The Bottom Line: Rights & Risks Upon Shareholder Death or Incapacity
Updated: Apr 2, 2021
Many years ago, there was an incredible biotech startup co-founded by an up-and-coming scientist and his business-savvy friend and co-venturer. The scientist was the brains behind the company's R&D, and the friend led the funding and sales activities.
It was a great (and highly profitable) partnership. The scientist held a 51% controlling interest in the company, and the friend happily enjoyed his 49% interest. The company grew quickly, and their team soon included junior researchers as part of a funding deal with a major health organization.
A few years into the (high profitable) venture, the scientist died in a tragic accident. His death would ultimately prove fatal to the entire enterprise.
What Happened Next?
When the scientist's estate was administered, the friend discovered that the Operating Agreement he and the scientist had signed at the creation of the company was ill-prepared to deal with the death or incapacity of the co-founders. Instead of permitting the friend a right of first refusal to purchase his deceased partner's shares, those shares simply became part of the scientist's estate.
The scientist's shares eventually passed to his widow. The widow was not scientifically-inclined, but now enjoyed a controlling stake in the company. She outright refused to consider selling her shares to the friend and, intent on continuing her late husband's cutting-edge research herself, she also refused to let any of the junior researchers assume leadership of the R&D projects.
With only a 49% interest in the company, the friend was powerless to timely challenge any of these decisions, and the lack of scientifically-competent leadership ultimately led to the retraction of institutional funding and the collapse of the company. The company's patents were eventually sold for pennies-on-the-dollar by appointed liquidators, and the meagre proceeds were entirely used to pay the company's creditors - including my client.
The wife and friend received nothing.
What could have been done differently?
This entirely-avoidable scenario is something that occurs all too frequently. There are countless businesses, companies, partnerships, and co-ventures that lack adequate controls in the event of the death or incapacity of key persons. It sets the stage for expensive litigation at best, and fatal leadership at worst.
Operating Agreements and Shareholder Agreements can (and should) contain express and definite terms that govern the rights of shareholders. The survival of the venture can often depend on such terms.
A simple and effective way to manage post-mortem shareholder rights is to offer co-founders the aforementioned 'right of first refusal'. This gives the company or co-founders the opportunity to purchase the shares of the estate of a deceased partner, or from the hands of the representative of a shareholder who has lost mental capacity.
Some will say that most will lack the liquidity to exercise a right of first refusal - and they'd be right. Most companies and shareholders don't keep the kind of liquidity necessary for a share redemption or acquisition of this scale on the books or in the bank. However, simple mechanisms like 'key person insurance' can be utilized to affordably manage the risk and provide the necessary acquisition funds.
A sign of a good general counsel is that they solve problems you never knew you had, and before those problems turn into crises. The scientist and the friend could have used a good general counsel.
Do you hold a significant interest in a company or business venture? If so, what does your Shareholder Agreement say about shareholder rights in the event of death or incapacity of a shareholder? What are you and the company doing to ensure that sufficient liquidity will be available if a redemption or first refusal event arises?
If you can't answer these questions, call Out-House Attorneys, LLC. We can take a look at your organization's documents to ensure that overlooked risks aren't hiding in plain sight. We can also work with insurers and accountants to ensure that the risk is managed and funded without breaking the bank or compromising your mission.
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