Like most legal disputes, shareholder disputes can vary between the trivial and the substantial. It will probably not surprise you to learn however that there are certain conditions in which such disputes are more likely to occur than in others, and start-ups fit squarely into that category.
The danger signs are:
- a limited number of founders, who have probably known each other for some time and, which is worse, they may even be related
- typically all will be employees, directors and shareholders
- because of the close relationship between the founders, and often because funds are limited, they will not have taken legal advice when setting up the company and there will be standard articles and no shareholder agreement.
What then happens? Typically a combination of some or all of the following:
- the business starts to be successful (or alternatively, hits the buffers) and tensions arise over the direction that the company should take
- a breakdown in the relationship between some or all of the individuals, usually over power or money or both
- a dispute as to the value of the company (and therefore of the shares)
- one of the shareholders (usually the proposed leaver) will consider that he has been forced out by the others and whilst he is prepared to sell his shares his valuation will significantly exceed what the others think and/or what they or the company can afford.
The result is deadlock; the perfect storm of an unforeseen dispute and no agreed way to resolve it.
So how can this situation be resolved?
There are essentially two ways, one is consensual involving negotiation between the parties and agreement. The other is non-consensual and involves lawyers and the court.
Very few shareholder disputes get to trial and it follows that most will settle and everything will work out in the end. But they are difficult cases to settle and the word “difficult” is one that causes lawyers to smile. They are difficult because:
- the participants often have unrealistic expectations about outcomes which are difficult to manage
- the close relationship between the founders that I have already described will mean that when the parties fall out there will be an emotional “divorce” between some or all of the participants, involving allegation and counter allegation. Commercial common sense plays very little part in this emotional response
- the cash available to resolve the problem will be limited.
As a litigator, shareholder disputes are a blessing and a curse.
They are a blessing because they are usually cases that involve significant legal fees. And not just legal fees either. In most shareholder disputes expert evidence from an accountant as to valuation will be required. One of the good things about instructing an expert accountant is that the accountant’s fees will usually make the legal fees look small.
But they are a curse because they are often very difficult to resolve, for the reasons just explained. They are also difficult cases to predict, in the sense of predicting a result. Whilst it is easy to say that the case is much more likely than not to settle (because statistically it just will), it is very difficult to predict at what level it will settle.
Don’t forget that for most lawyers being asked to advise on the chances of success of a case is an exercise in the use of percentages within touching distance of 50%. In the case of shareholder disputes the outcome is likely to be reasonably certain. The issue will be what the outcome is worth in financial terms, and that will depend on a number of factors which are not within a lawyer’s control.
In the absence of a shareholders agreement an individual shareholders rights are set out in the company’s articles of association and the Companies Act 2006. Standard articles of association are unlikely to be of any help.
The Act, however, has a wide discretion to make such orders as it thinks fit in response to an application by a minority shareholder where majority shareholders are acting in a way that is prejudicial to his interests.
What is unfair prejudice?
Examples of such conduct include:
- being excluded from management
- unfairness in the allocation of financial benefits, with salary and dividends being the usual basis for disagreements
- breaches of the company’s articles.
As an aside, as most shareholders in these situations are directors, a minority shareholder should always think carefully about his position as a director. There is often something to be said for sticking around, attending meetings and making yourself as unwelcome as possible in this situation as this can often lead to a quicker resolution. However, directors must always have regard to their duties as directors and if there is any suggestion of the board acting improperly then the minority director should consider his position and take advice. It is perfectly possible to be disqualified as a director whilst being completely ignorant of decisions being taken by the other directors without your knowledge.
The remedies available to a court in receipt of an unfair prejudice petition will include making an order:
- to regulate the conduct of the company’s affairs in the future
- to provide for the purchase of the shares of any members of the company by other members or by the company itself
- winding up the company on just and equitable grounds.
It is important to remember that the court will only make an order where it has made factual findings and frankly that is where the legal fees are incurred, because frequently the evidence presented by the parties will be of the “you said, he said, she said” variety.
So how can disputes of this nature be avoided?
Make a decision as to when you want to spend the money on legal fees. Do you want to spend money up front, or would you prefer to spend the money when things go wrong further down the line?
Make sure that when you incorporate you have robust, tailor made articles and a shareholders agreement. If you haven’t done that, then at the first sign of trouble seek a consensual solution through alternative dispute resolution.
ADR can include or exclude lawyers (although if they are excluded any resolution should be documented and implemented by lawyers) and it can make use of third parties as mediators. It offers an unlimited range of commercial options to resolve a dispute that are not open through litigation. It is important to have your accountant playing a part in these negotiations because of the potential tax consequences and also because there may be tax efficient ways of structuring a solution.
These options include:
- where the difference between the parties can be resolved, negotiating a blue print for the business and the relationship between the shareholders going forward
- devising a role for a sleeping partner, perhaps with different categories of shares being issued and allocated
- the purchase of shares from the proposed leaver, by the other shareholders, the company or a new shareholder.
Avoiding shareholder disputes is really about the old adage, to fail to prepare is to prepare to fail. However unlikely it may be, prepare for the worst.
The content of this article is for general information only. It is not, and should not be taken as, legal advice. If you require any further information in relation to this article please contact the author in the first instance. Law covered as at February 2022.