Planning for Shareholder Exits
There are several reasons a shareholder may leave your company, from deciding to sell their shares, to the company being sold. Even disputes can lead to a shareholder leaving. Company owners need to be prepared for these situations because of the voting rights these shareholders have and the effect they have upon leaving.
Why do people decide to become shareholders?
To have a plan in place for shareholder exits, you first need to know why a person has become a shareholder in the first place. It could be that they are seeking a lifetime business venture, or it could only be a short term investment opportunity.
Knowing the reasons a person has become a shareholder means you can have the relevant agreements in place ahead of time. Thus avoiding unnecessary disputes down the line.
Shareholders' agreements clauses dealing with shareholder exits
A shareholders' agreement is in place to protect both shareholders and the company issuing the shares. Although articles of association contain rules on how the company operates, it is more rigid than a shareholders' agreement.
When talking about shareholder exits, a shareholders' agreement and/or bespoke articles of association provide the necessary framework for dealing with the different scenarios which can happen.
So, what clauses are there which can help with shareholder exits?
Drag Along Rights
Drag along rights enable majority shareholders, who have sold their shares to a third party, to compel minority shareholders to sell their shares to the same buyer. This is usually done as part of a company acquisition.
This clause is used to 'drag along' any reluctant shareholders to ensure the sale of the company goes through. The shares must be sold at the same price by both majority and minority shareholders.
In the absence of a drag along clause, minority shareholders can potentially disrupt, or put a halt to the company acquisition, this is because most buyers will want 100% share purchase.
Being able to force minority shareholders to go along with the sale enables the majority shareholders to have a straightforward exit route. The minority shareholders are also protected because they know they are guaranteed to be paid the same price for their shares as the majority shareholders.
Majority shareholders will need to hold at least 51% of the overall shares before they can invoke the drag along clause. This percentage can differ according to the terms of the shareholders agreement, but it will always be a minimum of 51%.
There will also need to be a trigger event for the drag along clause, most commonly this is a company acquisition.
Tag Along Rights
If a company acquisition is taking place, tag along rights provide the minority shareholders with the entitlement to sell their shares under the same terms and conditions as the majority shareholders.
This is different from the drag along rights as they are 'tagging along' with the deal and not being left behind. Tag along rights compel the purchaser of the majority shares to also purchase the minority shares.
The difference between drag along rights and tag along rights is that drag along was designed to protect the majority shareholders and tag along was designed to protect minority shareholders.
If there is an absence of tag along rights, the purchaser would have majority control and could theoretically force the minority shareholders to sell their shares at a lower rate than that paid to the former majority shareholders. This means that with the tag along rights in place, the minority shareholders have a fair exit route.
Right of first refusal
A shareholder who wishes to leave the company, must first offer to sell their shares to the existing shareholders before any third parties. The existing shareholders must be offered the shares on the same terms as any third party would be.
Many investors will insist on a right of first refusal clause being included in the shareholders' agreement before making an investment.
There are occasionally exemptions included in the clause, normally restricted to transfers to close relatives. These exemptions will allow the shareholder to bypass the clause, so they won't have to offer to sell their shares to existing shareholders.
These provide the shareholders with the option to sell their shares at a specific price if a trigger event happens, or during a set period of time.
Having this in the shareholders' agreement can guarantee shareholders an option to exit the company without losing out on share value, albeit for a limited period of time.
Normally, a shareholder cannot demand that the company returns their investment in shares (there is no refund policy unless a company enters liquidation). In a similar sense, the company cannot easily, forcibly buy back its shares from the shareholders.
However, a company can issue redeemable shares, which makes it possible for the shareholder to return the shares to the company and redeem their initial investment. This can be an attractive option for short term investors.
These often come without any voting rights for the shareholders.
If there are only two director shareholders and they both have 50% shares in the company, occasionally a disagreement can lead to a deadlock. In this scenario, day to day running of the company can become difficult or impossible.
A deadlock provision can provide a way of dealing with such a situation. In some cases, this can mean one of the shareholders will need to exit the company. This can be the case when the working relationship completely breaks down, resulting in a loss of confidence and trust. If this happens, the options include:
- Company buyback- the company may be able to purchase the shares from the director who wishes to leave the company. The remaining shareholder does not need to part with their own money or raise additional funds.
- Sell shares - the exiting director can sell their shares to the remaining director. If a price cannot be agreed, you may need to instruct an independent valuer.
- Third party purchaser - the director who wishes to exit the company can sell their shares to a third party (subject to any other clauses in the shareholders' agreement e.g. right of first refusal).
- Sell company - if both directors wish to exit the company, or if the company will struggle with only one director, you may need to consider the option of selling the company.
Termination of shareholders' agreement
Usually there is a clause in the shareholders' agreement which stipulates the reasons why it may need to be terminated. One of the common reasons is that one of the shareholders is exiting the company. Other reasons can include the company being sold, or a breach of contract.
If a shareholder exits the company, you may need to create a new shareholders' agreement with the remaining shareholders.
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