We call it shareholder fatigue. Quite simply, the owners no longer see eye to eye. Often this is driven by exhaustion and frustration; there is no common vision or there is a lack of agreement on the direction of the company. Sadly, it can also be driven by work ethic, with many owners believing and resenting that they feel they are contributing more hours at the coalface than their other shareholders. Hours, however, should be paid and not confused with shareholdings.
If you reach the point of fatigue, you have the potential for a dispute or have already started one. Perhaps the founders have different ambitions, but the tension is building to the point where the parties can’t work together and don’t talk, rapidly deteriorating to mutually assured destruction where the Board fails to function. Sometimes the source of the dispute is beyond the shareholders’ control, death or a serious illness means the shareholder can no longer contribute to the business or is unable to discuss the options for their shares, leaving it to a family member or representative to try and agree a solution.
The Shareholders’ Agreement
“Prevention is better than cure” – the Shareholders’ Agreement is often perceived as just one of the documents one must sign to set up a company. Its role is often not understood or appreciated. This is where employing an experienced solicitor who specialises in share transactions and disputes is invaluable. Either when the business is being set up or at the point where it is gaining traction, there needs to be an adult commercial conversation that often feels strange. It is a bit like a pre-nuptial agreement; you are about to get married but are negotiating the terms of the divorce.
Some of the issues and solutions discussed and agreed at this stage may be covered if a key man insurance policy is taken out. There are also specifically known solutions such as drag-along and tag-along rights, which are important forms of investment realisation in a Shareholders’ Agreement. Drag-along rights favour the majority shareholder, while tag-along rights are more beneficial to the minority shareholder. If shares are 50/50 from the start, it is also important to agree on who is to be the Chairperson as they have the casting vote in 50/50 situations to avoid deadlock.
If a Shareholders’ Agreement is not providing the solution and shareholder fatigue is building, the solution may be in a mutual buyout which may be led by the Articles or the Shareholders’ Agreement. However, before this is looked at, there is an arbitration approach to create shareholder alignment. A third party is required to create an objective view of both the prospects for the company through a business review, as well as assess how the Board is functioning. Even family businesses suffer. Matters often get highly emotional and therefore, unfortunately, logic often takes a back seat and it becomes a horse trade with neither party happy. A qualified independent third party can help shareholders understand fatigue is not personal but may be related to:
- Risk profile or lifestyle choices rather than the commercials of the business. Sadly, fatigue can often show itself at the worst time when the company is struggling.
- Different perspectives of the marketplace based on preconceptions, often poorly researched.
- Agreeing different pay grades for hours worked. This is easier today as dividends have moved much closer to PAYE for tax purposes.
If alignment cannot be reached via changes and a plan, the next step is a buyout, but who buys who and at what value is a significant tension point especially if emotions have run high. Sadly, disputes or fatigue can become even more combative at the buyout stage often with valuation at the core; there is the old trading adage that if you buy you have paid too much and if you sell you did not get enough which adds to the tension. The stakes are high. If the parties cannot agree on valuation, strategy or the buyout, matters fall into the court system which is incredibly expensive in time and money. The shareholders pushing emotion from the equation and being commercial to settle is far better but how do you pay and afford it.
In our experience, too often the dispute goes legal and there is simply not enough time spent locked in a room for weeks if required, however awkward the meeting is. Luckily to agree the buyout, there is also help on hand, it is called tax relief. If a buyout is tax-effective, the tax savings can often bridge the difference. There are effectively three methods to achieve this. Foremost, a ‘company buyback’ where the company buys out the shares saving the need for after dividend money to pay for the buyout (or personal cash). ‘Pension planning’ or ‘trail out salary’ paid over time after the buyout can also be a mechanism, which has the benefit of being corporation tax deductible. There may also be a fourth, which is a non-embarrassment clause for a duration if the seller is worried about the buyer flipping the shares at greater value after the deal.
Assuming the company has sufficient distributable reserves, it might be possible for the company to buy back its own shares from the ‘seller’ so long as they have held shares for 5 years. The company buyback may require tax clearance. It will need to be recorded formally at Companies House. You cannot agree instalments, but you can agree to buy shares in tranches or batches which may also add cashflow.
A company must show that a buyback or buyout of shares is to the benefit of the company’s trade. HMRC consider resolving a shareholder dispute a benefit. There is also an advantage to a share purchase being taxed as a capital sale to the seller. At the time of writing, in the UK business asset disposal relief on the sale of shares is 10% on the first £1 million and 20% thereafter per executive shareholder with more than 5% voting shares for 2 years. For the company as the buyer, it is tax effective as the buying shareholders do not have to use personal reserves which invariably have also been taxed. The shares bought by the Company can be cancelled after the deal if required to maintain equilibrium with the remaining shareholders.
Minority Valuations (please see Avondale’s Valuation Methods and Multiple Arbitrage Guide to calculations)
A Shareholders’ Agreement or Articles may determine that shares are valued equally (pari-parsu) even if a minority, however, because minority shares have less influence and are illiquid in that many investors will not buy a minority in a private company, there is an acceptance they should be sold at a discount to 100% sale. This means a 100% sale may also be an answer to the dispute with all shareholders using the tax effective capital returns for other investments later. The courts in the UK use the following guide for minority shareholding values, however, it depends on the understanding between the parties and the negotiation leverage in live sales.
- 50% interest – Discount of 5% to 10%
- 50% interest – Discount of 15% to 25%
- 26% to 49% – Discount of 30% to 40%
- 10% to 25% – Discount of 45% to 50%
- 10% or less – Discount of 60% to 75%
In UK company law a minority of 25.1% enables a veto of special resolutions, which is why the value discount is not significant until it is beyond these levels.
One thing is clear – put the emotion behind, ignore the ‘who has or has not done or said what’ and concentrate on the commercials. These conversations are difficult, but Avondale’s experience of arbitration is to point out the mutually assured destruction (MAD) of not agreeing. It is interesting when once the parties objectively understand the way a court will look at matters, the costs involved and the leverage each side has to ravage destruction, how many opt for a sensible route out. Mapping out the MAD steps can help each side gain perspective objectively.
For help and advice on shareholder dispute, values and buybacks, contact us on +44 (0)1737 240888, our Contact Us page or email firstname.lastname@example.org.