1976, May, Pg. 597. Stock Repurchases in Close Corporations.

• Author: by Henry R. Crane

5 Colo.Law. 597

Colorado Lawyer

1976.

1976, May, Pg. 597.

Stock Repurchases in Close Corporations

597Vol. 5, No. 5, Pg. 597Stock Repurchases in Close Corporationsby Henry R. CraneA dissenting shareholder in a closely held corporation may be a formidable obstacle lying directly in the path of the corporation's journey to prosperity. Harmony is the key to the success of any family-held entity. There are several methods through which a corporation can alleviate its dissenting-shareholder problems, including recapitalization, a preferred stock bail-out or the use of a corporate repurchase of its stock. This article deals with the latter method.

An ExampleConsider this situation. Al, the owner of a large family-held corporation, has two sons, Bob and Clay. Bob is active in the operations of the business as are his two sons, Dan and Ed. Clay, on the other hand, is not affiliated with the business. After a short time Clay becomes dissatisfied with the amount of dividends that he

598has been receiving from his shareholdings in the corporation. His dissatisfaction is intensified because Bob, Dan and Ed comprise the Board of Directors and have the sole authority to raise or lower dividends paid by the corporation. Bob, Dan and Ed prefer not to increase the amount of the dividends, as they are looking forward to future expansion to be financed in part by accumulated earnings. Moreover, Bob, Dan and Ed receive salaries from the corporation and therefore have no need for additional dividend income. Clay decides to sell his interest in the corporation. This presents a substantial problem because Bob, Dan and Ed prefer to keep the corporation closely held in the family. In order to accommodate Clay while keeping the corporation closely held, Bob, Dan and Ed have two choices:(1) Bob, Dan and Ed could each purchase a prorated portion of Clay's stock; or

(2) The corporation could undertake a stock repurchase.

This article discusses the second choice and assumes that Bob, Dan and Ed themselves will not finance such a purchase. There is no pre-existing repurchase agreement between the parties.

The Repurchase"A stock repurchase agreement is a contract between a stockholder and a corporation whereby the corporation either binds itself to purchase or obtains an option to purchase part or all of the stock owned by a stockholder."(fn1) In return, the stockholder agrees to sell his stock only to the corporation. Repurchase agreements generally are used by close corporations in order to preserve their "closeness" by limiting the class of potential stockholders.(fn2) A repurchase also may be used to cure dissident shareholder malaise, to assist in paying death taxes, or to shift the balance of power in a corporation.(fn3) Because the stock of a closely held corporation has no ascertainable fair market value, a repurchase by the corporation is a useful and fair substitute for "a sale to a stranger at a distress price."(fn4) A repurchase agreement is contractual in nature and the flexibility of this contractual tool makes it particularly helpful in solving shareholder dissension.(fn5)

A corporation's stock repurchase should be distinguished from a stock "redemption," although these terms are used interchangeably in practice. "Redemption" refers to a corporate purchase of its own shares pursuant to a pre-existing provision in the articles of incorporation.(fn6) Generally speaking, the financial restrictions imposed on stock redemptions are less severe than those imposed on stock repurchases.(fn7)

Colorado's LawIn Colorado, the ability of a corporation to redeem or repurchase its stock is governed largely by statute. The decision to repurchase belongs to the corporate directors. No redemption or purchase may be made by a corporation "when it is insolvent or when such redemption or purchase would render it insolvent, or which would reduce the net assets below the aggregate amount payable to the holders of shares having prior or equal rights to the assets of the corporation upon involuntary dissolution."(fn8) Any director who votes for or assents to the purchase of a corporation's shares is jointly and severally liable to the corporation for the excess over the maximum amount which could have been paid had there not been a violation.(fn9) Within the limits of the statute, officers and directors must exercise their corporate powers honestly and in good faith using their best judgment and care.(fn10)

In repurchasing its stock, a corporation may expend funds only to the extent it has unreserved and unrestricted surplus.(fn11) Surplus is "the excess of the net assets of a corporation over its stated capital."(fn12)

599 600"Net assets" is defined as the "amount by which the total assets of a corporation, excluding treasury shares, exceed the total debts of the corporation."(fn13) Most state corporation statutes limit the repurchase of a corporation's shares to the use of "earned surplus," whereas Colorado law permits the use of funds other than earned surplus for repurchase of a corporation's stock. However, it is not necessary for a corporation to repurchase its stock with cash. Frequently a...