Using a Restricted Stock Agreement

At some point in the life of anyone who builds a business comes the question: How do I transition this business to others without losing complete control and possibly damaging the value of the business?

One of the most common ways to transition a business is to gradually sell or gift stock in the business to employees in whom the owner has confidence have the talent, ambition and work ethic to successfully guide the company into the future.

But how do owners protect their interests during this process?

POTENTIAL DISASTERS

Myriad catastrophic possibilities come to mind: What if a new stockholder unexpectedly becomes a nightmare and must be fired? What if a stockholder becomes unhappy and quits? What happens to their stock? Can a departing employee refuse to sell back the stock? Can an employee sell the stock to an unknown stranger or even a competitor? What if someone becomes divorced? Can the employee’s spouse, who knows nothing about the business, suddenly become a major stockholder by divorce decree? What if a stockholder suddenly dies? Will the stockholder’s heirs demand a role in running the business?

Each of these situations portends catastrophic consequences. Fortunately, there is a solution. Business owners can avoid these nightmare scenarios by adopting a simple agreement that any corporation can utilize.

Such a simple agreement goes by many names: A “Stock Agreement”, “Share Agreement”, “Shareholders Agreement” or “Restrictive Stock Agreement,” to name a few. The Restrictive Stock Agreement is perhaps the most accurate title. Every closely held business where shares or other forms of divided ownership define the ownership interests of the company is susceptible to the problems noted above. Anyone can be fired. Anyone can quit. Divorces are common. Everyone dies.

Don’t fool yourself. If you own stock in a small business, then you and all the other stockholders are vulnerable to disaster as a consequence of normal life activities; that is, unless you protect yourself.

A Restrictive Stock Agreement is an effective and simple means to achieve that protection.

TERMS OF AGREEMENT

A Restrictive Stock Agreement is a document adopted by corporate resolution and signed by each individual stockholder. The document generally states that in the event of a termination, death, divorce or other similar events, the stock held by the deceased, disabled or terminated employee must be purchased by either the other stockholders or the corporation itself at prices and pursuant to procedures set by the terms of the Agreement. The Restrictive Stock Agreement might also provide that in the event that a majority of shareholders wish to sell the entire corporation, the minority shareholders will be compelled to sell their shares as well. The intent of the agreement is to anticipate every possible contingency and establish an agreed procedure to deal with those contingencies. The document is an absolute necessity for every small corporation.

HOW TO DO IT

An enforceable Restrictive Stock Agreement can be established in a few simple steps. To start, the company engages an attorney to discuss the needs of the business and to draft the terms of the Agreement. The draft Agreement is reviewed and revised until all agree on its terms. Once the Restrictive Stock Agreement is in final form, the corporation adopts the Agreement by appropriate corporate resolution at a properly noticed corporate board meeting.

The document is then signed by all stockholders. Signatures on spousal consent forms are also recommended so spouses of employees who may have a community property interest in the corporate stock are bound by the agreement. Finally, and as required by California Corporations Code section 418(a), each existing stock certificate must be amended to note that the Restrictive Stock Agreement will govern future sales of stock in the corporation.

Once a Restrictive Stock Agreement and spousal consents are signed, and stock certificates amended, stockholders can rest assured that company stock will remain within the stated terms of control of the existing stockholders rather than ending up in the hands of heirs, ex-spouses, strangers or competitors.

Not only does this give peace of mind to stockholders, but it enhances the value of the existing stock by imposing continuity and stability.

A Restrictive Stock Agreement serves as the foundation for corporate succession planning and smoothly dealing with sudden changes in personnel.

In the most literal sense possible, no one in a closely held company should be caught dead—pardon the pun—without a well-crafted Restrictive Stock Agreement. Prepare yourself and your business for the future by adopting one.

William L. Porter is a principal in The Porter Law Group, located in Sacramento, California. He gratefully acknowledges the contribution by Hannah Kreuser to this article.