Reading time (mins): 6 if you get to the end (where practical tips await!)
Sophistication level (1 (idiot) – 10 (expert)): 7
Entertainment value (1 (turgid) – 10 (side-splitting)): 6
Shareholders and potential shareholders in companies need to be aware of the significance of the percentage of their shareholdings. Particularly if you only have a minority shareholding (ie under 50% of the shares). This recent case seems quite scary.
Mr Gilsenan owned all the shares in his company Euro Accessories Limited. One day he transferred 24.99% of the shares to Mr Monaghan, who had been with the company for five years as a sales rep. Two years later they fell out, and Mr Monaghan resigned. They spent the next two years failing to agree terms on which Mr Monaghan might sell his shares back to Mr Gilsenan. Mr Gilsenan eventually had had enough, so with his over 75% shareholding (just!) he did the following:
• He passed special resolutions to convert his shares into ‘A’ shares and Mr Monaghan’s into ‘B’ shares, and to change the company’s Articles to give the ‘A’ shareholder (ie him) a right to give notice to force the ‘B’ shareholder (ie Mr Monaghan) to sell the ‘B’ shares to the ‘A’ shareholder for ‘fair value’.
• He gave notice under the new Articles requiring Mr Monaghan to sell his shares to him for £175k.
• In coming to this price, he assessed the ‘fair value’ of the whole company (ie all the shares in it) and then took 24.99%, and then applied a large discount, to reflect the fact that 24.99% was only a minority stake and so had little value because for example it didn’t give Mr Monaghan any control over running the company.
• When Mr Monaghan failed to comply with the notice to sell, Mr Gilsenan implemented the share transfer himself, using powers he had added in the new Articles.
After a couple of years of being in shock (a couple of years, anyway, for some reason) Mr Monaghan went to court because he didn’t think what Mr Gilsenan had done was fair. He made the point that before all these changes were made, Mr Gilsenan would have had no right to force him to sell his shares at any time and at any price; and certainly not at a discount. He didn’t complain about the Articles being amended in the first place (I have no idea why – see my comments later). Instead, he argued that if he did have to sell, the ‘fair value’ should be one that was just and equitable in the circumstances, and that requiring him to sell at a discount would be unfairly prejudicial to Mr Monaghan’s interests as a minority shareholder, and so shouldn’t be allowed (under section 994 of the Companies Act 2006).
Both sides agreed as part of the proceedings to instruct a valuer to value the shares, including taking into account any discount that would under normal valuation practice be applied for a minority shareholding (to reflect the well-established disadvantages of a minority shareholding in a private company, such as having no control over how the company is run, and no ready market to sell their shares). The valuer valued all the shares in the company at £2.18 million, and said that the normal discount for a minority shareholding would be 55%. So Mr Monaghan’s 24.99% should be worth £545k if there was no discount, but only £245k if there was a discount. (And Mr Gilsenan happily agreed that he would pay this £245k).
What did the High Court judge say?
The judge said that the discount SHOULD be applied. It is established law that unless a company’s Articles say otherwise, a discount should be applied when valuing a minority shareholding, because it has no ‘control value’. There was nothing in the wording of the amended Articles to indicate that a different approach should be taken here. Although normal principles of interpreting commercial contracts apply when interpreting Articles of Association, they are a public document and have to be readily understood by anyone who reads them, so the court can’t (as with commercial contracts) look more carefully at the background facts (such as the fallings out and previous negotiations between the parties) when working out how to interpret them.
• It seems a bit unfair, or does it?
• The court focused on the lack of control of a minority shareholder over a company’s affairs as the main reason for justifying a discount. And there is plenty of precedent law to this effect. But why a 50% or more discount (which seems to be the ballpark percentage)?! As a rule, majority shareholders have the control over a company because they have the voting power to appoint the directors. But the directors are duty bound to manage a company in the interests of all the shareholders as a whole, and there are all sorts of laws designed to protect the minority shareholders to this effect, so why should the majority shareholders’ shares be worth so much more per share than those of minority shareholders?
• In reality I would have thought the better justification for the discount would be the inability for a minority shareholder to sell his shares when he wants to. There is generally no ready market for such shares. So in principle the laws of supply and demand do justify applying a discount to minority shareholdings.
• The court was simply asked to decide what the words ‘fair value’ in the amended Articles meant. So the judge spent ages focussing on this side of things. For some reason the court wasn’t asked to decide whether the premeditated actions of Mr Gilsenan in creating different classes of shares and changing the Articles with a view to then exercising the new buy-out right at a discount themselves amounted to unfair prejudice. Was this a mistake by Mr Monaghan’s team? However, the judge didn’t seem to think that this would have amounted to unfair prejudice anyway. I’m not sure why this would be right. Yes, there are long-established precedents for valuing minority shareholdings at a discount, and this can reflect the lack of control of the company or the lack of ability to sell the shares. But going back to my point about supply and demand, in many companies the minority shareholder will be happy not to have any control, but simply to have a ‘carried interest’ whereby they hang on to their shares (getting dividends at the same rate per share as all other shareholders, generally) and wait for the majority shareholder to want to ‘exit’ from the company by selling all the shares in the company. When this happens any minority shareholders would generally expect to be paid the same price per share as the majority shareholder. As far as I recall, this has been the case in all of the hundreds of company sales I’ve dealt with. And likewise if instead the company’s business and assets were to be sold and the company wound up, then the net proceeds after paying creditors would generally be distributed to all shareholders pro rata. So if Mr Monaghan was previously happy (and perfectly entitled under the previous Articles) to hang on as a shareholder on this basis and wait for a time when he would get a full undiscounted price for his shares, why should it have been fair for Mr Gilsenan to do what he did?
• On the same rant, many tailored Articles contain ‘drag along’ provisions (whereby a majority shareholder who wants to sell their shares can force the other shareholders to sell their shares at the same time. But I’ve never yet seen any drag along provisions which say that the majority shareholder can force the minority shareholders to sell at a lower price per share than the majority shareholder! And it’s also worth noting that under the statutory equivalent in s979 Companies Act 2006, which gives 90% shareholders who want to sell their shares ‘squeeze out’ rights to force the remaining minority shareholders to sell their shares to the same buyer, those minority shareholders are entitled to receive the same price per share as the majority shareholders.
Some practical tips (if you’ve read this far)
• Generally a majority shareholder can’t force a minority shareholder to sell his shares. That’s why if you are a majority shareholder in a company, you should think about the benefits of including drag along provisions in the company’s Articles, so that when you want to sell your company you can force the other shareholders to sell as well. You might find it hard to find a buyer for your shares if you can’t do this.
• If you are given the opportunity to acquire a minority shareholding in a private company, think carefully about what this means and what protections you might need. What is it really worth to you? Will you ever be able to sell your shares, or will your only likely opportunity come if and when the majority shareholder ever decides to sell? Are there any circumstances in which you might be forced to sell for less than you think they are worth? Check the Articles, and any shareholders agreement you are asked to sign. Do they say that no discounts should be made when valuing any minority shareholdings? Are you in a position to ask for a shareholders agreement to be put in place to give you some protections?
• If you are a controlling shareholder and are opening up shares to be held by important employees, think about whether you want to change the Articles (or put a shareholders agreement in place) to say that employees must put their shares up for sale if they stop being employees. Think about whether you would want to include any ‘good or bad leaver’ provisions (where the shares of a departing employee could be valued up or down depending on how long they remained with the company or on the reasons for their departure). And always add a drag along provision if you don’t already have one.
• In either case, check you are happy with all the share transfer provisions in the Articles or shareholders agreement, including those covering how shares should be valued and who decides this value (see this previous article https://www.onhandcounsel.co.uk/growingbusiness/expert-determination-of-fair-value-cream-holdings-case/
about a case on this subject). When drafting share transfer provisions it is always sensible to work with an accountant who will be best placed to know how these provisions would work in practice, for example if they were ever asked to value any shares.
• 100s more comments and tips on shareholder issues available on request…
• Have a look at my food for thought Guide on shareholders agreements https://www.onhandcounsel.co.uk/business-structuring/business-models-part-3-joint-venture-companies-and-shareholders-agreements/
• Wait for my long-awaited ‘dictionary of terms relating to shares etc’ (catchier title not yet arrived) to come out one day (hopefully this year).
Case: In the matter of Euro Accessories Ltd  EWHC 47 (Ch)