How to sell a company if you have dissenting shareholders – Part 1

Where the terms of an offer to purchase 100% of the shares in a company have been agreed between the board of directors of a target company and a prospective buyer, the board may still face an uphill struggle to complete the sale if a stubborn minority of shareholders will not agree to sell their shares.

From a buyer's perspective, dissenting shareholders, even if they are a minority, could be disruptive to the ongoing management of the company and may prevent the buyer obtaining full control of the company. So, what can the board and the willing majority sellers do to persuade a dissenting minority to engage in the sale process?

In this part one of a two-part blog series, we look at the potential options available for managing this type of situation through the target company's articles of association ("articles").

Drag along provision

Theoretically a straightforward option, a drag along provision gives shareholders holding a specified majority of shares in the company (typically 75% or more in nominal value) the right to compel the remaining minority shareholders to sell their shares to a third party on the same terms and at the same price per share as the majority shareholders.

Whilst exercising a drag right might seem like an attractive option to enable a buyer to acquire 100% of the share capital, such provisions can be complex to administer. Successful use of a drag along provision will depend on (1) the particular formalities of the drag provision being complied with to the letter; and (usually) (2) the buyer being a bona fide third-party purchaser seeking to purchase 100% of the shares. A disgruntled minority shareholder could look to delay or ultimately derail a sale by challenging the use of a drag provision if any part of the process stipulated in the articles is not followed correctly.

Where shares are sold under the terms of a drag along provision, the share transfer documents are usually signed under power of attorney by a director of the target company. The authority for the power of attorney is often included within the drag along provision, which may also provide that the attorney can give warranties (in respect of title and capacity) on behalf of the dragged shareholder. Regardless of whether the power to give warranties is included, there is likely to be a negotiation between the buyer and the majority sellers (who will generally give warranties under the share purchase agreement) on whether or not title and capacity warranties will be given by the majority sellers in respect of the dragged shares.

Dragging shareholders into a sale may also cause issues for a buyer that is looking to rely on W&I insurance, as any breach of warranty claim in respect of the minority shares not being owned by the dissenting shareholder is likely to be outwith the scope of the W&I policy (or increase the policy premium significantly).

For these reasons, the parties will usually look at exercising a drag right (if available) only as a last resort, once all genuine attempts to encourage the minority sellers to engage in the sale process have been exhausted.

Inserting a drag along provision

Drag along rights are not included in the Model Articles for private limited companies under the Companies Act 2006 ("CA 2006"), so must be inserted as a bespoke provision. Whilst it is common for private equity investors to add drag along rights at the point of investment in an effort to mitigate any roadblocks to an exit, this might not have been a consideration for a family run business. So, for companies not already equipped with drag along rights, is it possible to insert them into the articles immediately prior to completion of a sale in order to drag a dissenting minority of shareholders?

Provided the majority shareholders can achieve all relevant thresholds for amending the articles, it is possible, in theory, to insert drag along rights without the consent of the minority shareholders. However, this does not come without issue. There could be a risk of challenge by the minority shareholders under the unfair prejudice provisions contained in s.994 of the CA 2006.

Case law challenging the insertion of drag along rights immediately prior to a sale is limited, so it remains unclear how a court would view such an amendment to the articles. It can, however, be noted from case law available relating to an amendment to pre-existing drag rights prior to a sale that amendments made in good faith and in the interests of the company are more likely to be upheld by a court, whereas any evidence of improper motive may invalidate pre-sale changes to the articles.

Compulsory transfer provisions

Also known as "leaver provisions", compulsory transfer provisions can help a company to control who its shareholders are. These provisions can act as a safeguard for the company to prevent a shareholder who is no longer actively involved in the day to day to running of the company from exerting a degree of control and influence. Compulsory transfer provisions usually require shareholders who are officers, employees or managers of the company to transfer or forfeit some or all of their shares when their office or employment comes to an end. For example, the mechanism of forfeit might be either (1) an offer to transfer the shares to the remaining shareholders; or (2) to offer them to the company to purchase via a share buyback; or (3) conversion to a deferred class of shares.

Whilst such provisions may not always help if a potential sale is imminent, including them in a company's articles can be a useful tool for removing shareholders no longer involved with the company and thereby helping to ensure that all existing shareholders are positively engaged with the company.

See here for an earlier blog by Brodies which highlights the possible updates you may wish to consider making to your company's articles to help future proof them, including inserting drag and compulsory transfer provisions.

It is also worth noting that the drag along and compulsory transfer provisions discussed above can sometimes be found within a shareholders' agreement, if one has been entered into.

The next blog in this two part series will look at the mechanisms that might be available to a buyer under the CA 2006 to remove dissenting minority shareholders – the statutory squeeze out procedure and schemes of arrangement.

If you have any questions at all in relation to the matters discussed in this article, please do not hesitate to get in contact with your usual Brodies contact or one of the contacts listed below who will be happy to assist.