Category Archives: Minority Interest Holders’ Rights

Forming a Texas Corporation – Other Documents You Should Know About

 

Most folks forming a corporation are aware that you file a certificate of formation with the Secretary of State’s office in order to legally form the corporation and then adopt bylaws to govern the corporation’s day to day operations.  There are several other documents important to properly forming a Texas corporation that you should be aware of and I discuss several of them below.

Pre-Incorporation Agreements

Pre-incorporation agreements are those made between future shareholders regarding the formation of the corporation.  These agreements may be formal (preferred) or informal.  Pre-incorporation agreements vary widely but are often used if there is some concern that one or more shareholders may back out of their commitment to form the new corporation.   They are also used to document the future shareholders’ expectations with regard to employment, capitalization, management, and other terms.

In essence, the pre-incorporation establishes a joint venture between the parties for the purpose of forming a corporation and establishing its business.  The pre-incorporation agreement usually terminates upon formation of the corporation.

Subscription Agreement

A subscription agreement is defined as an agreement between a subscriber and a corporation or a written offer by a subscriber to a corporation, before or after its formation, in which the subscriber offers or agrees to purchased a specified ownership interest in the corporation. Pre-incorporation subscription agreements are irrevocable by the subscriber for six months unless otherwise agreed.  The subscription agreement will usually set forth the conditions of the subscription as well as the payment terms and timeline for the subscription.

These agreements are becoming less common because of the ease with which modern corporation can issue new shares in exchange for additional capital but they are still in use today.  One of the reasons they are still in use is to condition the subscriber’s obligation to purchase shares.  For example, the subscription agreement may condition a commitment from the subscriber to purchase shares upon the occurrence of some event, such as, the corporation securing debt financing, a total capital investment amount, a key customer, hiring a key employee, etc.

An important note: it is important for the corporation to be aware of State and Federal securities laws when considering a subscription agreement and issuing stock to an investor.

Buy-Sell Agreement

A buy-sell agreement sets forth the terms under which the corporation or the other shareholders of the corporation must purchase shares from an individual shareholder.  The agreement also sets forth the terms under which a shareholder must sell his or her shares back to the corporation or to the other shareholders.

The buy-sell agreement will usually contain specific trigger events that create the obligation to sell or purchase the shares.  Common examples of these trigger events include death, divorce, and dissociation.  The buy-sell agreement should set forth the manner of determining the price of the shares to be sold as well as terms for payment of the purchase price.  The buy-sell agreement may set forth different prices and payment terms for different trigger events.

The buy-sell agreement may be set forth in a separate written agreement or in another corporate document such as the certificate of formation, bylaws, or a shareholder agreement.

Shareholder Agreement

A shareholder agreement is a critically important document, especially for small or closely held corporations.  A shareholder agreement is a binding contract between the shareholders used to manage their relationship and the governance of the corporation.  The terms of the shareholder agreement may be the only recourse a disgruntled minority shareholder can rely upon to protect his or herself.  Likewise, majority shareholders may benefit from a shareholder agreement setting forth the shareholders’ agreement with regard to management, rights, duties, and standards of care.

The shareholder agreement is often used to modify the standard corporate governance laws in a number of areas by setting forth specific terms to govern issues such as those listed below:

  • placing restrictions on the transfer of shares
  • creating mandatory buy-sell provisions
  • establishing mandatory voting terms or altering voting rights
  • modifying fiduciary duties and standards of care for Directors and Officers
  • mandating dividend payments
  • setting forth restrictions, requirements, or terms for the employment of shareholders or their family members
  • protecting minority interest holder’s rights
  • modifying the reasons when a corporation may be wound up and terminated
  • setting forth methods for resolving management disagreements
  • mandating the election of specific directors
  • placing restrictions on the management authority or discretion of directors and officers
  • expanding the types of actions which require shareholder approval
  • mandating bylaw terms

Initial Organizational Meeting Minutes

As soon as the corporation is formed, the initial Directors must hold an initial organizational meeting although the meeting may be accomplished through a written consent.  Regardless of whether an actual meeting is held or action is taken by written consent, the initial organizational meeting is important to address the following business in addition to other matters:

  • adopting the corporate bylaws
  • electing officers
  • issuing stock and setting forth the consideration to be received by the corporation
  • adopting a minute book to document BOD actions
  • establishing corporate bank accounts
  • authorizing other significant actions such as borrowing money, significant contracts, or leases
  • adopting the corporate share certificate
  • approve the initial stock ledger

Assumed Name Certificate

If the corporation will conduct its business under a trade name or any name other than the one set forth on its certificate of formation, then the corporation must file appropriate assumed name certificates.  These certificates are filed at both the State and County levels.

Stock Ledger

The new corporation will also need to create its stock ledger.  The stock ledger will serve as the corporation’s official record of stock ownership in the event there is any dispute as to what shares the corporation has issued and who owns those shares.

Closely Held Corporations: Characteristics, Minority Shareholder Rights, and Control Issues

Closely held corporations present unique legal issues on a number of fronts.  The limited ownership group makes personal relationships more important and increases volatility amongst the group.  Owners of closely held companies tend to be more involved in the operations of the company.

What Is a Closely Held Corporation?

The most general definition of a closely held corporation is a company with a small number of shareholders. In Texas, there is a statutory process by which a typical for profit corporation may form a close corporation but this is not the only version of a closely held corporation.  A closely held corporation may exist even without a close corporation designation under state law.  S Corporations (a tax designation) are often closely held corporations because of their inherent shareholder limitation.

Regardless of how you define or create a closely held corporation, they have three distinct characteristics: (1) there are a limited number of shareholders; (2) there is a limited market for the companies stock (if any); and (3) the owners are often directly involved in the operations of the company.

What Characteristics Make Closely Held Companies Unique?

Limited Number of Shareholders.  The limited numbers of shareholders is the single biggest difference between a closely held company and a public company.  The shareholders almost always know each other prior to forming the company and usually form the company with a specific purpose and understanding about their roles and goals.  These goals may be delineated in the bylaws or a shareholder’s agreement.  The limited number of shareholders exponentially increases the importance of understanding their personalities and personal relationships.  The personality of the shareholder or shareholders owning a majority in interest can come to dominate the management and direction of the company.

Limited Stock Market.  By its nature, a closely held company offers a limited market for a shareholder to sell his stock.  Often times the company is formed with unique roles for each shareholder.  A third party will not be interested or able to fill that role if it acquires an ownership interest.  In addition, closely held companies often place limitations on the transferability of stock.  Given these limitations, a shareholder who wishes to sell his interest in the company is often limited to selling his shares back to the company or to the other shareholders.

Shareholders As Directors, Officers, or Employees.  Many times shareholders of closely held companies take on significant roles within the corporation as directors, officers, or employees.  This can create issues down the road, especially in situations where a minority shareholder feels disenfranchised.  For instance, should employee shareholders be given an employment contract or remain an at-will employee?  What happens if one shareholder leaves employment with the company while the remaining shareholders continue to draw a salary?  Either scenario could have a significant impact on a shareholder’s economic return.

What Are Some of the Unique Legal Issues Affecting Closely Held Corporations?

Minority Shareholder Rights.  Most legal issues for closely held companies arise when there is an inequality in ownership between two shareholders or the existence of more than two shareholders.  In either situation, there is a minority shareholder.  With two shareholders holding unequal interests, the shareholder with the lesser interest is obviously a minority shareholder.  However, anyone who owns less than 50% of the company can be a minority shareholder even if that shareholder in fact owns a greater stake in the company than any other individual shareholder.

For instance, take a company where A owns 48% of stock, B owns 26%, and C owns 26%.  No one shareholder holds a majority interest. But if B and C jointly decide on a course of action that negatively affects A, then A can be considered a minority shareholder.

This is important because the law affords minority shareholders special protections one of which is protection from oppressive conduct by the majority.  In Texas, oppressive conduct exists in two circumstances:

  1. when the majority shareholders’ conduct substantially defeats the minority’s expectations that, objectively viewed, are both reasonable under the circumstances and central to the minority shareholder’s decision to join the venture; or
  2. burdensome, harsh, or wrongful conduct, a lack of probity and fair dealing in the company’s affairs to the prejudice of some members; or a visible departure from the standards of fair dealing and a violation of fair play on which each shareholder is entitled to rely.

Control Rights.  Given the limited number of shareholders, it is relatively easy for one shareholder or a small group of shareholders to form a majority that can control the company and direct its actions with limited input from the minority.  This is separate from an issue of oppression as corporations are designed to work this way by default.  There are various scenarios where control can be an issue.

The first example is the instance in which the majority and minority interest holders share a common vision when starting a new venture.  However, over time the shared vision distorts and the minority interest holder becomes less effective in the decision-making process to the point of having no real control over the direction of the company.  As long as the legal formalities are followed (notice, meetings, elections, etc.), there is no recourse for the minority shareholder because most corporations default to a majority in interest rules.

A second example comes with the “big fish” investor.  Let’s take a group of engineers A, B, and C, who have a great idea but no capital.  Along comes investor D with all the money in the world and they form a corporations with an equity structure as follows: A, B, and C each have 20%; D has 40%.  D has the largest stake in the company because he fronts all of the capital and he expects to be able to direct the company’s actions in order to protect that capital investment.  But is that actually the case?  A, B, and C can still control the company as a group.