It is not uncommon for shareholders to disagree with each other about how the company is managed and controlled, or the direction and strategy the business is taking.
Having and airing different views can be beneficial for the business, but disagreement that results in a decision not being taken can be severely damaging.
Deadlock provisions within a shareholders agreement provide a means of resolving issues about which shareholders cannot otherwise agree or compromise on.
What is deadlock?
Usually, the shareholders agreement states the conditions that must be met for deadlock to occur. It only applies to a decision to be made by the shareholders (not the directors, who may also be the shareholders), and typically not when there is a single indecisive outcome. Usually, a number of votes on the same issue must be made over a period of time, where the outcome each time is consistently indecisive.
As an example, a matter might have to be voted on at three consecutive meetings with no resolution before deadlock provisions can be exercised.
The delay gives time to shareholders to compromise or find other ways of resolving the issue.
Another condition before deadlock is declared is usually that other methods of dispute resolution have been tried and failed. For example, the shareholders agreement might state that the shareholders use mediation to try to find a solution if the issue is not resolved after two general meetings.
When might you use them?
Deadlock provisions are a way of forcing a decision. They are usually made so severe to one side (usually the minority shareholders) that the threat of them being used is enough for one side to change the mind and for the issue to be resolved.
The circumstances under which they can be used are usually limited. For example, they might be able to be exercised only on matters relating to sales or transfers of more than 25% of the company’s shares to someone who is not already a shareholder.
Types of deadlock provision
Although deadlock clauses can be given all sorts of interesting names, they all tend to boil down to a requirement of one party to sell their shares to the others so that control changes and the remaining shareholders can pass a vote about the matter. In effect, they are all types of conditional termination provision.
Common ones used in shareholders agreements include:
One shareholder (usually the owner with the greatest shareholding) names an all-cash price at which they value their share of the company. The other shareholders then must decide as to whether to buy the shares at that price, or sell all their own shares at that price.
It is similar to a shotgun clause.
This method in theory should give a fair price, since the person who values the company the most should be able to buy out the others at a lower price.
This is a sealed bid auction, overseen by an independent party. Each shareholder sends a sealed bid for the other’s shares to the overseer. The bids are opened at the same time, and the shareholder who has bid the highest price must buy the others out at that price.
In theory, this maximises the value of the company, since each shareholder who is bought out is done so at a valuation higher than he or she places on the business.
This is a dutch auction, where the shareholders make sealed bids stating the minimum price at which they would sell their shares. The shareholder with the highest price must buy the shares of the others, at the lowest price.
This incentivises the shareholders to value the company highly but fairly.
Multiple choice procedures
Sometimes, an agreement might provide several options for resolving disputes, and the choice of which one to use for the particular situation.
The theory behind offering multiple options is that agreement on a small matter (which method of resolution to choose) is enough to start conversations about the larger issue. For example, where there are multiple strong personalities, disagreement might be a means of asserting authority over the others, rather than being a true disagreement about the issue at stake. Instead of considering principles, emotions block decision making.
Are deadlock provisions effective?
Deadlock provisions can break deadlock. The question is really whether the price of doing so is worth it. It is rarely so, especially for small and young companies.
The reason why lies in the fact that shareholders are likely to be directors of the company as well, and therefore important in day to day running. They are likely to have skills and knowledge that the business needs to succeed. If deadlock provisions are used, at least one is removed by forced buyout, and the long term cost to the company could be high.
Of course, the cost of not resolving the issue could also be high, even if the shareholder remained. However, if there is severe disagreement, there are other ways of seeking exit from the company or resolving the problem such as using drag along clauses. If the situation is so catastrophic that the value of the company is going to fall so much, then shareholders are likely to take other action sooner.
That is why we don't include them in our own shareholder agreement templates.
Deadlock terms are often drawn to be harder to one side over the other in order to be deterrence. They don’t take into account who has the better position of principle.
However, the main problem is one of cash. A shareholder may not have the money to buy the others out. Regardless of the price at which you fix the price of the shares in a sealed bid, if the winner cannot afford to buy the shares then the problem continues to exist.
Alternatives to deadlock provisions
A better way to avoid disputes is to make sure that deadlock cannot occur. The easiest way is to make sure that shareholders do not have equal voting rights in any combination.
Voting rights are usually based on proportional share ownership. So in a company with 100 shares, a shareholder with 50 shares can outvote either of the other two who hold 25 shares each. However, the two minority shareholders can create deadlock by voting together against the majority.
A shareholders agreement can be used, perhaps to give a third party (such as a trusted director who is not a shareholder) a casting vote if there is otherwise deadlock, or perhaps to change the voting rights on certain matters so that each shareholder has one vote each regardless of proportionate ownership.
Alternatively, the number of shares held can be changed, so that the majority owner holds slightly more than the other two combined.