Shareholder disputes: when breaking up is hard to do [Part 1]
24 November 2021 by Paul Croft
One of the downsides of COVID-19 has been an uptick in shareholder disputes, with cash-strapped business owners seeking to exit businesses or optimise their remuneration under the shareholders’ agreement.
Shareholder disputes can be expensive; they’re emotionally charged. They’re also avoidable. This article looks at the common causes of shareholder disputes and provides some tips for reducing the risk and scope of costly future disputes.
Common themes
While the underlying causes of those disputes are not specific to COVID-19, the most common themes present in shareholder disputes are those concerning:
- Poorly drafted accounting terminology
- Valuation approaches and dispute resolution processes not articulated.
Poorly drafted accounting terminology
As a forensic accountant, I see disputes of this nature often. When you’re starting a business with a friend or colleague, the last thing on your mind is a future dispute over how you’ll run the business, who’ll do what and how you’ll be compensated for your efforts. You’re looking to outline the arrangement between you quickly and on the cheap in a way that seemingly captures your intentions. Sadly, what often emerges in ‘contractual’ arrangements cobbled together in this way is confused accounting phrasing and terminology, which consequently leaves this forensic accountant scratching his head, trying to make accounting sense of what was written as agreed between the parties.
It’s not uncommon that accounting-related phrases drafted by non-accountants to confuse a range of legal and accounting concepts. I was recently asked to opine on directors’ fees payable under a shareholders’ agreement, calculated as a percentage of the “declared net profit issued to shareholders and directors”. In that example, the clause confuses the concepts of dividends paid to shareholders (to which directors, in their capacity as director, are not entitled) with the net profit reported by the company.
Valuation approaches and dispute resolution processes not articulated
Valuation disputes arise between shareholders for a variety of reasons including retirement of one shareholder or a shareholder feeling s/he is doing all the heavy lifting. A worst-case scenario – and one all too familiar in private companies – is that no shareholders’ agreement exists. At best, there may be a shareholders’ agreement, however, too often, such agreements fail to include clauses addressing such matters valuation approaches, “trigger events” that prompt buy outs, and a process for resolving any valuation dispute. In my experience, failing to include such clauses in a shareholders’ agreement typically result in costly, inefficient and drawn-out disputes.
One of the most common areas of private company valuation disputes is whether a value discount or premium should be applied to the value of a parcel of shares which is in itself a minority holding. A shareholders’ agreement that explicitly states that all shares rank pari passu mitigates the risk of this area of dispute.
I’m in a shareholder dispute: what can I do now?
When a dispute arises between current, past or future shareholders, a negotiated settlement is the best course of action.
In valuation-related disputes, understanding the context of the dispute and the intrinsic drivers motivating the dispute can help elucidate possible solutions appealing to all parties. For example, structuring the buy-out of one shareholder by another via an earnout can overcome the reticence of the retiring shareholder from exiting the business. Alternatively, breaking the impasse by seeking interest from a competitor or other third party in buying your shares can bring the other shareholders to the negotiating table to agree a commercial outcome (assuming, of course, that such action is not prohibited in the shareholders’ agreement).
At the extreme end, applying to the Court to wind up the company on “just and equitable” grounds or oppressive conduct are possible outcomes, although this can lead to permanent value destruction in the business (particularly if one shareholder is planning to resume the business in a new entity). However, the Courts are typically reluctant to order the winding up of solvent companies.
Simply leaving and starting up a competing business is not advisable, as it possibly exposes you to breaches of directors’ duties.
How can I proactively manage the risk of a future dispute?
The most effective way to proactively manage future shareholder disputes is to review the currency of the existing shareholders’ agreement, or get one drafted, with appropriate legal and accounting professional advice. There are a number of reasons why renegotiating or implementing shareholder agreements are justified, including:
- Are the accounting terminology and definitions used correctly to support the intended outcome?
- Is it justified by the business being different in terms of scale, nature and scope of operations, compared to the business when it was first established?
- Are the founding shareholders getting older and looking for an exit, are younger shareholders taking on greater roles or are the shareholders looking to bring in new shareholders?
- What relevant valuation “trigger” events might need to be included in the agreement that might give rise to a situation where a share sale is required? For example, on the death, retirement or divorce of one of the shareholders
- What is the process for resolving a future valuation dispute, such as the appointment of a single valuation expert?
It’s advisable to keep any drafting of valuation methodologies, approaches or formulae in the shareholders’ agreement as broad as possible: what seems commercial now, may not reflect market value in the future.
Need advice?
Early forensic accounting input may assist in developing the best legal strategy. We may be able to give a broad overview of the main issues after a brief review of available financials and an outline of the background to the matter. We aim to help, so please feel free one of experts:
