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Stock Restriction Agreements and Startups

Securities Law

Article on Securities Law

A series of articles provided by Michael T. Raymond, a securities attorney with the Detroit, MI, law firm Raymond & Walsh, and an Adjunct Professor at the Wayne State University Law School.

The purpose of this series is to acquaint readers with the basics of securities law. Securities law governs the raising of capital for business purposes.

10. Stock Restriction Agreements

This article considers the merits of a Stock Restriction and Purchase Agreement between the shareholders of a closely held company.

Because each shareholder of such a company typically relies heavily on the abilities and judgement of the other shareholders, they all have a natural common interest in preventing outsiders from buying into the company without the consent of the existing shareholders.

This same concern also applies upon the death of a shareholder, where each shareholder’s willingness to deal with other shareholders does not necessarily extend to willingness to deal with the deceased shareholder’s spouse or children.

To alleviate concerns over the continued control over closely held companies, shareholders often enter into a Stock Restriction and Purchase Agreement, thereby restricting lifetime transfers.

Such agreements often require that a shareholder interested in selling his or her shares, or the estate of a deceased shareholder, sell his, her, or its shares in the company only to the company or to the other existing shareholders of the company.

Another variation is to allow the selling shareholder, or an estate, the opportunity to sell shares to a third party only after the company and the non-selling shareholders have first declined to acquire such shares.

In addition, a Stock Restriction and Purchase Agreement can be helpful in assuring that the shareholders receive the fair value of their labor.

Generally, interests in closely held companies cannot be easily sold unless the entire business is offered for sale. The shareholders of closely held companies often spend substantial time and energy building up their business. Yet the shareholders are often concerned that they will not be able to extract the fair value of their labor and pass it on to their heirs or transferees.

If a “key” shareholder/employee dies, for instance, the value of the business may decline rapidly or, as is often the case, no one, including the other shareholders, may be willing to purchase the deceased shareholder’s interest for an amount at all close to its a fair market value.

A Stock Restriction and Purchase Agreement can minimize these problems by creating a guaranteed market for a deceased shareholder’s interest at a value which the parties have agreed to be fair. Moreover, the establishment of a reasonable fair market value through such an agreement may deprive the Internal Revenue Service of an opportunity to independently value the deceased shareholder’s interest in the company for estate tax purposes.

Such agreements generally provide that no shareholder may assign, encumber, pledge, transfer, or otherwise dispose of his or her stock except in accordance with the agreement and require that a restricted legend be placed on the stock making reference to the agreement.

In addition, the agreements generally provide the company and/or the non-selling shareholders with an option of first refusal. If this right is not exercised, the selling shareholder is allowed to sell his shares to a third party, provided that, upon receipt of a bona fide offer by a third party, the company and/or the non-selling shareholders again have the opportunity to acquire the stock on the terms set forth in the third party offer.

The agreements also generally provide that an employee/shareholder is required to sell his or her stock to the company and/or the non-selling shareholders upon cessation of employment with the company and, similarly, that the estate of a deceased shareholder is required to sell the deceased shareholder’s interest to the company and/or non-selling shareholders.

The agreements are often quite detailed in terms of the notice requirements and timing as well as valuation.

In summary, Stock Restriction and Purchase Agreements provide for the continuity of management control and the assurance of a readily available market in the event a shareholder wishes to sell his shares. As a result, two major issues facing shareholders of closely held companies may be addressed in an agreement which is mutually satisfactory to all shareholders.

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