UPDATED February 2021 – Please click here to read the latest version of this article
Consider the following scenario:
- Two friends who have known each other since university leave their current jobs to set up a new business.
- They agree that they will both be employees and directors of the new company and will each hold half of the shares.
- The business is successful but there are mounting tensions over the future direction of the company.
- Events come to a head and one of the founders (the “Leaver”) storms out saying he will never again work with the other one (the “Remaining Shareholder”).
- Not having foreseen any problems arising down the line, they did not take legal advice when setting up the company. They do not have a shareholders’ agreement or bespoke articles in place imposing an obligation on the Leaver to offer up his shares for sale to the Remaining Shareholder.
- The Leaver says he has been forced out by the Remaining Shareholder as an employee/director. He is willing to sell his shares, but he wants to sell them for £1 million. The Remaining Shareholder is keen to purchase them but he/the company only have access to £500,000 available cash.
This type of situation is fairly common, not least because often the first time that legal advice is sought is after things have gone wrong. The Remaining Shareholder suddenly finds himself in a deadlock with the Leaver. They disagree on the future direction of the company and they each have equal voting and management rights. They are no longer able to work with each other, but the Remaining Shareholder is not able to buy out the Leaver for the price he is asking.
There are two broad ways in which such a dispute may be handled – the consensual way and the non-consensual way. The following top ten tips outline issues to consider in order to break the deadlock in a consensual way. Non-consensual strategies will be looked at in an article to follow.
The Leaver continues in the business/holds his shares
- A good starting point is to consider whether the differences can in fact be resolved and whether there is a way for both parties to continue in the business together. Admittedly, where personality clashes arise, emotions are raw and often the parties cannot even stand being in the same room together, the parties attempting to resolve any differences between themselves may not seem like the best idea.Appointing a mediator to come in, identify the areas of disagreement and establish some middle ground may be the best way to facilitate a resolution.
- Another arrangement to consider is one where the Leaver steps back from his day-to-day involvement in the business. The Leaver keeps his shares but will continue in the business only as a ‘sleeping partner’. It would be prudent for the parties to enter into a shareholders’ agreement reflecting the new arrangement, including practical aspects like remuneration and bonus for the Remaining Shareholder as well as an agreed dividend policy.
- Alternatively, it may be possible for the Leaver to retain a stake in the company through a different class of shares. The Leaver would relinquish rights to his ordinary shares, and the parties could agree a class of shares, for example, with no voting rights and no dividend so that the Leaver would only benefit economically if the business is sold or some other realisation event occurs.
However, the parties should bear in mind that in relation to points 2 and 3, in order for the Leaver to be eligible for entrepreneur’s relief when he later comes to sell his shares, he would need to remain as a director of the company and, for example, attend board meetings. Likewise in relation to point 3, the Leaver would also need to retain at least 5% of the ordinary share capital in the company, allowing him to exercise at least 5% of the voting rights to continue to enjoy that relief. Each of these conditions would need to be maintained throughout the period of 12 months ending with the disposal of his shares. Accordingly, care would need to be taken if it is anticipated there might be a sale of the entire business within 12 months.
The Leaver exits the business
If options 1-3 above aren’t feasible, there may be ways to bridge the gap between the £1 million which the Leaver wants for his shares and the £500,000 which the Remaining Shareholder is in a position to pay.
- Make use of tax exemptions on termination payments. Is there a payment in lieu of notice (PILON) clause in the Leaver’s employment contract? If there isn’t one and there is agreement that the Leaver should be compensated for loss of office, a payment may be tax free up to £30,000, with no liability for NICs. Legal advice is essential here.
- The Remaining Shareholder should also consider whether the Leaver is eligible for entrepreneur’s relief, which will allow him to claim a favourable capital gains tax rate of 10%. In order to be eligible, the Leaver must have held at least 5% of the ordinary share capital in the company, allowing him to exercise at least 5% of the voting rights, and have been an officer or employee of the company throughout the 12 month period leading up the date of disposal. If the Leaver has only held his shares for, say 10 months, it would be of value to the Leaver for the Remaining Shareholder to defer the deal for a couple of months in order that entrepreneur’s relief does apply. On our above example, the parties are initially £500,000 apart. If the Leaver has to pay capital gains tax on the whole of £1 million, he would be paying up to £280,000. Following the structures in 4 and 5 above in respect of a £500,000 payment, the Leaver could see £30,000 paid tax free and £470,000 at 10% or £47,000 – a difference in tax of £233,000. This could make a material impact on the acceptability of the deal, as the Leaver should be focussed on what net of tax monies he is receiving.
- The Remaining Shareholder may be able to provide further comfort to the Leaver by offering a “non-embarrassment clause” in the share purchase agreement. This works to readjust the original sale price of the Leaver’s shares in a situation where the Remaining Shareholder sells on the Leaver’s shares, within a specified time period following the original sale. The Remaining Shareholder would need to share part of any uplift, which is aimed at ensuring that the Leaver doesn’t lose out on a higher sale price within an agreed period of time.
- Another possibility is to look at alternative structures. Is the company able to buy back some or all of the Leaver’s shares? If the company’s articles do not prohibit or restrict buybacks and there is cash available, this may be a good solution. However, it is important to keep in mind that, where there is bad feeling between the parties, agreeing the terms of a company buyback may still be a relatively drawn out process. Also, the Remaining Shareholder needs to ensure this won’t materially damage the company’s growth plans.
- The Remaining Shareholder may want to consider bringing new shareholders into the company. For example, this could be an external third party or perhaps the next layer of managers who buy out the Leaver’s shares. The advantage of bringing in new shareholders, such as managers, who already know the business and the existing shareholders is that it may be possible to negotiate short form warranties in these circumstances, which would be attractive from the Leaver’s perspective.There could be a mismatch in terms of tax relief for any new shareholder and for the Leaver himself. If the Leaver sells his shares directly to a new shareholder, the Leaver may be able to claim entrepreneur’s relief, but the new shareholder would not be able to claim Enterprise Investment Scheme (EIS) relief because there hasn’t been a new issue of shares. Is there a way for both the Leaver and the new shareholder to be able to claim tax relief? It may be possible to structure it so that the Leaver sells its shares back to the company, and then the company sells a new issue of shares to the new shareholder (who may then claim EIS relief). Whilst a share buyback is likely to be taxed as dividends (giving rise to income tax) instead of a capital receipt (giving rise to capital gains tax on which the Leaver may be able to claim entrepreneur’s relief), there may also be ways around this and it would need to be investigated further.
- If a third party is buying the Leaver’s shares, it may be worthwhile to negotiate deferred consideration, i.e. with additional payments being made over time. This could be based on the future performance of the company and, as well as being a cashflow benefit for the Remaining Shareholder, creates an opportunity for the Leaver to reap the full benefit of selling his stake in a profitable business and obtain a higher price overall than he might have otherwise obtained.The Leaver is of course then more likely to want to remain as a director of the company during the deferred consideration period so that he can drive the company’s performance. Furthermore, the tax treatment of any deferred consideration will need to be considered, in particular with regard to the extent to which the deferred consideration may benefit from the reduced entrepreneur’s relief rate and whether any part of the deferred consideration could be reclassified as employment income.
- In addition, if the Leaver is hesitant about not receiving full payment until long after completion, the possibility of the company giving security for the deferred consideration could be explored in order to provide some protection for the Leaver. The financial assistance regime has changed so that private companies are permitted to give such comfort. However, this may involve having to look at priority arrangements in relation to existing security granted by the company.
Shareholder disputes result in a stressful time for everyone involved. Where the deadlock can’t seem to be broken and there is a sizeable gap in expectations, there is a need to get creative using some of the above strategies. However, there are a myriad of legal and tax issues at play and all parties need to ensure that during the emotionally charged negotiation period, the day-to-day running of the business is not ignored. Also, compromise is essential as the non-consensual alternatives are not attractive.
The most important tip of course is for both of the parties to take legal and tax advice as soon as he can, in order to place himself in the best position possible and avoid allowing the Leaver to dictate the way forward.
Fox Williams has extensive experience in this area and has been involved in “breaking the deadlock” on numerous occasions in differing sectors.
Click the link below to read the follow up article:
Shareholder disputes continued: non-consensual ways of “breaking the deadlock”.