If you are a minority shareholder in a private company, there is no automatic right to make the majority shareholders buy you out when you want to sell. Yes, there can be rights of first refusal in your company’s constitution or in your shareholders’ agreement (if you have one) where you are required to offer the shares to the other shareholders first. This doesn’t, however, mean that they will accept your offer.
There are, in fact, a lot of situations where they won’t accept your offer – either because:
- They can’t come up with the money within the 30-day period or whatever time period you give them to buy the shares,
- They don’t agree with your valuation, or
- They don’t see the need to buy you out, since they have formed the view that you won’t be able to sell the shares to anyone else anyway (this is common so when the company is not making profits, or making profits but not distributing them).
The simple fact that the other shareholders don’t want to buy you out doesn’t mean they are acting oppressively against you. It might just mean that you are stuck with no way to sell your shares. When this happens, it is unlikely that third parties will want to buy into such company.
In practice, what tends to happen is that the majority simply wait until you realise you have no other options to sell your shares, then they buy you out for a pittance.
How to Fix It
If you are already stuck in a private company with the majority unwilling to buy you out and third parties unwilling to buy into your predicament, then the following advice might be cold comfort. If, however, you are contemplating buying a minority interest in a company, or you still have a happy relationship with the other shareholders and they are willing to listen to proposals that prevent you being trapped, read on. What follows is some practical advice on setting the stage for a happy exit from your minority position – it just takes a little advance planning.
You can put pretty much anything in a shareholders’ agreement, so you should at least put in how your shares are going to be valued when you sell. The constitution may provide for first right of refusal rights, and many shareholder agreements do as well, but they don’t require anyone to buy you out and often don’t set a price. So a good idea is to embody the valuation and the sale mechanism in the shareholders’ agreement. The best time to do this is when you buy in to the company. The second best time to do this is when everyone is still talking to each other (usually at the outset of the company). The worst time to do this is when everyone has started arguing.
Option to Sell
If you can’t get your valuation and sale mechanism into a shareholders’ agreement, you can still have a “put option” agreement where you can “put” your shares to the other shareholders for a price agreed in advance, or a price worked out according to a formula. When you put your shares to them, they have to buy them.
Again, the best time to do this is at the outset when everyone is still talking to each other and before the majority shareholders have worked out that they don’t really need to enter into such an expensive arrangement because you might not be able to sell your shares in the future anyway.
A put option is an agreement where you can give the other shareholder(s) notice that you want to sell at the pre-agreed price or according to the pre-agreed formula. They then get a certain period of time to come up with the money and buy you out. If there are any disputes, the put option should have a dispute resolution clause. Disputes are usually about price, so these disputes are referred to an independent valuer.
So far, so good. The difficulty arises, however, when the other shareholders can’t or won’t come up with the money to buy you out. In this situation, your agreement should say that you “go nuclear” – if they don’t buy you out, the company has to be liquidated. That usually persuades people to come up with the money. You could also agree to be paid out over time if that helps ease the situation.
This is an agreement between the shareholders that sets out what happens to everyone’s shares if one of the shareholders is unable to continue on in the business. It can be crafted to also include what happens when you simply don’t want to continue on in the business.
Usually, the events that trigger the buy/sell agreement are the “three Ds”: death, disablement and divorce. Other common events are retirement and bankruptcy. You can amend this to include other triggers as well. The mechanism is that you serve a notice on the others advising of that one of the trigger has occurred and that you want to be bought out (except perhaps the trigger event of your own death – someone else may have to serve that notice).
After this, the buy/sell agreement operates like a put option agreement – you put the shares to the other parties and they have to buy you out for the agreed sum or according to the agreed formula. There are two types of buy/sell agreements:
- Cross-purchase agreement: This is an arrangement where the remaining owners are to be the purchasers. Upon the trigger event, the other shareholders have to buy the your shares. If you are dead, well your executor will have to sell your shares and the other shareholders will be required to buy them.
- Corporate entity redemption agreement: Under this agreement, the company buys back your interest. You (or your estate) get cash from the company and the company buys and cancel the shares.
Insurance Funded Buy/Sell Agreement
As set out above, the most common problems in all these agreements is that the other shareholders don’t have the money within the usual 30-day offer period, or they don’t have the money at all, or they don’t agree with your valuation.
One way of dealing with the money issue is for the money to come from insurance policies that pay out when one of the buy/sell trigger events happen. The policies can be held under any of the following arrangements:
- Cross ownership, where the owners of the business hold policies on each other;
- Principal ownership, where the owner holds the policy on himself/herself;
- Discretionary trust, where the trustee holds the policies on behalf of all of the owners;
- Company ownership, where the business holds the policies on behalf of all of the owners.
As a minority shareholder, you can’t rely on a company constitution to protect you when you want to sell your shares. You are going to have to be pro-active and get yourself an option agreement, buy/sell agreement or an insurance funded buy/sell agreement if you want to extricate yourself from a minority shareholding.