An investor required minority shareholder protection. Two former colleagues wanted him to invest £100,000.00 in what seemed like a great business idea.
Our client, based outside the UK, was eager but concerned about the terms and conditions of the investment. He engaged us to explain the risks and confirm that the documents were standard practice in the UK.
Minority shareholder problems
Investors usually hold a minority stake in a business. In this case there were 3 key issues:
Firstly can the investment be diluted?
Secondly, is the investor able to ensure their investment is wisely spent?
Finally, are there any risks that the investor’s liability is greater than the amount paid for the shares?
Minority shareholder protection
To protect against dilution, it is important that any documents contain preemption rights. These give existing shareholders the right of first refusal, in the event that the business plans to issues shares to new shareholders. Preemption rights are often contained in the articles, or a shareholders’ agreement. Off the shelf documents will not give the right protection.
Minority shareholders require veto rights over certain business decisions. This will ensure that they can wisely manage their investment. For example, these could be pay rises for any founder, shareholder, or director.
In addition, there can be circumstances in which the investor’s liability exceeds their investment. One example is a sale where there is joint and several liability. The proposed documentation contained a drag-along right. A drag-along right would require the investor to join in any sale on the same terms and conditions as all sellers.
In addition, there was a provision that all parties would agree the terms of sale agreed by the majority shareholders. This means that on a future business sale the minority investor could face joint and several liability for a breach of warranty claim that far exceeded his initial investment.
Addressing investment risks
Of course, with any investment there are no certainties that the business will increase in value. Nevertheless, it is important for an investor to be well-protected. We ensured there are no circumstances where our client’s liability could be greater than his initial investment. That was out client’s concern.
Avoiding unfair prejudicial treatment
To avoid problems from arising we thought out steps that can be taken to avoid risk. We recommended the investment agreement includes:
- Power to issue voting shares to an external independent adviser;
- Appoint a non-executive director; or
- Include dispute resolution procedures to be followed before any action could be taken in court.
- Include buy out provisions to break the deadlock.
Buy out provisions
We explained that buy out provisions can take a variety of forms such as:
Russian roulette buyout
Here, shareholder 1 serves notice on shareholder 2. The notice states shareholder 1’s price for selling its entire shareholding to shareholder 2. Shareholder 2 can either buy the shareholding or sell its shareholding to shareholder 1 at that same price.
Texas shoot out buyout
Here, each shareholder submits a “sealed bid” to the company’s accountant, or other expert. The shareholder that submits the highest bid purchases the company at that price.
Valuation of the shares if the investor wanted to sell before the exit
The general rule is that if the articles or shareholders’ agreement deals with how the shares are to be valued and if this is fair the court will uphold the agreement when the shares are transferred. We knew from experience that valuation of shares in private companies can be hotly debated and different results can be produced.
Therefore we recommended that if the transfer price of the shares cannot be agreed a jointly appointed independent expert would be asked to report on the value.
The support given by Gannons on this investment decision was both clear and invaluable.