Shareholder buyout

What does shareholder buyout entail? 

Businesses are dynamic and are constantly evolving and there are various situations where a business may look to purchase a shareholder’s interest in the company, for example: 

• Retirement of an owner 

• A company restructuring  

• Dispute between shareholders 

A shareholder buyout refers to a company’s owners buying back a departing shareholder’s interest (their shareholding) in the company.   

How is a shareholder buyout performed? 

This process is usually performed in accordance with a shareholder buyout agreement, also known as a buy-sell agreement, which is a contractual agreement made between a company’s shareholders regarding the way in which shares can be bought and sold within the company.  Whilst not required by law, it is highly recommended that a company’s shareholders jointly enter into a buyout agreement.  

A shareholder buyout is usually performed via a share buy back but there are other possible options. They buyout can take place over a period of time if the value of the shares is large, however, it is very important to take into account the various tax implications that can arise before deciding the route to take.  

Generally, the price that will be paid is determined by the business’s Articles of Association, which generally will require an auditor’s valuation and sometimes by an independent valuation. Where it is not possible to agree a price then the use of mediation can be helpful, which can prevent lengthy and costly discussions that can be hard to resolve if there are shareholder disputes, impacting the business in general. 

Why does my company need a shareholder buyout agreement? 

A company’s shareholders may include a buyout agreement at any time, in the Articles of Association, in the company’s bylaws, or in a separate stand-alone written agreement.   

The shareholders of a company, not the directors, are the ultimate owners of a company. Most shareholders have voting rights, enabling them to vote on, and make, decisions on behalf of the company, for example:  

• Purchase of property 

• Dismissal of directors. 

Where a current shareholder resigns, retires, starts divorce proceedings, becomes bankrupt or even dies, having a properly drafted shareholder buyout agreement is vital to prevent confusion and disagreement over the status of the newly available shares.   

The importance of adopting a shareholder buyout agreement should not be overlooked. It is a pre-emptive measure that: 

• Minimises disputes between shareholders 

• Prevents costly disruption to business 

• Limits reputational damage. 

There are numerous benefits to ratifying a shareholder buyout agreement, some of which are discussed below. 

Controlling who ultimately owns the company 

A key advantage of these agreements is that they act as a way of controlling who can, and cannot, own shares in the company.  For example, an agreement commonly sets out that the departing shareholder’s interest in the company must be bought back by fellow shareholders - this is a useful and effective way to prevent an unwanted third-party buyer from gaining an interest in the company.   

Most ordinary shares carry with them voting rights and so this arrangement can serve as a mechanism of control. An agreement stipulating that outside buyers cannot purchase shares will prohibit inadequately experienced individuals from gaining an interest in the company.  Where a majority shareholder (owning 50% or more of the company’s shares) retires, for example, a shareholder buyout agreement can prevent a new, external shareholder form acquiring their powerful voting rights capable of vetoing motions at annual general meetings. 

This is particularly helpful when company owners want only certain family members to share ownership and control the future of the business.  

Limiting shareholder disputes over the value of a shareholding in the company

An agreement will specify how the value of the departing shareholder’s interest in the company is to be calculated.  A well-drafted agreement will set out how, in the event of a shareholder dispute over its value, the shareholding will be determined without going to court– such as by using a mediator.   A jointly approved method of valuing the shareholding will encourage agreement among the remaining shareholders on the price they will be paying to buyout the shares and discourage the need for expensive litigation to resolve shareholder disputes down the line. 

Shareholder disputes can also be staved off by drafting a clause into the agreement dictating how the shareholder buyout will be funded. This is likely to be a relatively flexible clause, allowing for the various scenarios in which a shareholder may leave their position, for example: 

• A company may invest in a life insurance policy in order to accommodate for buyout funding upon the sudden death of a shareholder  

• The voluntary departure of a shareholder may be dealt with by their shareholding being gradually bought back over time with the company’s profit 

Providing clarity in the event a shareholder divorces their spouse

The need for a clear, and fair, method of price calculation for a shareholder buyout is particularly crucial when the buyout trigger is the shareholder’s divorce. An ex-spouse of a shareholder (with formerly no direct interest in a company) may acquire part of their former spouse’s shareholding in their company as part of the financial remedy of the divorce. 

Many shareholder buyout agreements will dictate that a shareholder’s ex-spouse must sell their acquired ownership back to the company, including an agreed method of calculating the value of the shareholding in question in a shareholder. However, a buyout agreement can help prevent contestation by either spouse involved. 

All these advantages of adopting a shareholder buyout agreement revolve around the common ground of minimising disruption to the running of a business upon the voluntary or involuntary departure of an existing shareholder. Whether it is reputational damage caused by negative publicity around shareholder disputes, or the arrival of a new, third-party majority shareholder, the failure to prepare for shareholder buyout can have a destabilising effect on a company, and possibly its profitability.