I also want to point out two items: 1) The Capitalization Clause can be substituted with a Buy-Sell Agreement which is a much more extensive and detailed document related to proper capitalization of the business and 2) there should be a separate Cross Purchase Agreement between the owners of any small business.
This article will first describe the clause and its purpose. Finally I will identify the drawbacks to a typical capitalization clause often found in many existing shareholder agreements.
Purpose of the Capitalization Clause
The primary purpose of the clause is fund the initial capital of the company. Since this is a shareholder agreement, the company is set up as a ‘Stock’ company. Before continuing, I encourage you to read about the basic principles of stock and the terminology used with this term by reading my article entitled ‘Stock’.
The secondary purpose is to establish the respective ownership percentage based on the initial capital funding as determined with the primary purpose. Finally, the third purpose of the Capitalization Clause is to set the guidelines related to any change in capital needs of the company and how those needs will be met. This third purpose is the one hang up in creating a long lasting agreement between the parties as this part of the clause is usually poorly drafted.
The following subsections describe and illustrate the three primary purposes of the capitalization clause (Article) of the shareholder’s agreement.
With a single shareholder company, the initial capital follows the guidelines of the state’s compliance rules. Typically a dollar contribution is made to the company in exchange for a stock certificate. The shareholder’s agreement comes into play when more than one shareholder is involved. It is critical for all parties to discuss the initial contribution amounts prior to drafting this section of the Capitalization Clause. It is more common for the initial investors to transfer capital to the company in some other form of value than cash. Often, intellectual value is the most common contribution. Other forms of capital contribution include:
– Intangible Assets
– Rights to property or contracts
– Patents or Copyrights
– Tangible Assets
– Equity in Vehicles
– Equity in Equipment
– Real Estate
– Equity in Stock or other Market Instruments (Bonds, Options, Etc)
– Sweat Equity for the creation or idea of the company or for the physical work to date
The sweat equity exists more frequently and is a normal contribution for the company. Often the initial shares are awarded once the sweat equity is complete. This is referred to as ‘Vesting’ or earning the rights to the shares based on some unit of measurement. This section of the Capitalization Clause needs to clearly identify that unit of measurement. Examples of vesting accomplishments for sweat equity may include:
A) Completion of a number of hours of work
B) Meeting preset goals such as negotiating contracts or agreements with other parties
C) Closing on real estate
D) Acquisition of certain pieces of equipment
E) Date related such as the ‘First of New Year 2016’
So the initial subsection describes the actual value exchange for ownership of shares. In addition, this section needs to specify any limits on these shares such as ‘Founder’s’ or ‘Organizer’s’ initial shares with more restrictive covenants or rights. If this is true, then the Capitalization Clause should only address the initial shares. The secondary group is covered in a section of the agreement referred to as ‘Issue of Additional Stock’.
Again, the company must follow the state law and often is required to have permission to issue other forms of stock. Finally, a word of caution about this, if the IRS has granted permission for ‘S-Corporation’ status then there is no need to have classes of stock. S-Corporation status only allows for one class of stock.
Notice the primary purpose is to describe the initial capital contribution but does not identify the ownership percentages. The reality is that shareholders more times than not contribute something other than cash. So it is critical for the drafting of this clause to be divided into three distinct sections. The first section clearly identifies what is being contributed in exchange for ownership rights. Sometimes, this section will have an appendix document clearly identifying the asset in transfer and how it is retitled to the company. I can’t emphasize enough the importance of proper identification and value assigned to the respective assets as this section will act as the proper description for accounting purposes and tax documentation well into the future.
The secondary purpose is to describe the respective ownership percentages that each shareholder will have based on their respective contributions.
Now that we have identified the actual initial contribution, the second purpose is covered here. This subsection identifies the actual number of initial shares and the equivalent percentage of ownership. In addition, if there are stepping levels of issue of the initial stock, this subsection covers this stepping process. Sometimes, the initial contribution is for the formation of the company and stock is issue for voting purposes to set management and agree to the initial by-laws. However, the vesting issues come into play as identified in this subsection. As an example, the wording may state that the three initial investors each agree to contribute $10,000 per the paragraphs above for 100 shares each. On January 1, 2016, Shareholder ‘A’ will vest with an additional 100 shares contingent upon meeting the capital contribution per the paragraph above i.e. achieve the required goal.
Notice how this event changes the ownership or capital structure of the company in a major reorganization. If Shareholder ‘A’ complies with the capital requirements as identified under the primary purpose above and he ‘VESTS’ then he will own 200 shares to the other 200 shares held by shareholders ‘B’ and ‘C’. In effect, he will own one half of the company. So setting these terms is essential; so all parties are clear on what needs to be completed to reset the ownership rights for all shareholders.
Change in Capital Needs
This is the part of the Capitalization Clause that creates the greatest animosity between shareholders (owners) of a company. Often and actually almost all the time, the company runs into problems. One shareholder is silent and fails to provide labor or one of the shareholders has a knack for bringing in more value. As the company ages the relationship between the shareholders become strained often to the point where the company is on the verge of termination. This subsection of the Capitalization Clause is designed to alleviate this problem. Many shareholder agreements are poorly drafted as it relates to this capital funding issue. Many clauses allow a shareholder to contribute more capital and gain control of the company.
Remember in the stock format; any shareholder owning 50% plus one more share technically owns the company. By voting in new management, this shareholder can see to it that all the value of the company is transferred to him leaving the minority owner or owners out in the cold. It is perfectly legal. So this section is designed to either prevent this or minimize the impact of this business dilemma. So how do we prevent this? How do we allow for the one shareholder to escape the company if he is dissatisfied?
Well, first the paragraphs are designed similar to how partnership agreements are written. See Introduction to Partnership Agreements for a more comprehensive understanding. The key is to cover the more obvious issues one by one. The following are the most common shareholder capitalization issues and a brief description and solution.
Additional Capital Required – when a company grows, additional capital is needed. So a paragraph is written identifying the maximum dollar amount of additional capital allowed and a time period for the respective shareholders to contribute that capital. Often 90 days or more is a mutually agreeable time period to contribute additional capital. To resolve any disagreements, this section may articulate that if any shareholder is against contributing additional capital, then it is not a requirement but a voluntary function. However, you will still need to address ownership rights and voting rights. Good solutions to this issue include selling ‘Preferred Stock’ or ‘Convertible Stock’. Caution: S-Corporation status will not allow this type of solution.
Disproportionate Value – often one of the shareholders contributes more time or is the face of the company. When this shareholder is obviously the Key Man he will become disgruntled by the unequal share of value. For the drafter of this subsection of the change in capital needs the solution is either an additional contribution by the other shareholder equal to the value of the key man or as an alternative the key man is highly compensated for his services. In general, a measurement device must be identified and the best device for identification of this value is using an independent Certified Public Accountant. There should be a time period to allow for the other shareholder to select which tool is used to alleviate the value discrepancy. For a more comprehensive understanding of disproportionate value and the corresponding solutions, read my article: Capital Accounts – Business Partnerships and Limited Liability Companies .
Issuance of Dividends – this is one of those good problems to have. Sometimes the business is successful and generates money. The shareholders may disagree on whether to disburse the excess money or maintain the cash for future expansion or operations. Naturally this is a voting issue. But often these agreements are drafted to require a majority or some form of super majority (more than 67%) to make major changes in the capital structure. So a mechanism should be identified to independently direct the issuance of dividends if there is a disagreement. This mechanism can be as simple as a coin flip or using an independent third party to make the decision. This type of capital needs change is rare but I have seen this. The first two are the more common changes in capital needs issues.
In a typical shareholder agreement there are about four or five clauses that affect the business relationship between the shareholders. These include:
- Capitalization Clause
- Sale of a Shareholder’s Stock
- Issue of Additional Stock
- Significant Events Affecting Shareholders
- Inactive Participation
- Sale/Termination/Bankruptcy of Company
The rest of the clauses are mere legal formalities and have little to no effect on the business values to the shareholders.
This article is identifying issues related to the initial and ongoing capitalization of the company. So I’m not going to get involved in the other topics as they are for other articles in the future.
Given this, there are a lot of drawbacks to your typical shareholder capitalization clauses. The most common issue addresses an increase in capital for the operation. Often, a shareholder buys into the company and doesn’t think that in a year or two, the company will need a significant capital injection to either continue operations or expand operations. Often in the small business world, this shareholder does not have the wherewithal to contribute additional capital. The other shareholder or shareholders may have this knowledge and therefore using this clause they can ‘THIN’ down the other shareholder to the point where this shareholder has no ability to control his destiny. Remember this is a business decision and many shareholder agreements do not cover this issue. An easy and best solution is to require unanimous agreement by all shareholders to expand the capital of the company. However, if a shareholder is against additional capital contribution, this may affect those shareholders desiring to expand the company and gain more value. So there are different options.
- Sale of stock to an independent third party, e.g. non family members, no business colleagues; sale may occur with existing vendors, industry associates etc.
- Use of preferred or convertible stock
- Sale of another class of stock (typically nonvoting) to any third party
The second best tool to protect a shareholder is to use a loan agreement whereby the company has no choice but to allow the shareholder the right to maintain their ownership via a loan as their capital contribution. This loan is paid via dividends and those dividends are retained by the company in exchange for a reduction in the loan principle (don’t forget interest is an issue too). Another option is to allow for an extended period of time for the affected shareholder to contribute the respected capital. Good solutions include allowing for one to three years for the shareholder to make payments so they may continue to own their initial percentage of the company.
Much of this additional capital needs issue can be covered in the ‘Sale of Additional Stock’ section or clause.
As identified above, a secondary common capital needs issue is the disproportionate value between shareholders related to work ethic or knowledge. Easy solutions include adjustments to the affected parties’ compensation package or adding additional benefits. For the drafter of the clause, look for independent mechanisms to measure and evaluate the monetary discrepancy. Use non stock tools to alleviate the discrepancy.
So if you are looking to redraft your existing shareholder agreement or you are trying to figure out a way out of your existing agreement; you should look to the ‘Initial Capital’ section of your shareholder agreement for an answer related to the initial issuance or sale of stock. The better drafted documents identify the initial capital contribution, state precisely the ownership rights and finally address any change in capital needs in the future.
There are several drawbacks to many clauses and a well drafted Capitalization Clause will prevent shareholder disagreements in the future. The best tool is to use the unanimous decision requirement but I caution the writer that this may be more of a problem than a solution. It would be best to identify the most likely issues and use independent means of measurement and valuation to compensate those shareholders affected by the drawback. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you.