In this article we explain stock transfer restrictions in closely-held corporations and LLC. We answer the question: “when are stock transfer restrictions beneficial?” We discuss how to structure stock transfer restrictions in your operating agreement or buy-sell agreement. We explain various options for restricting transfer of ownership interests including requirements that the board or other shareholders approve a transfer of stock, rights of first refusal for transfer of stock, and mandatory purchase of stock by the company or other shareholders.
Closely-held corporations and LLCs generally have a small group of owners who have intentionally chosen to do business with one another. It is frequently important to all concerned that the owners have control over who may become a partner in the business going forward. To this end, owners of closely-held corporations and LLCs will often incorporate limitations on the transfer of ownership interests to third parties into either their LLC operating agreement or a buy-sell agreement.
A stock transfer restriction is essentially a contract between the shareholders of the corporation or members of the LLC. Therefore, the owners have the ability to be extremely creative in crafting a stock transfer restriction that meets their specific wants and needs. Stock transfer restrictions come in several general flavors:
We will discuss each of these types of limitations individually, but it is important to understand that they are often combined with one-another in an effort to provide security to the owners who are not disassociating from the company while at the same time avoiding holding a disassociating owner captive.
One method of ensuring that the owners of a business have control over who they partner with in the future is to require that a certain percentage of the board of directors, the shareholders, or members approve any transfer of stock to third parties.
This has the advantage of giving the remaining owners the most protection against doing business with someone that they would prefer not to. It also avoids putting the remaining owners in a position where they will need to raise capital quickly in order to prevent a sale to a third party.
The major downside of this method is that it is the most restrictive to owners who wish to disassociate from the company. It can lend itself to a situation where one owner who wishes to sell is held captive by the other owners. The remaining owners can refuse to allow a sale to a third party in an effort to force the selling owner to sell his or her shares to the remaining owners at a significantly reduced price.
One way to temper this potential unfairness is to combine a requirement of approval with a requirement that, should the company refuse to allow a transfer to a third party, the company or remaining owners be required to buy the shares at a price that is agreed in advance in the operating agreement or the buy-sell agreement.
The most straightforward way to limit the transfer of stock is to give the company or remaining owners the right of first refusal. In this scenario, the selling owner is required to bring a third party offer to the other owners who will have a fixed period of time to exercise the right to purchase the selling owner’s stock at that price.
This method has the advantage of ensuring that a selling owner will be able to sell his or her shares at fair market value. Market value is easily established by the offer that the selling owner receives from a third party. Proponents of this approach would argue that the remaining owners are protected, because if the potential third party owner is truly a concern they have the option to purchase the stock themselves.
However, the downside of this approach is that it requires the remaining owners to come up with the capital to purchase the selling owner’s stock within a relatively short amount of time if they want to avoid the third party transfer. This problem can be tempered by requiring the seller to finance the sale to the remaining owners, allowing the remaining owners to pay for the stock over time via a promissory note rather than in a lump sum.
Often, when an operating agreement or buy-sell agreement requires that a sale of stock to third parties be approved by the company, the agreement will also provide that if the approval is denied the company or other shareholders are required to purchase the stock at a set price.
This might take the form of a fixed price set forth in the agreement, fair market value as determined by an appraisal, or an industry-specific formula to determine the value of the stock. For more, check out: How to Determine a Business’ Value for Buy-Sell Agreements.
Often, the agreement will provide that once the actual value of the stock is determined by appraisal or formula, the company will have the luxury of purchasing the stock at a reduced price: a certain percentage of the actual value. This is often agreeable to all concerned when the operating agreement or buy-sell agreement is executed, because it disincentivizes owners from disassociating with the company while still providing them with an “out.”
Like a right of first refusal, the mandatory purchase of stock presents the problem of raising capital to purchase the stock. This problem may be tempered by use of a promissory note. For a discussion of other methods to provide for this scenario, check out: How to Fund a Buy-Sell Agreement.
Stand-alone mandatory purchases of an owner’s shares are most common when the company wants to provide an exit strategy for owners’ retirement after a certain period of time with the company.