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Shareholder Agreements: worst-case events

Post-termination: non-compete clauses

The thing with business, especially small business, is that people tend to have their fingers in an awful lot of pies. Not surprisingly, this can lead to controversy, particularly if shareholders leave to set up, or are involved in, a company that has the potential to be ‘the competition’.

For some, this will be a matter of morals – how very dare you! I’d never poach customers, staff or ideas from this company I’ve invested so much time and effort in! I have principles, sir!

While for others, it’s a case of every man for him or herself – I have invested time and money in this place, but I think I can get a better return with my new venture, so laters losers!

Whatever your personal views on the right way to behave, a Shareholder Agreement can remove any uncertainty and ambiguity, ensuring that all shareholders comply with an ethical code that suits your company, including when and how they may compete with the company during or after their involvement with it. This is called a non-compete clause.

A non-compete clause in a Shareholder Agreement can place a restriction on shareholders from setting up in competition with the company while they are still involved with the company, and/or for a period afterwards.

This is often one of the most important clauses in a Shareholder Agreement because most departing shareholders will know so much about the company’s business plan and client list that they could do real harm by setting up in competition. However, this is also one of the most commonly infringed clauses.

The downside is that to get your ex-business partner to stop infringing requires you to take legal action to enforce the non-compete clause in the contract. If you are successful you may be able to recover some of your costs but, as with any legal action, it can be a real aggravation.

The point is that it is an imperfect solution, and a civil claim (breach of contract) not a criminal one – so Scotland Yard/NYPD will be singularly unimpressed if you phone them to complain that your former friend is stealing your clients!

If you find that your ex-business partner is poaching clients in breach of a restriction he signed in the Shareholder Agreement promising not to, your remedy is to claim damages for your loss, and possibly also to obtain an order from the court ordering him to cease poaching clients.

Exit planning: ‘drag along’ & ‘tag along’ clauses

You might not want to think about the end when you’re setting up your business, as it’s still new and precious; a puppy you want to nurture and protect from the world. But, as all good bank robbers know, you always need an exit strategy.

In a Shareholder Agreement, an exit plan takes the form of a proposal for selling or winding up the business in the event of certain criteria being met. This might include a certain turnover target being achieved, an offer being received from an interested buyer, or, worst-case scenario, if the business is failing. As shareholders can have differing motives for investing, they are likely to have different views on when is the right time to get out of the company; a cohesive exit strategy can prevent discord.

A buyer of a company will almost always want to purchase 100% of the shares. However, there is no requirement in company law for all of the Shareholders to sell their shares; this means that a single shareholder (even one with a minority stake) can block the deal for the rest of the shareholders.

This seems a little unfair, so that’s where ‘drag along’ and ‘tag along’ clauses can play their part in a Shareholder Agreement.

A ‘drag along clause’ allows a majority of shareholders to accept an offer for all of the shares in the company, forcing the minority shareholders to sell to the interested buyer as well. Thus, the minority are ‘dragged along’ in the sale.

A ‘tag along clause’ protects the minority shareholders by allowing the minority to ‘tag along’ with a proposed sale of the company if they want to. The clause prevents the majority shareholders from selling unless the interested buyer makes an equal offer to the minority shareholders on the same terms as offered to the majority shareholders.

Cross-option agreements: death of a shareholder

As the heading suggests, this clause considers what happens in a company on the death or critical illness of one of the shareholders. There are potentially some undesirable outcomes for more than the unfortunate victim:

1. the surviving shareholder may wish to purchase the shares of the deceased shareholder but the Personal Representatives of that person may not wish to sell them;
2. the widow/er of the deceased shareholder may wish to have involvement in the running of the business, which the survivor may not appreciate;
3. the next of kin of the deceased shareholder may be left with shares that are not capable of sale and no way of turning those shares into cash.

So what is the solution? A clause in the Shareholder Agreement that gives the surviving shareholder an option to buy the shares of the unwell/deceased shareholder, and a corresponding clause that gives the next of kin an option to force the surviving shareholder to purchase the shares and thus turn paper shares into real money.

A secondary problem in this scenario is that the surviving shareholder may not have access to sufficient funds to purchase the shares. This can be planned for by each shareholder taking out insurance on the life of the other, or the company taking out insurance on the lives of the shareholders. This would usually be arranged by an Independent Financial Adviser.

Deadlock & dispute

As any married couple will tell you, no matter how strong a relationship may seem disputes inevitably arise. In business, slamming doors and ‘the silent treatment’ can disrupt sales and unsettle employees and is unlikely to resolve the problems, so a deadlock or dispute resolution clause written into a Shareholder Agreement is always a good idea, especially where there is equality between the shareholders and risk of dispute is therefore greatest – for example in a 50/50 company.

If there is a dispute between the shareholders then there are a number of methods which the Shareholder Agreement can introduce:

1. a casting vote to be given to the Chairman of the board;
2. arbitration: bringing in an independent party to be a mediator;
3. buy each other out: this will usually take one of two forms: ‘Russian Roulette’, where one shareholder offers to sell all his shares to the other at a specified price and the other shareholder must either accept the offer and buy out at the price stated, or sell all of his shares to the other at that same price. Alternatively, there’s the ‘Texas Shoot-Out’ where sealed bids are submitted to an umpire and the party who submits the highest bid then buys out the other at that price. Both of these methods can favour the shareholder with the deepest pockets;
4. voluntary winding up of the company: this will occur by default if the other options fail or if the Shareholder Agreement does not set out a method for resolving disputes. In practice, it can be not dissimilar to cutting off your nose because your face has offended you.