Commercial/Employment UPDATE

Issue No.6 January 2005

Shareholders’ Agreements

In the third of our case studies looking at the importance for all companies to implement a shareholders’ agreement, we examine the issues associated with an investor taking less than a 25% stake in a company.

Case Study 3 – Minority Shareholder holding less than 25%

Where a shareholder holds less than 25% of the shares in a company he can block neither special resolutions nor ordinary resolutions. Accordingly he cannot even block a resolution to change the Articles of the company. Protections set out in the Articles may be removed by the majority and whilst such removal would effect all parties equally they may have a far greater impact on a minority shareholder. Even if the minority shareholder negotiates special rights to attach to his shares, if these are set out solely in the Articles, the majority might be able to dilute these or even remove them altogether.

Mr Cheddar, Mr Brie and Mr Stilton (the “Founders”) have been in business together for a few years and their company, Cream Crackers Ltd, has been trading with some success. All three of the Founders believe there is a need for expansion and that investment capital is required. As luck would have it Mr Cheddar is introduced to Mr Chalk at a cocktail party where Mr Chalk wastes no time in regaling Mr Cheddar with tales of the money he has recently made on the sale of his business, White Cliffs Ltd (though quick to bemoan the amount of money he had to pay his lawyers!). Mr Cheddar jumps on the opportunity to explain that his company was looking for funding and that Mr Chalk may be interested in making an investment. Mr Chalk sees private equity as a way to make a big return on his money though he has no desire to get back into running a business. He looks at the company’s figures and decides that Cream Crackers Ltd has got great potential.

The parties sit down and agree terms. Mr Chalks will invest £1m in Cream Crackers Ltd in return for 20% of the shareholding. Mr Chalk will be issued with Preferred Redeemable Shares, a separate class of shares to those held by the Founders. He is also to receive a fixed dividend. He is to have a seat on the board, but only while he holds at least 20% of the issued share capital.

The Founders instruct their lawyers to draw up the necessary paperwork and Mr Chalk is presented with a draft New Articles of Association for Cream Crackers Ltd in which all the rights attaching to his shares are incorporated. Mr Chalk decides not to instruct lawyers. He felt they added little value on the sale of White Cliffs Ltd and cost him too much money. He reviews the Articles himself, sees that all the agreed terms are incorporated and promptly makes the investment.

Shortly after the investment is made an opportunity arises for Cream Crackers Ltd to acquire a competitor. The Founders believe it to be an ideal way to expand the business, but Mr Chalk has always been an organic man. He grew White Cliffs Ltd from 2 employees to 30 and never made a corporate acquisition during his ownership. His business model worked and he had assumed that his investment would be used simply as working capital to help the organic growth of Cream Crackers Ltd. He is out voted on the board and the acquisition goes ahead.

A shareholders’ agreement can provide how investment capital is used as well as incorporate any number of management restrictions preventing the company from undertaking certain matters without the consent of all the shareholders.

Further management decisions are made which are not to Mr Chalk’s liking and each time he is out voted. After some time the Founders find Mr Chalk’s presence on the board frustrating and irritating. They realise that if they issue more shares they can reduce Mr Chalk’s holding to below the 20% threshold he requires to keep his seat on the board. However, the New Articles contain pre-emption rights such that Mr Chalk would always have the right to retain his holding. The Founders resolve to amend the New Articles removing the pre-emption rights, and to issue new shares to themselves, at market value, such that Mr Chalk’s holding reduces to 15%. The Founders then resolve to remove Mr Chalk from the board.

A shareholders’ agreement can restrict the shareholders from amending the Articles of a company without the consent of all the shareholders, regardless of the size of their holding. Further it can enshrine pre-emption rights and the right to be appointed to the board of a company.

The business continues to be profitable but only just. All profits that are made are being used to pay Mr Chalk’s fixed dividend. The Founders believe this is severely limiting the potential of the business, but Mr Chalk refuses to give up this right. The return he is getting on his investment is reasonable and he is in no mood to do the Founders any favours after the stunt they pulled removing him from the board. From where he’s standing the whole business stinks and frankly he is cheesed off! The Founders are advised that on account of the fact that Mr Chalk holds a separate class of shares to theirs, the rights attaching to them cannot be amended unless 75% of the holders of shares of that class of shares determine so.

The Founders devise a plan. They issue themselves new shares of the same class as those held by Mr Chalk. In so doing they reduce Mr Chalk’s holding of that class to 25%. They then resolve to convert the Preferred Redeemable Shares into ordinary shares. Mr Chalk’s holding reduces to 11% of the issued share capital.

A shareholders’ agreement could prevent any new issue of shares without the consent of all the parties to it. Further if rights attaching to shares are set out in a shareholders’ agreement, then those rights could not be amended without the consent of the party holding those shares, regardless of the size of his holding.

The business continues to prosper helped to some extent by the further investments made by the Founders in order to dilute Mr Chalks shareholding and remove the rights attaching to his shares. It is not long before they are approached by a competitor who makes an offer to acquire 100% of Cream Crackers Ltd. The Founders approach Mr Chalk who would be required to sell his holding if the sale is to go through.

Mr Chalk however finally sees an opportunity to extract some revenge for the way he has been treated. He refuses to sell his shares to the purchaser, but proposes instead that the Founders purchase his shares from him at a price which is 15% more than that being offered by the purchaser. If they were to accept such proposal they would then hold 100% and the deal could go through. The Founders are left to ponder this rather grating predicament.

Shareholders’ agreements can incorporate ‘drag-along’ rights which can force a minority shareholder to sell his holding to a potential purchaser of a company where the majority have accepted an offer.

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.