Shareholder Departure Legal Issues

When a shareholder leaves a company, various issues can arise regarding the shareholder’s legal liability and obligations to the company, and how the shareholder’s stock in the company should be transferred. How these issues are handled depends on the individual circumstances involved, the reasons for the shareholder’s departure, and to a great extent the intent of the original shareholders and the agreements reached between them.

One of the primary concerns is how the company’s equity is allocated, initially and over time. The shareholder’s interest may be based on contributions of cash, property, skills and know-how, marketing ability, product development, or some combination. One way the company can control outright ownership of the stock, which will affect the buy-out paid to a departing shareholder, is to “vest” the stock. This could be based on a calendar vesting schedule, in which the shareholder earns a percentage of the stock for each year with the company. Another alternative is “milestone” vesting in which ownership depends on the achievement of clearly identifiable milestones, such as completion of a product prototype, or first shipment of a product.

The original shareholders may have established a stock restriction agreement, by which the remaining shareholders have a preferential right to purchase the stock from a shareholder who departs for any reason. This type of agreement is generally instituted to give the shareholders control over who participates in the company. How the shares are valued at the time of departure will be a critical point, and should generally be predetermined when the agreement is established. This could be the fair market value, an agreed value or an appraised value. The terms of any venture capital or other financing the company has received must also be taken into account before making payment to buy out the departing shareholder’s stock.

The departure of a shareholder could potentially involve breach of contract or breach of fiduciary duty. If the shareholder is also an executive or employee of the company, there will be an employment contract, either explicitly in writing or implicit. Certain actions by the shareholder leading up to the departure could be considered a breach of the contractual terms. Corporate law also imposes a fiduciary duty on the directors that requires them to act in the best interests of the company’s shareholders. In a closely held company where the shareholders work together and may act as directors, there could be a breach of fiduciary responsibility when, for example, by leaving the company, a majority shareholder who is critically important to the company could potentially damage the interests of smaller shareholders.

A covenant not to compete places certain restrictions on a departing shareholder, such as a prohibition on working in the same field for a period of time after leaving the company, using insider knowledge of the company’s customer base to unfair advantage, or recruiting employees from the company to start another business and create new competition. The key to a fair non-competition agreement is to clearly set out the areas of concern and strike a balance that addresses the legitimate business interests of the company without placing an undue burden on the departing shareholder.

Provisions should be made to protect the company’s intellectual property including patents, copyrights, trademarks, and trade secrets. This protection should extend to all intellectual property contributed to the company or developed during the course of the business. There should also be a confidentiality agreement to prevent the departing shareholder from disclosing proprietary information that a third party could use for its own benefit.

Many of the issues that can potentially arise when a shareholder leaves the company can be foreseen and the means for resolving them can be included in a shareholder agreement. A shareholder agreement should include an arbitration clause designed to resolve disputes that could lead to a shareholder’s departure. And the agreement should specify an exit strategy specifying the rights on sales of shares between existing shareholders, and rights when a third party offers to buy the shares of a departing shareholder. The key to minimizing the legal issues that arise when a shareholder leaves the company is to plan ahead and define as many potential issues as possible in the shareholder agreement.