Checklist – Shareholders’ Agreement for a Design Professional Corporation

Checklist for Drafting a Shareholders’ Agreement for a Design Professional Corporation

By James E. Robinson, Esq.

When preparing a shareholders’ agreement, the owners of a New York design professional corporation (“DPC”) should consider addressing the following issues in that agreement.

What will the respective ownership interests of the various shareholders be?

In a DPC, more than 75% of the shares must be owned by design professionals and the largest single shareholder must be a design professional (or an employee stock ownership plan satisfying certain conditions).

Is there any particular number of shares of stock that the parties wish to have issued? (A common arrangement is that 200 shares are authorized and that some, but not all, of those shares are issued initially, so that additional shares are left for issuance to new or existing shareholders as circumstances dictate. In any event, the initial choice is not written in stone and can later be changed.)

What vote (majority, two-thirds, etc.) of the shareholders will be required to authorize the issuance of additional shares to a new or existing shareholder? With regard to the issuance of additional shares to an existing shareholder, the parties may wish to provide that there will be no such issuance unless there is a proportional issuance of shares to all shareholders or the issuance is approved by a vote of the shareholders other than the shareholder(s) who will be receiving the additional shares.

There are a number of issues to be considered with respect to the corporation’s management structure:

How many directors will there be? (In a DPC, more than 75% of the directors, including the chairman, must be design professionals, so that if there will be 1 non-professional on the board then there must be at least 5 directors, if there will be 2 non-professionals on the board then there must be at least 9 directors, etc.) Will the directors be elected annually (the default) or will the shareholders agree in advance to elect certain people to serve as directors indefinitely (or for some other term)?

What vote will be required in order for the shareholders take action on a matter (e.g. a majority, two-thirds, etc.)?

It’s not uncommon to set a greater voting requirement for shareholders (e.g. two-thirds, unanimous, etc.) with respect to certain matters affecting the very structure or existence of the corporation, e.g. dissolution of the corporation or approval of the sale of all or substantially all of the corporation’s assets – do the parties wish to include such a greater voting requirement?

What officers will the corporation have (e.g. president, secretary, treasurer, etc.) and are there any special powers or responsibilities that particular officers will have? (In a DPC, more than 75% of the officers, including the president and/or CEO, must be design professionals.) Officers are generally appointed by the board of directors, however it may be agreed that certain people will hold particular offices and that their term in office will continue for a particular period or indefinitely.

Are there to be restrictions on a shareholder’s right to sell his or her shares? A common requirement is that a shareholder wishing to sell his or her shares must first offer them to the corporation or the other shareholders, sometimes at a reduced price such as book value (the idea being that the other shareholders wish to be able to control who they’re in business with).

What will happen upon the death of a shareholder? Often, the corporation or remaining shareholders will want the right to purchase the interest of the deceased shareholder so as to be able to retain control of the corporation. If provision is to be made for a buy-out of the deceased shareholder’s interest, will life insurance be purchased to fund the buy-out?

What will happen upon the disability of a shareholder? Here there are usually two considerations. First, will a shareholder who becomes temporarily disabled be entitled to continue to receive salary/compensation (or partial salary/compensation) for some time period? Second, if a shareholder becomes permanently disabled, or if a disability continues for some extended period – say, a year – will the interest of the disabled shareholder be bought out by the corporation or the other shareholders? Will disability income insurance and/or disability buy-out insurance be purchased to cover these contingencies?

What will happen upon the retirement of a shareholder? Here again, a buy-out is often provided for because it allows the remaining shareholders to retain control of the corporation and provides the departing shareholder with a source of funds for retirement or other endeavors. Is there to be a minimum age (e.g. 65) or date which must be reached before a shareholder may retire and “cash out” (or will there be a reduction in the amount of the purchase price for a shareholder’s interest depending on how early he or she retires)? Note that with respect to non-professional shareholders of a DPC, the law requires that their interest be bought out within 30 days after they cease to be employed by the corporation, whether by virtue of retirement or otherwise.

What will happen in the event that a professional shareholder loses his or her license to practice? The law requires that the interest of such a shareholder be bought out for book value within six months. These are only default provisions, however, and they may be changed pursuant to the terms of a shareholders’ agreement (though the six-month period may only be shortened, not lengthened). Book value is often substantially less than the fair market value of a shareholder’s stock, so the shareholders should carefully consider whether they wish to stick with the default rule or whether they wish to establish an alternative means for determining the purchase price for the shares of a professional shareholder who has become disqualified.

In the event that a shareholder’s interest is to be bought out, how will the value of that interest be determined? There are any number of approaches, including: (i) agreeing on a number and providing for that number to be updated from time to time (this approach is the simplest and most cost-effective, but subject to the reality that in many cases the shareholders neglect or forget to update the number); (ii) agreeing on the use of a formula (e.g. a multiple of earnings) or the average of the values yielded by multiple formulas; or (iii) agreeing to obtain a formal appraisal of the value of the business at the time of the buy-out (this is the most expensive approach, but generally the most accurate). How will the purchase price be paid? A common approach is to specify an immediate down payment, say 20%, but then allow a number of years, perhaps 4 or 5, for payment of the balance by the corporation or remaining shareholders.

As suggested by the preceding points, an issue with respect to buy-outs is whether the interest of a departing shareholder will be purchased by the corporation (a “redemption”) or by the other shareholders (a “cross-purchase” – often made by the remaining shareholders in proportion to their respective interests in the corporation)? There may be tax benefits/costs associated with one method versus the other and thus the corporation’s accountant should be consulted on this question. In a DPC, either a redemption or a proportional cross-purchase of the interest of a departing non-professional shareholder will always continue to satisfy the requirement that less than 25% of the ownership be by non-professionals. In the case of a departing professional shareholder, however, neither a proportional cross-purchase nor a redemption will guarantee that a permissible ownership ratio is maintained (for example, if a DPC had one 20% non-professional shareholder and two 40% professional shareholders, and one of the professionals wished to leave, then having the corporation redeem his or her shares would leave only 60 shares outstanding, with the non-professional shareholder now owning 20/60 or 33% of the outstanding shares). The owners can still determine whether the preference will be for a redemption or for a cross-purchase in the event that the shares of a departing professional shareholder are to be bought out, but special qualifying language and/or formulas will need to be included in the shareholders’ agreement in order to ensure that a buy-out won’t result in the non-professional shareholders owning 25% or more of the corporation’s stock.

Are there to be any restrictions on the right of a departed shareholder to engage in a similar practice or business? Such restrictive covenants can incorporate, among other things, a time component (e.g. the restriction will be in effect for one year after a shareholder leaves the corporation); a geographic component (e.g. the former shareholder cannot operate a like business within a 5-mile radius of any office of the corporation) and/or a client-based component (e.g. the departed shareholder will be prohibited from soliciting or accepting work from existing or identified prospective clients of the corporation).

Is any provision to be made for the involuntary expulsion of a shareholder? This can be advantageous if a shareholder becomes disruptive or difficult to work with, but on the other hand it may make a shareholder vulnerable to the other shareholders “ganging up on him or her.” If provision will be made for expulsion, then under what circumstances may it occur? Will cause be required or can a shareholder be expelled for no reason? What vote of the shareholders will be required in order to authorize an expulsion? How will the interest of a shareholder who is expelled be valued? Will the purchase price for his or her interest be reduced if the expulsion is for cause?

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Please note that this article is intended only as a general discussion of issues which may be confronted by the owners of New York design professional corporations and that it should not be taken as creating an attorney-client relationship or as legal advice with respect to any particular person, business or situation. Circumstances and the applicable legal principles vary and you should consult with an attorney before entering into any contract or agreement.