Planning for termination and exit in your shareholders' agreement
When you form or buy into a company, by far the most important question to discuss with fellow shareholders and to agree in the shareholders’ agreement is what is generally called the “exit strategy”. That is how the agreement is unwound.
Start with a plan that fits the aims of all shareholders
Having a plan (a statement of intention) about how all shareholders will exit is a good start to a successful business time together.
You cannot make steadfast rules about how the business will run its course but you can agree that you will actively look for an exit within a given time scale. For example, you might decide you will:
- look for a buyer after five years; or
- dissolve the company and cash up if you have not sold the company after ten years;
- expand the company, keep it moving and make a public placing (“IPO”) of its shares when that is possible
We are not suggesting that you can run a business on the basis of wishful thinking. Rather our point is that, just as you include other terms within the agreement, it is worth stating general intentions because they provide the framework within which the precise decisions can be made later on.
Then plan for the less desirable
It is far more likely that "Plan A" doesn't happen than it does.
Next, you need to make a list of what else might happen. For ideas, consider:
- a dispute among all shareholders forces you into divided camps or deadlock
- a director-shareholder acts in a way to harm the company and triggers a bad leaver clause
- a family law judge gives shares of one shareholder to her husband or his wife on divorce
- a lender shareholder needs his money back in a hurry, or at least on the expiry of the term of the loan
- one of you dies
- one of you becomes bankrupt
- for any reason, one of you becomes desperate for money in your private affairs
- a majority decide to sell the company
But the reason for “exit” is not as important as what you decide to do about it. You cannot control the reason, but you can control many of the things that happen when a shareholder exits.
For example, you might decide that you want each shareholder to have a cross option.
With your list of eventualities, consider how the position of each shareholder is affected, in terms of value, but also in terms of the other reasons they might have for being a shareholder. A good way to do that is use a shareholders agreement that already considers many of those matters as an aide-memoire for discussion.
To summarise: the key is to plan what happens if for as many eventualities as possible.
Devices for fairness
As long as all the shareholders agree on a course of action, you do not need precise rules. So what can be done to make the separation as easy and as fair as possible?
Right of preference, right of pre-emption or right of first refusal (ROFR)
These are three terms for the same arrangement - a process whereby a shareholder who finds a buyer for his shares must first offer them to every other shareholder on the same terms pro rata with his existing holding. It favours the status quo, since, if all shareholders exercise their right, the proportional ownership in the company remains the same.
But there is a problem. Finding a third party to buy at a true market value is difficult. No buyer who knows about the ROFR term would spend the time investigating the deal seriously because the likelihood is that the other shareholders will exercise their right, and he will have wasted his time. But not telling the buyer about the ROFR, i.e. negotiating in good faith, is not likely to result in the buyer offering the true value.
The second, very interesting device relates to a situation where the shareholders arrange that if they receive an offer from a third party to buy the company, they will benefit equally. This prevents a buyer from doing a deal with a majority to obtain control, then bullying the minority into selling out at a lower price later. This is a “tag-along” provision, named because all the other shareholders "tag-along" with the terms of sale offered to the shareholder who negotiated with the buyer.
The effect of a tag-along provision is that it rarely needs to be activated. The very fact that it is in place, means that a shareholder who learns of third party interest in the company knows there is no alternative but for all the shareholders to work together to maximise the sale price.
Of course, if a minority objects to the price on offer, there is nothing to prevent them from holding on to look for a higher price in the future. They have a choice, but they do not hold up a deal preferred by a majority. We explain the concept of the clause in greater detail.
Generally discussed in the same breath as tag-along is “drag-along”. This deals with a similar situation as for tag-along, but assumes that the prospective buyer is interested only if he can buy all the shares. So drag-along forces the minority to sell on the terms agreed by the majority. The effect we have described above, whereby all the shareholders have an incentive only to work together, applies here too.
More detail can be found about drag-along clauses here.
Beware the lender-shareholder
One of the most damaging hits to the value of shares is caused by the company defaulting on a debt to a shareholder. If a loan in default is to a bank, the route of the disaster scenario is well known. We will not dwell on it here. But a large lender may either take a similar route as a bank lender, or he may take over the company as a profitable going concern “by the back door”.
Let us assume that the big lender is also a shareholder, with an immovable director in place. The company hits hard times and cannot pay interest when due. The shareholders assume that the big lender will give them some leeway and make a short term concession on the interest debt because he has an interest in the business.
Instead he gives them an ultimatum. He will appoint a receiver in which case the shareholders will receive nothing for their shares, or he will buy their shares for a price which is a small fraction of what the shareholders think they should be worth. Faced with this dilemma, shareholders usually sell. So the big lender obtains control of the profitable company for a small price.
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