Many closely held businesses, which are comprised of a limited number of founding shareholders, elect to do business as an S Corporation because of the favorable tax treatment. A shareholder of an S Corporation who wishes to leave the business is free to do so at any time. However, the more important issue for a departing shareholder is the manner in which he will be able to dispose of his interest in the company.
Unlike publicly held corporations, where shareholders do not participate in the management of the business, shareholders in an S Corporation not only own the enterprise, but actively participate in the management and control of the company as well. One of the most notable distinguishing characteristics of an S Corporation is that the business is formed so that control remains in the hands of the original founding shareholders. To prevent outsiders from obtaining control of the business, most S Corporation bylaws prohibit the transfer of the stock to outside third parties.
In order to ensure that control of the business stays in the hands of the remaining founders upon the departure of one of its shareholders, most bylaws of S Corporations provide the company with a right of first refusal on the stock of the departing shareholder or contain a mandatory buy-out provision.
The buyout and right of first refusal options offer the remaining shareholders the ability to retain control of the business in the event one of the shareholders leaves the company. Because the stock of S Corporation’s is not publicly traded, one of the problems that frequently arises is how a company ascribes a value to the departing shareholder’s stock. A departing shareholder might not agree with the value offered for his stock by the corporation, particularly if it appears the valuation was done in an arbitrary manner that does not reflect the fair or intrinsic value of the enterprise.
To avoid valuation disputes in the event the departure of a shareholder triggers the mandatory buy out or right of first refusal provisions, the bylaws of many S Corporation’s will provide for a specific valuation methodology. This can include present value analysis of the company’s earnings or an asset valuation-pricing model. In some cases, the bylaws can provide for the valuation matter to be referred to an independent business valuation consultant or arbitrator.