Why is resolving disputes between founders such a challenge?

No matter what the context, breaking up is hard to do. But in some circumstances you may feel like it’s your only option.

Some of the hardest disputes we are asked to resolve are those involving businesses co-founded by a partnership or a small team. Individuals come together with the best of intentions, but rarely stop to think what will happen if things go wrong. This means they will not have bespoke articles of association or a shareholders’ agreement to describe what ought to happen if one party decides (or is forced) to leave the business.

All too often rifts develop as the company grows. Perhaps the founders have divergent aspirations, or different appetites as to how much time they are able (or willing) to commit to the business. Even for rock-solid friendships, running a company can be a strain. Unfortunately some circumstances can be more troubling. We have resolved disputes where one founder has developed a drug or alcohol addiction/dependency which is inevitably harming the business as well as the relationship with fellow business partners.

Whatever the underlying issue is, the most reliable method for resolving a dispute between the founders of a company is to encourage the parties to place emotion to one side (which is often easier said than done) and to come to a commercial settlement. Usually this means one party buying out the other. This presents a whole other challenge – how on earth do you pay for it? The remaining shareholders might put their hands in their own pockets, but those pockets usually need to be deep to satisfy an aggrieved departing shareholder.

Can the Company afford to buy the shares?

Assuming the Company has sufficient distributable reserves, it might be possible for the Company to buy back its own shares. This has the obvious advantage that the remaining shareholders don’t need to fund the purchase themselves. Furthermore, the shares bought by the Company are usually cancelled after the deal (or perhaps are held by the company itself as treasury shares), meaning that there is no risk of upsetting the existing balance of power among the remaining shareholders. This can however impact on SEIS/EIS investors, where all remaining shareholders receive an uplift.

How to structure the deal so that the payment is taxed as capital on a Company buyback

If someone other than the company purchases shares, the sale proceeds will be taxed as a capital gain. However, when a company purchases its own shares it is in effect returning money from the company to the shareholder.

Unless certain conditions are met, money paid out of distributable reserves for shares will be taxed as a dividend. Currently, a higher-rate tax payer will pay income tax at a rate of 32.5% on dividends and an additional rate tax payer will pay 38.1%.

However, if certain criteria are met, then the proceeds of a share sale will be taxed as a capital gain, meaning higher and additional rate taxpayers will pay only 20%. This difference might be enough to save a deal, and so lawyers will try to make sure a share sale gains capital treatment if at all possible.

In order to gain capital treatment when a company purchases its own shares it must be shown that the share purchase is to the benefit of the company’s trade. Rather helpfully one of the clear examples given by HMRC of a share purchase that definitely is the benefit of the company’s trade is where there is a dispute between shareholders and the proposed purchase is to buy-out the disgruntled shareholder.

In order to qualify for capital treatment the seller must have held the shares for at least five years.

It is possible (and often advisable) to ask HMRC for prior clearance to ensure a particular transaction will be taxed as capital.

Can the Company buy the shares in instalments?

The short answer is yes, it can. However, there are traps to avoid and procedures to follow. Company tax laws require that payment for the shares must take place on the date of the buy back. The solution to this is to buy back shares in tranches, but that will mean continues (albeit diminishing) ownership by the outgoing founder.

It is possible to transfer the entire beneficial interest in the shares on day one, and for the legal interest to transfer in respect of each tranche when payment is received.

Creative deal structures that can help get a settlement over line

There may be circumstances where a deal needs a little extra help. Perhaps there is not enough money in the Company to fund a buy-back, or perhaps the departing shareholder is not an employee or director of a company (meaning they cannot benefit from BADR – see below) or has not held the shares long enough to benefit from capital treatment. Perhaps the deal is only possible if payments are made in instalments. For any number of reasons, lawyers might need to structure a transaction in a particular way to achieve an outcome that satisfies everybody.

One solution which we particularly like is to make use of a brand new holding company (the TopCo). In this scenario the new TopCo purchases all the shares in the original company. In exchange for their shares the departing shareholder receives cash or some other consideration (loan notes issued by the TopCo, for instance), while the “remaining” founders exchange their shares in the original company for shares in the TopCo. As the departing shareholder is selling their shares to a third party (the new TopCo) it is certain that the shares will receive capital treatment. While this approach does have some technical hurdles it allows for a great deal of flexibility, and is a very helpful way of unlocking otherwise irreconcilable founder disputes.

Business Asset Disposal Relief

We have already seen that there is an advantage to a share purchase being taxed as capital, but this advantage can be even greater if Business Asset Disposal Relief applies. If so, then the gain will be taxed at 10% for the first £1M of qualifying gains in a person’s lifetime. In order for BADR to reduce the rate of Capital Gains tax the shareholder must have been an employee or officer of the Company for at least two years prior to the share sale and must hold at least 5% of the company’s issued (and voting) shares.

Alex Kleanthous

A highly experienced, tactically astute yet practical litigation lawyer, Alex has 30 years experience in resolving disputes.

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