S corporations are closely held, meaning that they have only a limited number of shareholders. Often, no ready market exists for the sale of shares. In the absence of corporate bylaws and written shareholder agreements spelling out the rights and limits of authority for each of the shareholders, a minority shareholder may find her investment locked in and her lack of control exploited. Majority shareholders may run the corporation for their own benefit.
Control of the Board of Directors
Some states require S corporations to have a board of directors. In other states, a single director may act alone, placing the decision-making power in the hands of a single person whose interests may not align with the interests of minority shareholders. Even in states that require an S corporation to have a board, a majority of board seats may filled by persons whose economic interests align with the majority shareholder -- family members, for example -- and not with minority shareholders.
Dilution of Shares
An S corporation can issue additional shares as a means of raising capital. It can be argued that this does no more to dilute a minority shareholder's interests than the issuance of a bond or the taking out of a bank loan. Each of the new shareholders then has a voting right that further reduces the existing minority shareholders' ability to control corporate direction. For example, the new shareholder may intend to buy out the corporation, A possibility then exists of collusion between the existing majority shareholder and the new shareholder that gives the majority shareholder an improper advantage. The buyer may pay less for corporate shares but give the majority shareholder a generous consulting contract.
Minority Shareholders' Roles
Small businesses often start informally. The articles of incorporation may be generic boilerplate. Beyond the bylaws, there may be either a brief written agreement between the founding shareholders or no written agreement at all. The roles of the principals remain undefined. You and two friends may start a social network company, for example, and you see yourself as the company manager and your friends as the technical developers. Once the S corporation is up and running, they may decide they want a more experienced manager. Without a written shareholder agreement supporting your rights, if they fire you, you retain your shareholder interest, but you lose your position and the salary that goes with it.
Importance of Contractual Agreements
To avoid what Attorney Saboor Abduljaami calls "the oppression of minority shareholders," he advises clients investing in S corporations to insist on detailed corporate articles of agreement. He also recommends that the shareholders have a written agreement detailing their voting rights, employment rights and the specific rights and obligations of each shareholder. The agreement should also spell out rights of succession and what happens if the managing shareholder becomes disabled. Each executive should have an employment contract. These protections reduce the likelihood of friction in the future over shareholder rights.
Patrick Gleeson received a doctorate in 18th century English literature at the University of Washington. He served as a professor of English at the University of Victoria and was head of freshman English at San Francisco State University. Gleeson is the director of technical publications for McClarie Group and manages an investment fund. He is a Registered Investment Advisor.