ShareholdersOctober 1, 2020by Business Valuation TeamMinority Shareholder Exit Strategies – Shareholders Agreement

Minority ownership interests in private firms are naturally valued lower than the prorated en bloc equity value. The exception happens when the shareholder agreement or other forms of contract states otherwise.

Also, third party buyers have a mutual interest only in the majority ownership interests for private firms. This further lowers the value of the minority ownership interests.

Hence a viable strategy for a minority shareholder to withdraw from the shareholding, is to strike a deal with the remaining shareholders, who seek greater control over the private firm and a larger equity interest.

When such a ‘triggering event’ does not exist in the shareholder agreement, shareholders would then activate the reciprocal buy-sell clause – the ‘shotgun’ clause – which safeguards the liquidity of an ownership interest.

In this clause, the minority shareholder can offer his/her voting shares to another shareholder for returns defined in a contract between them.

When a shareholder receives such an offer from a minority shareholder, he/she will have to decide whether to:

(1) accept it and buy the shares off the minority shareholder based on the explicit terms of the sale dictated in the contract; or

(2) reject the offer, and let the minority shareholder take over his/her voting shares instead based on the explicit terms of sales dictated in the contract.

Either way would result in a transaction between the parties named in the contract.

One impending issue of using a shotgun clause is when both shareholders do not have equal negotiating power. This happens when one of the shareholders has greater financial support, or greater ownership of the company, or a better grasp of the company’s existing and future financial status. There are also situations, more common with small businesses, where one of the shareholders is more reputable and well-connected, and hence receives more ‘personal goodwill’, which is a non-transferable asset. This means a higher business value for the shareholder receiving the ‘goodwill’.

To reduce the impact of such inequality issues of a shotgun clause and protect the interests of all the shareholders, both the withdrawing and the remaining, the shareholder agreement would have another clause stating ‘the right of first refusal’, which can be composed using one of the following methods:

  • ‘Hard’ right of first refusal

Here, the minority shareholder may seek proposals from an interested third party, and then show the best offer to the remaining shareholders.

The remaining shareholders are given the chance to buy over the shares at the said offer within a stipulated time frame.

Should these shareholders decide not to buy, or a decision is not made outside the time frame, the minority shareholder can then sell to the third party.

This approach is more advantageous to the remaining shareholders. Competing with the effect of the right to first refusal, the third party buyers would rush through the evaluation and tend to propose an offering price that is higher or lower than the business value of the company. Either way will incur loss to the third party or the minority shareholder.

  • ‘Soft’ right of first refusal

In this approach, the minority shareholder may set explicit terms of the sale of his/her voting shares, which is then proposed as an offer to the remaining shareholders, who will decide to buy over the shares within the stipulated time frame.

Should these shareholders decide not to buy, or a decision is not made outside the time frame, the minority shareholder can then choose to sell in an open market at the same offer or more.

This is more advantageous for the minority shareholder as his/her subsequent offers to other potential buyers will not be affected by the first refusal right.

Then what happens when a shareholder plans to sell their shares to third party buyers?