Company owners should ensure they have measures in place to manage shareholder exits, whether it’s a case of a shareholder deciding to sell up, a dispute which results in a shareholder leaving, or the sale of the business.
In this blog, we will consider some of the most popular shareholder exit strategies and mechanisms used by limited companies, focusing on how a shareholders’ agreement can facilitate a shareholder exit.
Planning for shareholder exits
In private limited companies, where shareholders will often be directors or hold significant voting rights, it is a good idea to clarify the reasons why someone becomes a shareholder in the first place.
Are they seeking a lifetime business venture or a short term investment opportunity? The answer will often determine the likely exit scenario.
Knowing this in advance can help the company to plan the best strategy for shareholder exits by putting in place relevant agreements, avoiding unnecessary disputes further down the line.
Shareholders’ agreements: the key clauses dealing with shareholder exits
A shareholders’ agreement is a formal arrangement established between the company’s shareholders, governing their relationship between one another.
The purpose of having a shareholders’ agreement in place is essentially to protect the shareholders who have invested in the company and to safeguard the organisation.
Whilst the articles of association also contain rules on how the company operates, it is not as flexible as a shareholders’ agreement.
In terms of shareholder exits, a shareholders’ agreement and/or bespoke articles of association* provide the necessary framework to deal with the different scenarios which can arise.
We will take a look at some of the relevant clauses below.
* The model articles of association (as prescribed by The Companies (Model Articles) Regulations 2008) are too limited in their scope to deal with many shareholder exit scenarios, so they will usually need to be adapted to be effective. In many instances, it may be better to create a shareholders’ agreement instead.
Drag along rights
Drag along rights enable majority shareholders, who have agreed to sell their shares to a third party (normally as part of a company acquisition), to compel minority shareholders to also sell their shares to the buyer.
Under this clause, the majority shareholders are effectively ‘dragging along’ any reluctant minority shareholders, to ensure the company sale goes through. The shares must be sold at the same price by both majority and minority shareholders.
In the absence of a drag along clause, minority shareholders can potentially disrupt and even scupper a company acquisition, since most buyers will want to purchase 100% of shares.
Being able to force minority shareholders to go along with a planned sale enables majority shareholders to guarantee a more straightforward shareholder exit route, and prevents them from becoming trapped in a company.
However, drag along rights also provide some protection for minority shareholders, by ensuring they are paid the same price for their shares and are not losing out on the deal.
The percentage of voting rights which need to be held by the majority shareholders to be able to invoke the drag along clause will differ according to the terms of the specific shareholders’ agreement, but it will need to be at least 51%.
There will normally also be certain types of events which trigger the drag along rights – notably a company acquisition.
Tag along rights
In the event of a company acquisition, tag along rights provide minority shareholders with the entitlement to sell their shares under the same terms and conditions (e.g. price) as the majority shareholders.
Rather than being ‘dragged along’ by the majority shareholders, they are instead ‘tagging along’ with the deal and not being left behind. Tag along rights compel the purchaser of the majority shares to also purchase the minority shares.
Whereas drag along rights are designed primarily to protect the rights of the majority shareholders to exit, tag along rights mainly provide protection for the minority shareholders.
In the absence of tag along rights, the new purchaser would have majority control and could therefore theoretically force the remaining minority shareholders to sell their shares at a lower rate than that paid to the former majority shareholders. So, in effect, a tag along clause provides the minority shareholders with a fair exit route.
It is worth noting that tag along rights do not have to be invoked by the minority shareholders. As such, if there is a tag along clause but no drag along clause, minority shareholders can refuse to sell their shares (even though this may be to their disadvantage).
Right of first refusal
Right of first refusal (also known as right of preference or right of pre-emption) requires a shareholder who wishes to sell their shares and exit the company, to first offer the shares for sale to the existing shareholders, before selling to a third party.
The existing shareholders must be offered the shares on the same terms as they were offered to the external prospective purchaser.
Many investors will insist on a right of first refusal clause being included in the shareholders’ agreement before making an investment (to prevent competitors getting involved later down the line).
There are occasionally exemptions included in a right of first refusal clause, normally restricted to transfers to close relatives. These exemptions will allow the shareholder to bypass the pre-emption clause, so they won’t have to offer to sell the shares to the other shareholders before transferring them.
Put options provide shareholders with the option to sell their shares at a specific price, either upon a trigger event (e.g. a company acquisition) or during a set period of time.
Drafting a put option into a shareholders’ agreement can guarantee shareholders an option to exit the company without losing out on the share value, albeit for a limited period of time.
Please note: This type of clause is often part of a ‘put and call option’ – a call option is the reverse of a put option, i.e. it allows the shareholder to purchase more shares at a set price during a limited period of time.
Shareholders cannot normally demand that the company returns their investment in shares; there is no automatic refund policy (unless a company enters liquidation). Similarly, the company issuing shares cannot easily forcibly buy back its shares from shareholders.
But a company can issue redeemable shares, which make it possible for the shareholder to return the shares to the company and redeem their initial investment. This can be an attractive option for shareholders who come in as shorter term investors, seeking to make profits from a regular dividend payment.
Redeemable shares will normally also be preference shares, i.e. with a fixed rate of dividend which is paid out before the other share classes – meaning that they take precedence over ordinary share dividends. Redeemable shares will often come without any voting rights.
If there are only two director shareholders who both have 50% shares in the company, occasionally a disagreement can lead to deadlock. In this scenario, day to day running of the business can become extremely difficult or even impossible.
A deadlock provision in a shareholders’ agreement can provide a mechanism for dealing with such a deadlock situation. In some cases, this will involve one of the shareholders exiting the business. This will often be the case if the business relationship completely breaks down, with a resulting loss of trust and confidence. In this scenario, options can include:
- Company buyback – subject to having the requisite cash in the bank, the company may be able to purchase the shares from the director who wishes to exit the company. This means that the remaining shareholder does not need to part with their own money or raise additional funds.
- Sell shares – the exiting director can sell their shares to the remaining director. If the parties cannot agree on a price, it may be necessary to instruct an independent valuer.
- Third party purchaser – the director who wishes to exit the business can sell their shares to a third party, subject to any other clauses in the shareholders’ agreement or bespoke articles of association (e.g. a right of first refusal).
- Sell company – if both directors wish to exit the company, or if the business will struggle if one leaves (e.g. because they have skills critical to the business), it may be necessary to consider the option of selling the company.
Termination of shareholders’ agreement
There will normally be a clause in a shareholders’ agreement which stipulates the reasons why it may need to be terminated.
One of the common reasons for terminating a shareholders’ agreement is that one of the shareholders is exiting the company. Other common reasons are when all shareholders are in agreement, e.g. due to the company being sold, or if there has been a breach of contract.
In the scenario that a shareholder exits the company, it may be necessary to create a new shareholders’ agreement with the remaining shareholders.