Shareholders' agreements - a valuable tool in buy-ins

NOTE: The following article is from the collection of articles in our Automobile Dealership Buy/Sell Newsletters. The newsletter deals with the complex area of buying and selling automobile dealerships. Some of the material may not be up to date because of changes in the law from the date shown at the end of the article. This article is not to be taken as legal, accounting, tax, or other advice. You should consult your own professionals for such advice and for any updating of the information provided.

A “buy-in” can present thorny problems to parties in dealership transactions but these problems can be addressed, and future difficulties avoided, through thoughtfully negotiated Shareholders’ Agreements.

The purpose of this article is to describe the important issues that need to be addressed before going forward with a buy-in opportunity – particularly concerning the management of the business (i.e., how are important business decisions to be made), and future control over the trading and ownership of the dealership business entity. I will also review alternatives for handling these issues in dealerships formed as corporations (whether “C” or “S”).

A “buy-in” generally refers to the sale of equity in a dealership, with the original owner retaining an ownership interest, often, a majority interest. A variety of motives support the decision to allow a buy-in, such as retirement planning, attracting or keeping key management personnel, or obtaining necessary capital investment.

The sale or transfer of equity in a dealership corporation is generally accomplished by stock transfers. While other ways of allowing equity participation exist, such as profit sharing plans and even shadow stock, the fact that traditional buy-ins require factory approval all but ensures that an immediate transfer of a least some stock will be required. The stock could come from a sale of the existing shareholder’s stock, or as part of a new issue from the corporation. The number of shares ordinarily involved in this type of buy-in transaction is less than 50% of the total number of outstanding shares, although we have seen buy-in transactions whereby the selling shareholder and buying shareholder will each become 50% shareholder owners of the dealership corporation.

In the absence of other arrangements which will be discussed below, a corporation is subject to the control of those holding a majority of its voting shares. Although the directors of the corporation technically have the power to make all management decisions, they serve at the will of the majority shareholders i.e. those holding a majority of the voting shares can elect a majority of the directors, and can remove such directors from office at any time, with or without cause.

However, there are several devices which may curtail the majority running rough-shod over the minority and which can prevent deadlock situations in the event each shareholder owns exactly 50% of the stock. Examples of such devices include:

An article in the articles of incorporation requiring a greater than majority vote (“supermajority”) by the shareholders or directors in order to authorize certain acts. For example, the provision could provide that for all acts the law says need director or shareholder approval, that approval must be by 66% of the shareholders. This can give minority interests some degree of veto power to stop actions detrimental to their interests.

A shareholder pooling agreement whereby two or more shareholders agree to “pool” their votes, or to vote in a specified way on specified manners for an agreed period of time. Sometimes the question is raised of whether a court can force the parties to vote as the pooling agreement says (“specific performance”), or whether the court would be limited to awarding damages after the breaching votes were cast and counted. Shareholders of statutory close corporations, discussed in greater detail below, enjoy the advantage of knowing that their pooling agreements may be specifically enforced.

• A voting trust in which each shareholder involved transfers legal title to his or her shares to a trustee in return for a “voting trust certificate;” although the certificate evidences the shareholder’s equitable ownership of the shares and right to dividends and distributions from the corporation, the right to vote the shares is conferred upon the trustee for the life of the voting trust. Voting trust arrangements are valid for any corporation (not just statutory close corporations) as long as they meet certain California statutory requirements i.e. a voting trust must be in writing, open to shareholder inspection, and for a duration of up to ten years.

• A shareholders’ agreement, which is an agreement among all shareholders of a close corporation (or between a sole shareholder and the corporation) regarding the way the corporation is to be managed. California corporations can reap the full benefits of shareholders agreements only by electing close corporation status, which election is made by amending the articles of incorporation. In California, and other states where shareholders’ agreements are valid and enforceable, such agreements have become as important as the articles of incorporation and bylaws of the corporation in fixing the management situations under which the corporation will operate and in essence have become to a close corporation what a partnership agreement is to a partnership.

Of the devices discussed above for allocating management and control of a corporation in a manner disproportionate to share ownership, the most advantageous and flexible device for the dealership business would be the use of a shareholders’ agreement. One approach to using these agreements involves creating a list of all types of decisions the business would expect to make, ranked in order of importance. The parties would then agree that the shareholders’ agreement will authorize action by the board of directors or certain officers alone as to all matters below a certain point on the list. As to all matters above that line, the shareholders rather than the board or officers would exercise direct control. While this line drawing is totally up to the parties, matters “above the line” usually include election of directors, fixing of managers’ salaries, distribution of dividends, and the like. Without close corporation status, such agreements would probably be invalid because such matters normally rest within the exclusive jurisdiction of the board of directors.

In addition to the permitted use of shareholders’ agreements, there are other advantages to a corporation electing close corporation status because it enables the business to be run more flexibly and informally than is permitted with other corporations, i.e. the shareholders can function pretty much as owners of the business, like partners without the necessity of observing many typical corporate formalities. It is not difficult for a dealership to become a close corporation by complying with the following four requirements which the corporation must meet: it must be a “corporation” under the California General Corporations Law; the corporation name must contain the word corporation, incorporated, limited or some abbreviation of those words; the number of shareholders of the corporation cannot exceed 35 (with a legend on all share certificates to that effect); and its articles of incorporation must contain the statement “This corporation is a close corporation.”

The benefits of a close corporation shareholders’ agreement stand out most sharply in the scenario of an exact 50/50 buy-in. In this situation, each shareholder would want the right to elect the same number of directors and thus the corporation could face constant deadlocks in reaching corporate decisions respecting issues of management and control.

However, by utilizing a shareholders’ agreement, the selling shareholder and buying shareholder can agree up-front as to the division of management. True 50/50 buy-ins may require a three-way division of control, among the board, the shareholders as a group, and a managing shareholder acting alone. For example, the selling shareholder may want, at least temporarily, to be the managing shareholder and thereby retain exclusive management and control over matters such as banking arrangements and borrowing decisions; decisions relating to the dealership floorplan lines of credit and financing of retail contracts sold; decisions relating to the hiring and firing of dealership personnel; and franchise decisions affecting the dealership business. The remaining management decisions could be allocated between the board of directors and the shareholders as a group, i.e. the shareholders would have to approve certain fundamental corporate decisions, such as corporate mergers and voluntary dissolutions, whereas the board would be charged with making the remaining decisions. The shareholders’ agreement could also provide mechanisms in the event of a corporate deadlock on those issues left to the board and/or majority vote of the shareholders. One such mechanism is mandatory binding arbitration.

After a buy-in, the parties will want to prevent unanticipated transfers of ownership of shares of the corporation’s stock. Here again, the shareholders’ agreement can include cross-purchase options in favor of the corporation and shareholders giving such parties a purchase option at a specified price upon the “trigger events” such as the death or disability of a shareholder; the attempted sale of stock by shareholder to a third party; or the attempted involuntary liquidation of the corporation by a shareholder.

All of this is only a brief sampling of the power of shareholders’ agreements. They may also specify methods of distribution of corporate income that are not controlled in any way by share ownership percentages. Likewise, shareholders’ agreements may control amounts to be received by the shareholders upon dissolution, again, without reference to the actual number of shares held. Before making use of these rather drastic tools, however, dealers should be sure that all tax and legal implications have been reviewed by counsel and tax professionals. With proper care, shareholders’ agreement can prove to be a very valuable tool for a dealer who is contemplating a buy-in transaction.

This article was written in 1996.