If someone wishes to sell or transfer their shares, you may want the other shareholders to have to approve the transfer first.
Let's look at an example. Let's say you go into business with two of your friends, Bill and Richard. You get along really well with them and share the same vision for your business. Bill eventually decides that he wants to go another direction and tells you he doesn't want to be a part of the business anymore. He still owns his shares, of course, so he decides to sell them to Elon. But there’s a problem: you really can't stand working with Elon. Your visions are different and there's no way you can see yourself working well with him. On top of that, Elon has a business that could compete with yours.
To avoid this bad business partner issue, you can make share transfers subject to the approval of the other shareholders.
We make a few exceptions where a shareholder vote is not needed:
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- Transfers to holding companies and trusts for tax and estate planning purposes, so long as the individual shareholder maintains control.
- Special cases of transfers that we'll go over in the next few questions, including rights of first offer and refusal, drag-along rights, tag-along rights, and shotgun clauses.
There will come a time when you may want to issue new shares in your company. Each time you do, the percentage of the company owned by your current shareholders goes down and so does the voting control they have. This is called "shareholder dilution".
One way to deal with this problem is to give each shareholder the right to buy any new shares being issued first before they are offered to someone new that is not yet a shareholder. This is known as a “preemptive right”. It works by giving existing shareholders the right to buy the same proportion of new shares as what they currently own. So for example if someone owns 20% of the company today, they can buy 20% of any new shares offered.
One important thing to understand about a preemptive right is that it is just the right, not an obligation, to buy new shares.
A right of first offer means a shareholder who wishes to go find someone to buy their shares has to first offer to sell the shares to the other shareholders.
Sometimes a shareholder decides it's time to see if they can find some outside party to buy their shares. A right of first offer means that before a shareholder can look for an outside party to sell their shares to, they have to first offer the shares to the other shareholders.
If the other shareholders do not want to buy the shares, then the selling shareholder is free to go look for an outside party to buy them for the same price and on the same conditions as were offered to the other shareholders.
The selling shareholder has 6 months to go find a buyer. After that, the right of first offer rules begin again.
A right of first refusal means when a shareholder gets an offer from an outside party to buy their shares, they have to give the other shareholders a chance to match the offer.
A right of first refusal means that if a shareholder receives an offer to buy their shares from an outside party, the shareholder has to first let the other shareholders match the offer. If the other shareholders want to accept the offer, then they get the shares. If the other shareholders refuse to match the offer, the sale goes ahead to the outside party.
What's the difference between a Right of First Offer and a Right of First Refusal?
You may be wondering what the difference is between a right of first offer and a right of first refusal. They are very similar and the difference comes down to the order of events.
If the outside party offer comes first, then you follow the right of first refusal rules. The price is set by the outside party. The other shareholders have to decide whether to match, or refuse to match, the outsider's price and terms.
If there is no outside party offer yet but the shareholder has decided they want to go find someone to sell their shares to, then you follow the right of first offer rules. The shareholder that wishes to sell sets the price. The other shareholders have to decide if they want to accept the offer.
In both cases, the outcome is basically the same - the other shareholders get the first opportunity to get the selling shareholder's shares if they want them. If not, the selling shareholder is free to go ahead with a sale to an outside party.
When you're selling your business, a potential buyer may offer to buy all the shares of the company. If a majority of the shareholders want to accept the offer, a drag-along right means they can force the other shareholders to also sell their shares.
Let's say you have an offer from someone to buy your company and a majority of the shareholders want to go ahead with the sale. Great! But, you have one shareholder that's just not agreeing to go along with the sale and is holding it all up. The person who wants to buy your company may back out because they want all of the company's shares, not just part of them.
To get around this problem, you can have a "drag along" right. It works just like it sounds - the other shareholders can force the uncooperative shareholder to sell their shares, dragging them along in the sale of the company if they have to.
A potential buyer may offer to buy shares from just one or a few shareholders to gain control of the company, rather than buying shares from everyone. A tag-along right gives the left out shareholders the right to join in on the deal and sell their shares, too.
Let's say you have an offer from someone to buy your company but they only want a part of it – just enough to control the voting of the company. As an example, say you have three shareholders in your company, each owning a third of the voting shares. The buyer offers to buy the shares of just two of your shareholders, so one shareholder is left out.
A tag-along right is meant to give some fairness to the left out shareholder by allowing him or her to join in on the deal. In our example if the third shareholder decides to tag along, he or she joins in on the deal on the same terms (e.g. price, etc.).
You may see a problem here though. The buyer only wanted 2/3rds of the shares, not all of them. If the buyer does not want to buy all the shares now with the tag-along shareholder joining the deal, we make an adjustment. All three shareholders will now sell 2/3rds of their shares, so no one is left out.
A shotgun clause is an agreement between shareholders that allows one shareholder to put a price on the table for the value of the business and leave it up to the other shareholder(s) to take the money or match the offer.
A shotgun clause is meant to end a disagreement between shareholders by forcing one of them out of the company. So, it is a pretty serious clause to consider putting into your agreement. Here's how it works.
Alex decides he wants to either (1) sell all his shares to Brian and Chelsea or (2) buy all the shares of Brian and Chelsea. But one way or another, someone has to go. Alex tells Brian and Chelsea that he is triggering the shotgun clause and is offering to sell his shares for $100 per share.
Brian and Chelsea have a choice to make. They can choose to buy Alex's shares for $100 per share or they can sell their shares to Alex for the same price. There are three basic outcomes:
(1) If both Brian and Chelsea decide to buy Alex's shares, then they will buy Alex’s shares and divide them up between them according to their existing ownership position in the company.
(2) If both Brian and Chelsea decide to sell their shares to Alex, then Alex must buy all of Brian and Chelsea's shares for the $100 price per share that started the shotgun.
(3) If Brian decides to buy Alex's shares but Chelsea decides to sell her shares to Alex, then Brian ends up having to buy both Alex's shares and Chelsea's shares.
So as you can see, in a shotgun situation someone ends up going. That's how it's used to end shareholder fights. Shotgun clauses are a little dangerous because of that; if you include one, you must be prepared to lose your shares if the shotgun clause is triggered.
