What is an Equity Ownership Agreement?
Equity ownership agreements are written contracts that outline the rights and obligations of the parties with respect to the recorded equity ownership holdings. These agreements generally specify the terms under which each party is entitled to participate in the management of the company, receive distributions, transfer or dispose of its equity ownership and – in the case of a winding up, sale or merger – receive its equitable share of the proceeds. Specific provisions may vary based on the legal form of the entity involved, the relevant federal law (IRS and SEC), the relevant state law and the type of transaction. For purposes of this discussion, we will refer primarily to a corporation that has elected corporate taxation .
In the context of an acquisition or sale of a business, the equity ownership agreement traditionally forms the framework to which parties will look to determine their rights to participate in the transaction, whether as an "investor" (i.e., a purchaser) or as a seller of the equity securities of the company. Equity ownership agreements typically come in two forms – a subscription agreement for new issuances and a stockholders’ (or shareholders’) agreement for existing issuances. For example, a subscription agreement generally provides that the issuer has an obligation to sell securities, whereas a stockholders’ agreement would grant the incoming investor the right to purchase exiting ownership interests and/or regulate the transfer of such interests among existing owners. Other agreements, such as an investor’s rights agreement, provide basic protections to the investor, such as information rights and tag along and/or drag along rights.
Key Features of an Equity Ownership Agreement
The key elements of an equity ownership agreement vary depending on the nature of the business and the relationship between the parties involved. However, a well-crafted agreement will generally include the following components:
Ownership Percentages: Clearly defining the percentage of equity each owner holds is essential. It protects against disputes over ownership stakes later on.
Rights and Responsibilities: The agreement should outline the rights of each owner, such as voting rights or decision-making authority, as well as their responsibilities, such as contributions of time or capital.
Transfer or Sale of Equity: Provisions regarding how an owner can transfer or sell their equity to another party can prevent conflict and ensure that the business is not forced into difficult taxation or finance situations because of unexpected changes in ownership.
Non-Compete and Confidentiality Clauses: These clauses can protect the business from unfair competition and unauthorized disclosure of sensitive information.
Dispute Resolution: Having a pre-agreed method of resolving disputes—whether through negotiation, mediation, or arbitration—can save time and money in the event of a disagreement among owners.
Length of Agreement: While most agreements are effective indefinitely, specifying the term of the agreement can be useful if all parties wish to review and potentially renegotiate terms periodically.
Termination: The exit strategy for any business should be outlined in the agreement, including whether it is voluntary or involuntary, how remaining owners are to be compensated, and whether the business will be dissolved or passed on to other owners.
Advantages of Using an Equity Ownership Agreement Template
One of the top benefits of using an equity ownership agreement template is the ability to save a significant amount of time. When developing the agreement from scratch, there are several hours of work that must be invested if you want to do an adequate job. However, with a template, you can have the agreement completed within a fraction of the time.
Using an equity ownership agreement template will also help ensure that you are complying with applicable laws. Real estate law can be very complicated, but by purchasing an equity ownership agreement template that was developed by a legal professional, you can ensure that you are covering all of the relevant laws. Beyond making sure that you are in compliance with the law, using a template will help you in a number of different ways.
It provides a clear and structured format that you can stick to while developing the agreement. This can help you maintain your focus on the important points that need to be covered. It also makes it easier to reach an amicable agreement with the other parties involved in the contract. They can work on their own portion of the agreement by using a copy of the template while you work on yours. When you get together, the two of you can merge the two contracts together and complete a final copy.
A frequently overlooked benefit of using a template is the fact that you will have a copy of the contract that is saved. Whether you send a copy through e-mail or by mail, you will have a record of the contract and the date that you sent it to the party you signed the contract with. This can be useful in the unlikely event of a legal dispute.
How to Personalize an Equity Ownership Agreement Template
It is important to remember that any customized language (such as the names, roles and contributions of various individuals) should be approved by legal counsel prior to finalization. Each agreement is a bit different, based of the following factors: while the same general principles and ideas can be utilized across documents, the unique terms and key points are different for each.
Changes to the pre-printed language should also be reviewed and reconciled with the existing terms in order to ensure consistency throughout the document, and so that the new text does not conflict with other parts of the document. You may also run into conflict with other agreements such as, buy-sell agreements and/or employment agreements.
Below is a list of areas where you may be able to customize your equity ownership agreement template. It is not intended to be all-inclusive, as there are many factors to consider when relying on these generic templates.
A small word of caution: use these areas as a starting point only. Depending on factors that are unique to your business entity, you will find that certain provisions may not apply.
Equity Ownership Agreement Mistakes to Avoid
When drafting or completing an equity ownership agreement, individuals often make the following mistakes and omissions:
- Mistakes regarding the applicability of the FREE OPTION. You could be tied into an agreement for more than ten years if you agree to an option that does not apply to you. Agreements are pretty much standardized and you may assume that you are going to get the free option when in fact the business has an option that does not apply to you.
- Insufficient space for the parties to sign. You need to have room for all the parties to an equity ownership agreement to sign. You have to pre-qualify all parties before you have an agreement signed. There is nothing worse than having a deal in writing and not having enough space on the agreement for all the parties to sign.
- Not having the Form 1023 completed correctly. Most filings of the form 1023 are incorrect and will get bounced by the IRS unless you are very careful about completing the form. All of our clients complete this form themselves and we do not charge them to re-do it prior to filing. Everyone in our office reviews these forms because they are so important.
- Never having a date on the agreement. All equity ownership agreements are prepared without a date on them . The day you execute and get an agreement signed is the date you want for the agreement.
- Using the wrong form or agreement for the situation. You must have the correct agreement for the specific situation. Agreements are all different and they are all wrong for the individual business owners.
- Incorrectly filling out the equity ownership agreement. All agreements are filled out the same way. If you don’t do them correctly you are going to end up with an incomplete agreement. All owners should have some kind of a stock/s membership interest certificate. Some people think that they are going to put an agreement in place without having a certificate. You are going to have to have the certificate. They are not very expensive. Equity ownership agreements must be prepared and signed correctly so that they can be found for all owners.
- Not getting the consent of all owners. The agreement will not be valid if the agreement is not signed by all owners. I see all kinds of agreements that were partially signed. Every single party no matter who they are must sign the agreement before it can be valid. Remember also that a member of a limited liability company is treated as a partner, so you must have consent from all members of the LLC.
Legal Considerations and Compliance
Before committing to an equity plan, it is essential for employers to ensure the provisions are not inadvertently discriminatory. The granting of equity ownership should likewise be in accordance with applicable state and federal law, such as Disparate Impact regulations, especially if the employer is a government entity. Obtaining a determination on whether the granting of equity ownership will result in a discriminatory impact requires the following analysis.
First, the parties must identify the practice(s) at issue. This includes not only the particular employment practices considered discriminatory, but also the effects of the challenged practices on different groups, and how those practices contribute to the disparity. Employers should perform a statistical analysis of the data that establishes the existence of a disparity. In this instance, demographic information is usually used.
The next step is to establish a legitimate business justification for the practice. Specifically, the employer must show that the practice that would otherwise be discriminatory is actually job-related and necessary to the business. A legitimate business justification exists if the practice, even though it may have a disparate impact on a protected class, is necessary to successfully accomplish the employer’s business purpose and is related to the job. Employers should remember that this test is included to validate the employer’s right to establish neutral employment practices.
This leads to the final step, which is demonstrating that there are no alternative practices that have less adverse effects. This requires an employer to show they considered other employment practices that would have achieved the same business goals without adversely affecting a protected class.
The foregoing steps differ from the analysis used for employment discrimination litigation. An employee claiming that a particular practice satisfies the second element of a prima facie case must merely show that the practice has a disparate impact on a protected class. Courts typically disregard the contrary evidence at that stage, so long as the evidence was sufficient to create a presumption of discrimination. Under this approach, the burden of production, not the burden of proof, shifts to the employer to demonstrate that the practice was justified by business necessity under the ultimate test of whether the practice is "related to job performance." An employer could prevail at this stage by showing that the challenged practice is job-related, but an employer defending under the business necessity test is not limited to job-related defenses, but may rely on any nondiscriminatory reason that, through the use of objective factors, defeats the inference of discrimination.
Some courts have embraced this definition of the business necessity defense and rejected tighter formulations. The Third, Seventh and Eleventh Circuits, for example, have accepted the broader view of business necessity.
Frequently Asked Questions on Equity Ownership Agreements
How can equity ownership agreements protect founders and investors?
Equity ownership agreements set forth the rights and responsibilities of owners, founders, and investors. Without these documents, who gets a say in major decisions regarding the business and how are profits split among owners? Equity ownership agreements provide protections and rights for all parties involved in the business — founders, investors, and management.
If I use a company formation service, do I still need equity ownership agreements?
Using a company formation service will not replace the need for equity ownership agreements. For example, even if you file Articles of Incorporation to form a new C-Corporation or S-Corporation, there is usually a provision in the governing state corporation code allowing shareholders to create a more detailed shareholder agreement to outline more specific rights and responsibilities for shareholders .
Do equity ownership agreements require professional legal help?
It is recommended to consult a business attorney when creating equity ownership agreements. However, most small business owners can complete equity ownership agreements without an attorney by using agreement templates.
Are equity ownership agreements different for LLCs and C-Corps/S-Corps?
Yes, equity ownership agreements such as membership interest purchase agreements are different than shareholder purchase agreements for W-2 entities. Member interest purchase agreements are generally similar to partnership agreements where the owners can have a single membership interest each (1 vote) or have membership interests based on any combination of percent ownership and voting rights. Shareholder purchase agreements are generally either unanimous consent agreements or are based on capital stock distributions (e.g., 1 share, 1 vote).