By Rajnish Puri
Small business owners – new and established – often inquire about the pros and cons of creating voting and non-voting forms of equity. Naturally, the primary motivation behind the inquiry is to limit the number of persons who can influence business decisions. This article examines the relevant issues to consider when issuing non-voting shares in the context of California corporations.
New businesses, when deciding on the form of legal entity for their existence – a corporation, limited liability company, partnership or other – consider a variety of factors. The analysis typically includes an examination of issues pertaining to tax implications, the ability to attract investors, simplicity of corporate documents, effective governance models, and the flexibility of establishing employee incentive plans. Management and control of business affairs is a theme that connects most issues and, therefore, gets a strong consideration in the decision making process. Interestingly, having the ability to control a business is not just confined to new enterprises; it comes up regularly throughout the life cycle of any organization and most certainly at moments of transition such as recapitalization (raising new capital or rearranging the deck of existing investors), succession planning (transferring ownership to the next generation that would include actively and passively involved family members), and the sale of a business (who decides whether or not to sell), to name a few. This issue, when examined in the context of a corporation, often raises the idea of establishing voting and non-voting shares. Having the two categories of shares, in many instances, makes sense – the premise being that the ability to vote on company affairs be restricted to a select few who have primary responsibility for growing the business compared to those who remain passive investors or hold a minority position. But, just because a category of shares is labeled non-voting, does it take away all of the voting rights of a shareholder owning such shares? Not in the case of shareholders of corporations organized in California. Therefore, if one is not aware of the rules dealing with this subject, granting non-voting shares might inadvertently create the very rights that were intended to be prevented.
The Rule. California law, specifically Section 400(a) of California General Corporations Code (CGCL), allows corporations to issue one or more classes or series of shares that can have “full, limited or no voting rights.” However, as a condition to issuing shares with limited or no voting rights, corporations must ensure that there exists a class or series of shares that has full voting rights. Based on existing law, holders of non-voting shares are precluded from voting on routine corporate matters like the election of directors or other material transactions requiring shareholder approval, thereby eliminating their voice from management and control.
The Traps. Despite the obvious non-voting label, CGCL creates two exceptions, which, if overlooked and left unaddressed, could potentially give the non-voting shareholders a veto right in certain critical situations. Section 903(a), which describes the procedures of amending a corporation’s articles of incorporation, requires that certain amendments must be approved by holders of outstanding shares of a class, “whether or not such class is entitled to vote” as per the articles. This exception could pose a problem when a corporation seeks to raise new capital and create new classes of shares that often trigger the need to amend the articles, and the terms are not favorable to the holders of non-voting shares.
A similar situation arises in the context of corporate reorganizations – a term defined under Section 181 to include a variety of merger transactions – which call for shareholder approvals. Section 1201(a) states that the principal terms of a reorganization must be approved by holders of “each class” of shares. While the rules provide some comfort by noting that different series within the same class do not constitute different classes for purposes of the required approval – thereby allowing the (majority) voting stock to control the approval process notwithstanding the (minority) non-voting position – there could be situations, particularly in closely held businesses, where the voting and non-voting shares represent equal ownership of the business. Effectively, under certain circumstances, the holders of non-voting shares might have the ability to block an amendment to the articles or a reorganization.
The Solution. What is otherwise expressly prohibited under CGCL can be mitigated by having contractual commitments between shareholders. As a condition to granting non-voting shares to shareholders, the holders of voting shares can require the holders of non-voting shares to agree in advance to vote along with the holders of voting shares in reorganization transactions and other specified situations involving the corporation. The agreement among shareholders could also provide for serious consequences of a breach by a party of its obligations under the agreement, which, if structured carefully, would serve as a strong deterrent. Such agreements can be set forth in voting agreements among shareholders, which are permitted under CGCL Section 706.
In conclusion, it is important to consider the limitations of non-voting shares and address them to ensure there are no surprises at critical moments of an organization’s life cycle.
Hope you found the above discussion helpful. In my upcoming posts, I plan to share with the readers practical knowledge and trends on a variety of corporate finance topics applicable to early stage and established businesses. Stay tuned for another conversation on ClarkTalk!!
Thank you for joining us on ClarkTalk! We look forward to seeing you again on this forum. Please note that the views expressed in the above blog post do not constitute legal advice and are not intended to substitute the need for an attorney to represent your interests relating to the subject matter covered by the blog. If you wish to consult with the author of this post or another attorney at Clark & Trevithick, please contact Raj Puri by email at firstname.lastname@example.org or telephonically by calling the author at (213) 341-1322.