Commercial/Employment UPDATE

Issue No.4 November 2004

Shareholders’ Agreements

Many parties set up in business together and run it through a private limited company. Shares in that company are issued to those parties commensurate with their relative contributions, whether cash, other assets, or skills and time. Whilst the rights attached to those shares will always be governed by both the Articles of Association of the company and by statute, most importantly the Companies Act 1985, often the parties will fail to put in place a shareholders’ agreement. While the business flourishes and the relationship between the parties is good the need for such an agreement may not be obvious, but being in business with other people strains relationships. In a series of case studies we aim to highlight the invaluable benefits a shareholders agreement can bring, both in terms of providing the parties with a focus as to how the business will operate at the outset of the venture, and, where the relationship breaks down, protecting minority shareholders and resolving deadlock situations. In the first of our case studies we look at a 50 : 50 joint venture:-

Case Study 1 – 50 : 50 Joint Venture

Where two parties each hold 50% of the shares in a company, neither party has a majority. No ordinary shareholders’ resolutions, which require the consent of shareholders holding more than 50% of the votes, or special resolutions requiring 75% of the votes, can be passed without the consent of both parties. Further, often the two parties are the only directors of the company and accordingly no board resolution can be passed without unanimous approval. There is ample opportunity for a deadlock to occur in such circumstances and the following case study highlights, among other things, the difficulties facing such parties without a mechanism to resolve that deadlock.

Mr Yin and Mr Yang decide to set up in business together and incorporate Equality Ltd. They both contribute £100,000 of capital to the business and are each issued 100 ordinary shares. The first directors of Equality Ltd are Mr Yin and Mr Yang.

The business flourishes. After 2 years Mr Yin believes it is time to realise some of the fruits of his labour and suggests to Mr Yang that they declare a dividend. Mr Yang believes that rather than distribute the profits of Equality Ltd they should be reinvested in the business in order to finance growth.

The matter is discussed at the next board meeting. Mr Yin is unable to convince Mr Yang that the profits should be distributed and accordingly the board (comprising Mr Yin and Mr Yang) can neither pay, nor recommend to the shareholders, payment of a dividend. The board is deadlocked.

Shareholders’ agreements can set out a dividend policy. The parties will be bound to procure that the company gives effect to that policy.

The business continues to flourish, profits accumulate and Mr Yang believes it is time to expand the business through the acquisition of a competitor. Mr Yang believes the best way to do this is for both shareholders to inject further share capital into business. Mr Yin however has fallen on harder times and does not have the funds to finance such an injection. He knows however that if Mr Yang subscribes for new shares and he does not, Mr Yang will hold more than 50% of Equality Ltd which will give him control. Mr Yin can, however, see the opportunity and his preference is to borrow money from the bank.

At the next board meeting Mr Yang proposes a resolution to issue shares to himself at such a price as to give the company the required funds. Mr Yin blocks this resolution. Mr Yin proposes a resolution to borrow money from the bank. Mr Yang, upset that his resolution had been blocked, and believing that interest rates are too high blocks Mr Yin’s resolution. Funds cannot be found for the acquisition and the opportunity is lost.

A shareholders’ agreement can set out obligations on the parties relating to raising further finance. It can also provide mechanisms to resolve deadlock, whether it be through arbitration, or, in more serious circumstances, the opportunity for one party to acquire the shares of the other, be it by way of a ‘russian roulette’ mechanism, a ‘mexican stand-off’ or sealed bids, or, ultimately, it can require the parties to put the company into liquidation.

Relations between Mr Yin and Mr Yang become strained. Further, whilst competitors of the company have merged, enabling them to increase their productivity and become more competitive, Equality Ltd is beginning to lose market share and its balance sheet is showing a down turn.

A competitor shows an interest in acquiring Equality Ltd and makes an offer to Mr Yin and Mr Yang for 100% of the issued share capital of the company. Mr Yin’s financial struggles continue and he sees this as the ideal opportunity to realise his investment and get him back on the straight and narrow. He is extremely keen to accept the offer. In contrast however other investments of Mr Yang have borne him fruit. He is financially secure. His successes have given Mr Yang an optimistic outlook to life and he believes he can turn round the fortunes of Equality Ltd. Accordingly he refuses the competitor’s offer. The competitor is not interested in 50% of the company and walks away.

Shareholders’ agreements can determine exit routes and provide mechanisms, such as drag and tag along rights, to resolve situations such as those described above.

Relations between Mr Yin and Mr Yang deteriorate further. Mr Yin is determined to sell his shares to raise money. He offers them to Mr Yang at what he believes to be market value. However Mr Yang knows Mr Yin’s predicament and didn’t get where he is today through compassion. He offers to acquire Mr Yin’s shares at half the price originally offered by Mr Yin. Mr Yin, whilst desperate for cash, cannot bring himself to sell his shares at this price.

On exit shareholders’ agreements can determine how shares should be valued where the parties cannot agree a price.

As luck would have it Mr Yin meets Mr Virus at a convention for businesses with interests similar to those of Equality Ltd. Mr Yin explains that he holds 50% in Equality Ltd and that he is looking to sell his stake. Mr Virus owns a competitor of Equality Ltd and sees an opportunity. Mr Virus and Mr Yin strike a deal under which Mr Yin sells his shares to Mr Virus who now holds 50% of Equality Ltd with Mr Yang.

Shareholders’ agreements can place restrictions on the transfer of shares.

Mr Yin continues as an employee and director of Equality Ltd. While he has realised capital through the sale of his shares to Mr Virus, he still needs an income and is keen to see the business continue to secure his employment. He believes that through his directorship he is best placed to ensure the success of the business. Mr Yang is incensed by the deal done behind his back. Further he is not happy about being in business with a competitor of the company. The relations between he and Mr Yin have deteriorated to such a point that they are no longer able to work together. Mr Yang is unable to remove Mr Yin from the board as he has been advised that the shareholders of the company (now himself and Mr Virus) need to pass an ordinary resolution, requiring more than 50% of the vote, to do so. Mr Virus is refusing to pass such a resolution unless he himself is appointed to the board, which he has been advised would also require an ordinary resolution. It is bad enough for Mr Yang to have Mr Virus as a shareholder of the company, there is no way he will have him appointed to the board

Shareholders’ agreements can not only determine the composition of the board, but can set out what the quorum for a board meeting will be, how the chairman will be elected and whether the chairman will have a casting vote.

Mr Virus is using his position as a shareholder of Equality Ltd to help him redirect business from Equality Ltd to his competing company. Soon Equality Ltd is in financial trouble and Mr Virus makes an offer to Mr Yang for his shares. Mr Virus’s ruthlessness surpasses even that of Mr Yang and the offer is derisory. Mr Yang considers that, were he to liquidate Equality Ltd, his return would considerably exceed that of the offer made by Mr Virus. Unfortunately he is advised that in order to liquidate the company the members need to pass a special resolution, requiring a 75% majority. He suggests liquidating the company to Mr Virus, but Mr Virus refuses. Why should Mr Virus allow a liquidation where a liquidator would sell off the assets at the best price he could, when if he stuck to his guns the point would arise at which Mr Yang would effectively be forced to sell? Ultimately Mr Yang is advised that if he wished to liquidate the company he could, without Mr Virus’s consent, but he would have to seek an order from the court. This is likely to be expensive if Mr Virus objected to the application. Ultimately he decides to cut his losses and run and to sell his holding to Mr Virus for a price at which even the optimistic Mr Yang sees no silver lining!

Shareholders’ agreements can impose restrictions on shareholders from competing with the company. Further they can provide circumstances where a party could force the company to be liquidated.

Note:

Please note that this newsletter is not intended to be a comprehensive statement of the law and should be used for guidance purposes only. If you require specific legal advice please contact Mark Machray or Edward Bond or by telephone 020 7493 2903.