To understand fundamentals of stock ownership this article first explains the basic rights belonging to a shareholder. These basic rights are commonly restricted in small business with the implementation of a shareholder’s agreement. This agreement identifies the core understanding between the shareholders; especially related to the financial relationship and control issues. Finally, this article will touch base on how this financial and control relationship works and how to protect your investment as either the primary (key man) owner or the investor as it relates to ownership.
Basic Rights of Stock Ownership
Before explaining the basic rights, the reader must understand that there are different forms of stock. Cammon stock which is a certificate granting equal status among shareholders for dividends and pre-emptive rights (the right to buy new shares when offered). The equality is on a per share basis. Typically dividends are authorized and paid on a per share basis. So someone owning 10 shares has more dividend earnings than a shareholder with 9 shares. Other forms of stock include:
A) Preferred Stock – Obligates the business to pay a minimum interest per year; but generally grants no voting rights.
B) Class Stock – Classes are identified in groups such as Class ‘A’ or Class ‘B’. Each class has limitations on rights to earnings and voting power.
C) Convertible Stock. – Allows the owner the right to convert a share into more common stock upon the occurrence of an event, such as a financial milestone or date.
D) Options – The right to buy stock at some specific price or on a certain date.
This package of information is only covering common stock.
Two of the most common misunderstandings related to common stock are the beliefs that the shareholder can act on behalf of the company or manage the company. This misunderstanding is a result of the small business environment because the manager is often the sole shareholder. Common stock confers a right to vote for directors. It is exactly like the American political system. Citizens vote for representatives that in turn set policies. Unlike politics, stock owners do not elect the chief executive; the company’s board of directors appoint the head of the company. So in reality a shareholder controls the company with the ability to elect directors to a board. This voting capacity is the essential element of controlling the company. Without this voting right, a shareholder has little to no say in the management of the company. A shareholder controls the company by voting for directors that in turn appoint a management team.
Almost every state in the union defines common stock with the following fundamental rights:
1) A right to vote for directors in proportion to stockholdings (percentage of ownership).
2) A right to receive dividends if authorized by the board of directors in proportion to stockholdings.
3) A pre-emptive right to purchase additional stock in proportion to stockholdings.
These rights DO NOT grant additional powers including:
1) Acting on behalf of the company
2) Setting policies or procedures
3) Acting in a management role
Notice that these additional powers are the real control powers in a company. So if a shareholder, even a minority shareholder (a shareholder owning less than the largest shareholder) wants to control the company; he can only do this by electing directors to the board that will put in place a management team and set policies to establish this control. So how can a minority shareholder obtain this power over an equal or majority shareholder? The answer lies in the shareholder agreement.
The purpose of the shareholder’s agreement is to document the legal and working relationship for all shareholders in small business. In almost every case one of the shareholders is the primary driving force of the business. This shareholder is commonly the originator or founder of the business. The other shareholders were brought in for their capital investment. In some situations all or the majority of shareholders work in the company. This is often true in family business operations.
A well written shareholder’s agreement sets the limitations for the respective shareholders. There are basically three kinds of shareholders. The first kind of shareholder is the key man that wants to both own and control the company. In most cases this individual is the founding shareholder and the one with the knowledge and persistent. As to control, this owner understands how the company must be managed and controlled.
The second kind of shareholder is the investor. He is there solely for the return on his equity investment. Often this individual has more dollars tied up than any other kind of shareholder.
The third kind of shareholder is the partially invested shareholder. Commonly, this person is a family member that is only there for a job or to fulfill a legal compliance obligation or serve as a proxy for the key owner.
The basic relationships above are control and ownership. Control allows the individual to steer the company and dictate the policies and procedures. Whereas ownership is more oriented towards the financial gains the business potential brings.
The shareholder agreement must be drafted to protect all kinds of shareholders. Remember this document restricts the common stock rights that are granted by law. Without this signed document by all shareholders, control and ownership is equal for all shareholders based on their proportional share.
There are three shareholders of ACME Company with ownership percentages as follows:
Shareholder Shares Issued % of Voting Rights
X 48 48%
Y 49 49%
Z 3 3%
Total Outstanding Shares 100 100%
Which shareholder controls the company?
Without a shareholder’s agreement, none of the shareholders control the company. Novice business entrepreneurs will say that ‘Y’ controls with a 49% ownership position. In reality, all three shareholders control equally. How so?
Without a shareholder’s agreement state law governs the definition of control; which means 50% plus one more share is required to appoint directors (remember, directors appoint officers to manage the company). ‘Y’ needs to form a coalition with either ‘X’ or ‘Z’ to achieve a 50% plus one more share’: This means ‘Z’ with only 3% voting power has as much control as ‘X’ and ‘Y’. All three are equal as it relates to control.
The difference is in ownership. Each is entitled to profits based on their respective percentage of stock holdings. Shareholder agreements can restrict the voting rights for shareholders, thus changing control. As an example, using the ACME, Company example above, the voting restrictions can be stated as below:
A shareholder is allowed to appoint one director for every 24.5% of all voting shares. Any voting capacity of less than 24.5% or remainder is equal to zero votes. So let’s look at the shareholder’s rights to appoint directors:
Notice now how ‘Y’ appoints 2 directors and also controls the board of directors with 2 out of 3 votes? So now ‘Y’ controls the company and owns the plurality position.
This is how family businesses can manipulate the company to benefit certain family members. In the ACME, Company the three could be siblings. ‘Z’ has no real interest in the company but the parents are advocating that this company is a family business. Thus ‘Z’ is now an owner satisfying Mom and Dad and yet has no control and limited financial reward. Now let’s flip this around. ‘Z’ is the patriarch of the family, founded the business and wants to continue controlling the company; yet, financially reward his two children ‘X’ and ‘Y’. How can the shareholder’s agreement be written to achieve this goal?
There are several different methods to do this, look at the following methods:
In a typical small business there is only one or just a few directors (original owner, the lawyer, the CPA etc.). The shareholders agreement states that the director(s) are permanent and upon termination or death of a director only the original shares can appoint a replacement. This means only the shares owned by ‘Z’ have voting rights.
Another method is tenure. The agreement restricts the ability for a shareholder to vote his/her shares unless a minimum time of ownership as elapsed (like 15 years). An exclusion clause may stipulate that if no shares meet the minimum time requirement, then the time period for holding decreases in one year increments until there is a minimum number of shares complying with tenure (meeting a time test). So if Dad dies, the next most senior shareholder assumes voting capacity, i.e. can appoint the directors.
The agreement states that existing director(s) can not be replaced without 100% approval of all existing stock. Thus the existing board remains intact.
Certain share certificates have no voting rights related to appointing members of the board of directors. ‘Z’s certificate carries this right whereas ‘X’ and ‘Y’ have this restriction. With the above methods ‘X’ and ‘Y’ may own significantly greater proportion of the company yet lack the ability to control the corporate operations.
Overall the shareholder’s agreement can be drafted to dictate both control and ownership no matter what percentages of ownership exist for shareholders. Naturally I encourage owners of a business to communicate and work with an attorney familiar with business agreements. Read How to Find a Good Attorney located in the legal section for more information.
From the perspective of pure ownership, this shareholder agreement appears to grant more power to the control aspect at the cost of ownership. This is especially true if the officers are allowed to set their own salaries. Even if the board of directors set the salaries of officers and the board is controlled by a limited shareholder pool it is quite easy for the board to drain profits thus negating any value passable to other shareholders (those shareholders invested for monetary gain). Review this illustration:
ACME, Company – Profit Manipulation
‘Z’ founded a drilling and pump production company serving both energy and water extraction companies. To purchase the necessary equipment, ‘Z’ sold off 90% of his company to both ‘X’ and ‘Y’. ‘Z’ wrote the shareholder agreement granting control to himself. ‘Z’ appoints all three directors. Over time ‘Z’ begins to distrust ‘Y’ and ‘Z’ and decides he should receive the bulk of the generated value by dictating to his directors an increase in his salary. An additional $200,000 is approved as a raise to ‘Z’. Review the following schedule to understand the impact on ‘Y’ and ‘X’:
‘Z’ used his control to also gain the value customarily granted to ownership. It would appear that ownership is too risky to even get involved. So how is the shareholder agreement written to protect a true and pure investor (one that is only interested in his share of profits)?
There are actually several tools written into the agreement to protect ownership rights. One tool is the right to appoint a minimum number of directors. In the above case, the by-laws are written to state that a unanimous agreement is required from the board to authorize the salary of any officer or key man. Secondly, the board is expanded to five directors. The shareholder’s agreement grants both ‘X’ and ‘Y’ the right to appoint a director each. Now ‘X’ and ‘Y’ are protected from profit manipulation by ‘Z’. In addition a clause is inserted stipulating that any by-law changes requires a 100% approval from all shareholders. This clause is inserted in the by-laws.
To truly protect owners from profit manipulation or full control by a minority shareholder provisions are included in the shareholder’s agreement or by-laws for the following:
A) Borrowing of money by the company in excess of a certain debt to equity ratio requires full approval of all shareholders.
B) All unsecured debt must by guaranteed by the controlling shareholder (increases the risk to the controlling shareholder).
C) Any fixed asset purchase in excess of a certain set sum of dollars must have 100% shareholder approval.
D) Any retained earnings in excess of a certain balance must be distributed to all shareholders within three years.
E) There must be 100% board approval to hire family or proxy employees (this is in the by-laws).
F) Acts discredible to the company performed by the controlling shareholder is grounds for termination and/or dissolution.
A CONTROLLING SHAREHOLDER DOES NOT MEAN A MAJORITY OR PLURALITY OWNERSHIP OF SHARES. A CONTROLLING SHAREHOLDER IS ONE THAT IS GRANTED THE RIGHT TO MANAGE THE COMPANY. THIS POWER VESTS FROM THE SHAREHOLDER’S AGREEMENT.
As stated earlier, a good business attorney can draft a set of by-laws and a shareholder’s agreement to achieve proper control and protect ownership rights.
Summary – Stock
The shareholder’s agreement is designed to protect ownership and grant control to the founding owner. In general the document restricts the three primary rights granted to shareholders. These rights include 1) the right to vote for directors in proportion to shareholdings, 2) the right to a proportional share of dividends when authorized and 3) pre-emptive rights to purchase more shares in accordance with existing proportional ownership.
Restrictions focus on control of the company’s operations and ownership (access to generated profits). Clauses in the document stipulate control and ownership. Most importantly, a well drafted document sets the legal and working boundaries so the business can thrive and achieve success. 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. If interested in my services as an accountant/consultant; click on ‘My Services‘ in the footer of this article.