- Appointing an independent adviser
- Negotiating an exit to bridge the valuation gap
- Alternative structures
- Recent examples and ways of breaking the deadlock
- Non-consensual ways of breaking the deadlock
Shareholder disputes can arise for various reasons. Common examples include:
- disagreements over the direction and development of the underlying business;
- deterioration in the relationship between key individuals (sometimes caused by the disparity in the respective effort being invested in the business); and
- conflicts over funding and/or dividend distributions.
Where one of the parties (the “Leaver”) decides he no longer wishes to work with the other (the “Remaining Shareholder”) there are several consensual and non-consensual ways of resolving the dispute.
The consensual methods include:
Shareholders may also consider alternative structures, including a buy-out by an external buyer, share buy-backs and setting up a new company. Recent examples and ways of breaking the deadlock are included here.
Non-consensual methods present more legal challenges, and include compulsory winding-up, a sale of assets or a pre-pack sale.
If a dispute has arisen and parties have been unable to reach a desirable compromise by negotiating directly with each other, mediation should be taken into consideration to resolve, or if possible, narrow the areas of disagreement.
As a neutral and independent person, the mediator will encourage a dialogue and establish a middle ground so that the parties can find an amicable outcome.
Ideally the parties will have a shareholders’ agreement in place with a dispute resolution clause that will set the parameters for mediation. Otherwise, parties could look for a mediator from their professional or social circle; refer to a mediation service provider or, a panel of mediators, who will recommend a shortlist of experts to choose from.
A week before the meeting (in Covid times these would be online), parties are advised to provide the mediator with a concise statement outlining their case, perceived differences, and position. At the meeting, the mediator will attempt to reach a consensus through a combination of private discussions with each party and joint meetings with both sides present. The mediator will use his professional knowledge and skills throughout the negotiation, but no final solution will be imposed on the parties.
If a settlement is reached, the terms should be incorporated into a settlement agreement and/or deed of waiver of claims. Often this will be accompanied with share purchase agreements and/or formal employment termination agreements. Agreements reached in mediation can be enforced through the courts. Submitting to mediation avoids the high costs and stress involved in litigation and allows the parties to keep the dispute confidential and without prejudice. This helps retain the image of the company until a solution can, hopefully, be reached. Mediation might also avoid the division between “winner” and “loser”, commonly seen in litigation, which fosters animosity between the parties and eventually impacts the future of the business.
4. Appointing an independent adviser
The company may also consider appointing a non-executive director or board adviser to assist in the negotiation process.
5. Negotiating an exit to bridge the valuation gap
Where the Leaver chooses to sell his shares and exit the company, often the parties will find themselves on the opposing sides of a “valuation gap”. The below structures/options can be taken into consideration to bridge such a gap:
i. The Leaver may be able to make use of tax exemptions on termination payments. If it is agreed that the Leaver should be compensated for his loss of office, a payment may be tax free up to £30,000 (Employer National Insurance contributions will apply to any award in excess of the £30,000 threshold). Legal advice is essential here as the availability of this relief has become increasingly restricted in recent times.
ii. Ask the company accountant to produce a realistic valuation of the shareholding (although a key question will be whether a discount is applied to reflect any minority discount).
iii. Review where monies are available from so the buy out could be funded from a mixture of other shareholders; the company itself and/or new investors.
iv. Consider deferred payment terms (not available if the company purchases its own shares). This may result in discussions with the Leaver about them receiving security to guarantee future payment.
v. The Leaver may be eligible for business asset disposal relief, which will allow him to claim a favourable capital gains tax rate of 10%. There are several conditions that need to be met to be eligible for this relief and, again, please seek tax advice to check your eligibility.
vi. Offering a “non-embarrassment clause” in the share purchase agreement. This works to readjust the original sale price of the Leaver’s shares, if the Remaining Shareholder sells the business, at a higher price, within a specified period in the future.
vii. The Leaver may decide to step back from his day-to-day involvement in the business and continue as a sleeping partner. Under such circumstances, the parties may enter into a new shareholders’ agreement (and the Leaver may exit their service agreement) to reflect the new arrangement.
viii. Alternatively, or in addition, a different class of shares could be agreed between the parties. 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.
6. Alternative structures
i. Buy out by an external buyer
The Remaining Shareholder may also decide to bring new shareholders into the company.
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 tax treatment of any deferred consideration will need to be considered.
The Leaver may require security for the deferred consideration in order to provide him with some protection. This could be by way of a charge over the assets of the company and/or a PG from the remaining shareholders.
Buybacks may be a good solution if there is cash available and the company’s articles do not prohibit or restrict them. However, agreeing the terms of a company buyback may still be a relatively drawn-out process and the Remaining Shareholder needs to ensure this won’t materially damage the company’s growth plans.
iii. Setting up a new company
Under the Companies Act 2006, when the Company finances a buyback, the total consideration has to be paid on the day of closing. Often, however, there might not be sufficient cash available to buy the Leaver out immediately. The solution may be for the remaining shareholders to establish a new company (NewCo) with the intention of purchasing the Leaver’s shares at a deferred consideration. Newco may do a share for share swap with the Remaining Shareholders. The Original company (OldCo) will lend the NewCo funds going forward avoiding the legal issues encountered in a buyback. Tax clearance should be sought for the transaction and consideration needs to be given to stamp duty which may be payable on all the share sales/swaps.
7. Recent examples and ways of breaking the deadlock
A common misunderstanding is that there is always a contractual right for the company or the Remaining Shareholders to be able to buy out a Leaver’s shares. In the absence of a leaver clause in a shareholder’s agreement or bespoke articles, there isn’t. Equally there is no compulsion on the company to offer to purchase such shares.
Recently we’ve seen the following scenarios (and many others) where agreement has been reached and the dispute settled:
- a company was in the process of removing the Leaver as a director and employee (which would have meant the loss of Business Asset Disposal Relief);
- a company was able to buy back shares as the Leaver was threatened with an employee disciplinary process;
- the Remaining Shareholders had gone so far as consulting with an insolvency practitioner to instigate a pre-pack administration sale and, on receiving evidence of this step, the Leaver agreed to sell;
- a friend of the Leaver acquiring the shares (pre-emption rights were not taken up) which resulted in the restrictive covenants ceasing after an agreed period of time post sale; and
- the Leaver agreeing to sell at a reduced price in exchange for a full release of the restrictive covenants.
8. Non-consensual ways of breaking the deadlock
A consensual exit is normally the preferable route to breaking a deadlock and parties are highly advised to exhaust the above options before considering any non-consensual alternatives. These will present more legal challenges and parties should seek legal and tax advice as soon as they can in order to place themselves in the best position possible. If you find yourself unable to resolve the dispute in a consensual way, please refer to our article about non-consensual ways of breaking the deadlock. The article includes the following:
- Applying pressure on the Leave to sell – Assuming the Leaver has resigned as a director of the company, the Remaining Shareholder could apply pressure on the Leaver to sell his shares, for example, by increasing his own salary to reflect the increased work he has taken on. However, this and the other options are often fraught with legal difficulty.
- Unfair prejudice and purchase orders – A shareholder may be able to bring a petition under section 994 of the Companies Act 2006, by showing that the other shareholder is at fault by acting in an unfairly prejudicial manner.
- Compulsory winding up – The parties may decide that their only option is to discontinue the business and wind up the company. The company or a shareholder(s) may petition the Court for the winding up of a company on the grounds that it would be just and equitable to do so. The Court’s decision is however discretionary.
- Sale of assets – The Remaining Shareholder could sell the company’s assets to a third-party company or a newly incorporated company. Once the assets have been transferred to the third party or newly incorporated company, the Leaver will own shares in an empty shell company.
- Pre-pack sale – It may be possible to place the company into administration and then immediately sell the company’s business under a sale to a third-party company or newly incorporated company which would be arranged before the administrator is appointed.
If you have any questions about these issues in relation to your own organisation, please contact a member of the team or speak with your usual Fox Williams contact.