation have been prepared, you will need to pay the required filing fee with your document.

The cost of this may vary depending on whether you are forming a for-profit or nonprofit corporation. It does not take too much work, which is likely to cost less.

What Is a Shareholder?

A shareholder can be a person, a company, or another institution that has ownership of at least one single share in a company. As shareholders are the corporation's owners, benefits can be made if the company is successful when stock has gained in value. If a company performs badly, however, a shareholder could lose money if the stock price declines. Fortunately for most corporate shareholders, compared to partnerships or sole proprietorships, they are not liable personally for the corporation's debts and any other obligations of a financial nature that may arise. This means typically, if the corporation goes under, any creditors are not permitted to ask shareholders to pay anything, but they can in the case of a privately held entity where the owner may be asked to pay the debts.

Shareholders do have the right to ask to inspect the corporation’s records and books and are even in the position to sue their corporation for any misdeeds on the part of its directors and other officers. Common shareholders can vote on important corporate matters, like who is on the board of directors and if a proposed merger is allowed to take place. What is very important is, if a corporation has to liquidate its assets due to dissolution or bankruptcy, the shareholders can take a proportionate amount of the proceeds. In some cases, bondholders, creditors, and preferred shareholders are accorded priority in front of common shareholders in the situation of liquidation. Shareholders also have the right to take a part of any dividends that the corporation declares.

What Is a Shareholder Agreement?

As the name suggests, a shareholder agreement is typically an agreement drawn up between some or all of a corporation’s shareholders. It is an arrangement whereby a company's shareholders describe the way in which the company has to be operated along with the rights and obligations of the shareholders. Included also is any information concerning regulations about the management of the company, the shareholders' relationship, the ownership of shares, and the protection and privileges of shareholders.

Overall, the shareholder agreement’s intention is to ensure that all the rights of the shareholders are protected and they are treated fairly at all times. It also gives shareholders the right to make decisions in relation to those outside parties who may wish to become shareholders in the future and offers safeguards for those who are minority shareholders. Including minority shareholders’ rights is not a compulsory part of a shareholder agreement, but it can be included.

Two or more shareholders can draw up an agreement presented in writing as long as the shareholders exercise the voting rights they have in relation to their shares as laid down in the agreement. An example of the use of an agreement could be when two or more minority shareholders of the corporation come to an agreement to vote together on director appointments so that their voting power as a collective is stronger than if they voted individually.

In private corporations that have multiple shareholders, the shareholders of such corporations will usually agree, in writing, to a shareholder agreement. Any written agreement drawn up by all the corporation’s shareholders may add restrictions to some extent as to the directors’ powers to supervise or manage the business and the corporation’s affairs.

What Normally Happens Following the Approval of the Articles of Incorporation?

In many situations, once a corporation has filed its articles of incorporation, it is by default managed completely by the shareholder-elected directors and by the officers who have been appointed by the director(s) and are consequently supervised by them. Typically, what is called a shareholder agreement permits the corporation’s shareholders to alter that default and the shareholders are given the power to supervise and manage the corporation to the degree that has been reached in the agreement. The agreement could permit shareholder consent to make alterations to the corporation’s constating documents, any allotment or issuance of shares, the sale or purchase of real property, and any decisions that are normally left to the corporation’s directors where there is no unanimous shareholder agreement present.

As well as restricting the corporation’s directors’ powers or laying out how shareholders may vote, there are other crucial issues that can be addressed in a shareholder agreement, as follows:

The method for paying out shareholders’ loans
The way shares will be handled if a shareholder dies, faces insolvency, or is confronted with a marital breakdown
Provisions for handling the sale or purchase of shares owned by a shareholder, i.e. rights of first refusal, forced sale, or any specific requirements when a sale takes place to someone who is not a current shareholder
Assigning a dispute resolution method for resolving shareholder disputes
Provisions which limit the right of a shareholder to compete with its corporation or solicit any clients or any employees from within the corporation

Facts about a Shareholder Agreement

Further to just adhering to the articles of incorporation and the bylaws documents, there are additional reasons why a corporation’s shareholders would want to supplement these two constitutional documents:

For privacy purposes because the two constitutional documents are available for the public to inspect while the shareholder agreement is typically private, shared only by the parties involved
Less expensive and easy to form, administer, alter, and terminate
The shareholders can reach agreement that arbitration should be the process used to resolve disputes arising between shareholders
They are flexible and can be changed easily without having to go through the process of amending the articles of incorporation or bylaws constitutional documents
It offers minority shareholders protection if the shareholder agreement has made that decision

Basic Provisions Contained in a Shareholder Agreement

The following provisions are typically included in a shareholder agreement:

Regulating ownership as well as the voting rights of company shares, which include provisions for lock-down, share transfer restrictions, security interests, grants over shares, rights of first refusal for shares that have been released by the corporation, drag-along and tag-along rights, and rights for the protection of those who are minority shareholders
Management and control, which includes the power to nominate a person to be elected on the board of directors and enforcing super-majority voting for important matters
Provisions for the resolution of disputes that may occur in the future between shareholders, including deadlock provisions
The amount and nature of initial contributions
How contributions in the future should be made
The law that governs and covers the shareholder agreement
Environmental and ethical practices
Designation of key roles and responsibilities

One thing that should be emphasized is the ease with which a shareholder agreement can be formed and amended, unlike bylaws and articles of incorporation documents. One of its drawbacks, though, is there is sometimes a conflict between it and the corporation’s articles of incorporation and bylaws documents. It can sometimes be used as proof of monopolistic practices and a conspiracy.

Important Questions

Is a shareholder agreement a good idea?

A shareholder who is part of a shareholder agreement has the same powers, rights, and duties as a corporation director as well as liabilities. This is in line with the shareholder agreement on director powers in relation to the managing of the corporation and when the director is relieved of his or her duties.

When should a shareholder agreement commence?

In some cases, there is a situation where only one person owns all the corporation’s shares so a shareholder agreement would hardly be necessary. Otherwise, some type of shareholder agreement is definitely a good idea, particularly in small, private corporations where only a small number of shareholders are involved or if a corporation started with one owner and is now seeking further investors. The success of any private corporation is typically dependent on those people who have control over the business. Sometimes, unplanned events occur which could lead to alterations in the ownership of shares, which could in turn have a negative effect on a corporation’s success. A shareholder agreement that has included restrictions on to whom and how shares may be transferred could be the preferred way of planning for the corporation’s future while at the same time protecting shareholders.

How does a majority shareholder fit into a corporation?

Someone who is considered to be a majority shareholder in a corporation possesses 50% or more of the shares. Typically, the majority shareholder is the corporation’s founder or, when a corporation has been passed by inheritance, the descendants of the founder. By owning so many shares, the majority shareholder also has voting interests in proportion to the percentage number of shares owned. This means that he or she has a significant impact on how the corporation is run and the direction in which it should move. Many majority shareholders hand over the corporation's management roles to managers and executives as they wish to have a hands-off approach. Sometimes, majority shareholders choose to relinquish their role in the corporation and attempt to sell off their shares to their competitors. A majority shareholder of a small corporation often plays the CEO role too. In larger corporations that have a worth running into the billions of dollars, the investors might include institutions that own significant numbers of shares.

What is the role of a majority shareholder in a buyout?

When a buyout is likely to take place, an entity from outside has to acquire more than 50% of the corporation’s outstanding shares. A majority shareholder might hold 50% or more of a company’s shares, but he or she might not possess the authority to approve a buyout unless additional support has been obtained depending on what is contained in the corporate bylaws. When a super-majority is needed for a buyout to occur, the majority shareholder could be the only deciding factor in situations where he or she holds sufficient shares that meet the requirements for a super-majority and at the same time the minority shareholders remaining do not have any additional rights allowing them to block the decision.

What are the rights of a minority shareholder?

A minority shareholder’s rights should be included in a shareholder agreement and could include the declaring of fraud or a derivative action in the minority. These can both effectively block a buyout completion. When the minority shareholders think the buyout is not fair and want to withdraw their shares from the business, they are able to exercise their appraisal rights. This gives the court the right to decide if the share price offered is fair and gives the option to compel the business initiating the buyout to pay a specified price if required.

General Shareholder Rights

One of the most important things as far as shareholders are concerned is that they have the right to get a percentage of any dividends that the corporation has declared. They can also ask to look over the company’s books and important records. If they believe the directors or any other of the corporation’s officers are responsible for any misdeeds, they do have the right to sue. Most importantly, if the company moves into liquidation, the value of any assets that are sold due to a bankruptcy or dissolution should be shared amongst the shareholders depending on how many shares they owned. However, if money is owed to any creditors, they get paid off first.

Summary

A corporation is not required to have a shareholder agreement, but due to the flexibility of this document and what it can include, it is in the interest of shareholders to legalize such an agreement so as to protect their rights and the success of the corporation. Depending solely on articles of incorporation and bylaws is an unwieldy method for running a modern-day corporation.

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