Director-shareholder exits business and creates deadlock

A dissenting director who holds shares can cause issues. Failing to address such issues could leave a company deadlocked. Here, the dissenting director-shareholder also wanted to leave the company.

How we negotiated a deal

The remaining director instructed us on behalf of his company, and we then took several steps to resolve the issue. First we valued the departing director-shareholder’s shares. Then we put forward a reasonable settlement offer to him, with a view to concluding a deal. Next we drafted the buyback documentation for the company’s purchase of shares, before we finally ensured that the payment qualified as a capital payment. This made the deal attractive to the departing director-shareholder.

SME director-shareholder conflict

For SMEs, in our experience, the most difficult problems arise when directors, who are also shareholders, depart. Such directors often intertwine their personal and company positions. This means the legal and private aspects are difficult to separate.

SME director-shareholder issues

The smaller the business, the closer the ties between shareholders. When creating a business, potential issues such as the management of the business; what happens if the shareholders fall out; and what happens when directors and shareholders depart, are rarely formally agreed upon.

Lack of legislation

When these issues emerge, the result is deadlock for the company. When this occurs, legislation does not wholly cover some aspects of the process. For instance, how departing directors and shareholders exit a business. This itself includes forcing them to sell shares, the timing of the process, and forming the basis of a share valuation in a private company.

Our client understood the share valuation and the director-shareholder’s departure was worth a lot of money. He sought our advice and guidance.

Articles of association and/or shareholders’ agreement

Our client’s articles of association, which were standard, did not cover a director-shareholder leaving the business. Nor was there a shareholders’ agreement. Hence, the departing director could leave the business whilst keeping his 50% shareholding.

For our client, this was disastrous, leaving him unable to make shareholder decisions without the departing director’s consent. Such decisions typically require over 50% of the shareholders to agree, and sometimes 75% or even 100% agreement. Without the other shareholder’s agreement, the articles of association could not be changed.

Offer to buy/sell shares

We advised our client to purchase the departing director’s shareholding. In order to do this, we prepared a valuation of the shares which reflected fair market value. We offered a reasonable sum. This was because our client had already offered the departing director-shareholder a lower sum prior to instructing us, but the departing director-shareholder had refused this offer.

Additionally a reasonable offer reduced the chances of the departing director-shareholder obtaining an independent valuation, that may be more favourable to him. In addition to this, the company would have to foot the bill for the independent valuation, as the company wanted the share sale and purchase to take place. Our client wanted a quick resolution.

We prepared advice for the departing director-shareholder that explained the tax implications of selling his shares. We assured him that we would structure the deal to treat the proceeds as capital rather than income. He could then claim entrepreneurs’ relief that reduced the rate of capital gains tax payable to 10%.

Completing the sale/purchase

For the departing shareholder, the capital treatment of the transaction was important. We obtained clearance from HMRC that the transaction would qualify for Business Asset Disposal Relief.

In addition, the departing director raised concerns that the company might be sold at a higher value in the near future. Selling his shares now meant he would miss out on the increased valuation. To close the deal, we drafted provisions which enabled him to receive a proportion of the proceeds if the company was sold in the near future. These are called “anti-embarrassment” clauses.

These provisions clinched the deal. The departing shareholder agreed, and our client gained complete control. Our client then instructed us to draft bespoke articles of association to better protect the company should new shareholders join.

Alex Kennedy is an associate in the dispute resolution team at Gannons.