An important aspect of shareholder protection is their exit rights. In a public company, an unhappy shareholder can sell his shares on the stock exchange and exit the company. However, it is not so easy for a shareholder to dispose of his shares in a private company. This is especially when the company’s constitution restricts the right of shareholders to transfer their shares.
Therefore, exit clauses are often incorporated into the shareholder agreement to ensure that shareholders in a private company would be able to dispose of their shares and exit the company in a manner equitable to all shareholders.
Types of Exit Clauses Available
Types of Exit Clauses (excluding pre-emptive clauses) that shareholders can incorporate into the shareholder’s agreement include:
- A put option
- “Tag-along clause” or “piggy-back right”
- “Drag-along clause”
What Do the Exit Clauses Do?
Put option
A Put Option would entitle a shareholder who is selling his shares to require the other shareholders to purchase the shares. The exercise of the put option can be made subject to a particular time period or if a particular event occurs. The option must state the amount of shares that can be bought or sold, and either the share price or a clear formula for the calculation of the price of the shares.
For example, A has a put option over twenty per cent of his own shares in the company. He can exercise the put option if the company is insolvent. When the company becomes insolvent, A can then exercise his put option to sell his shares to B at the price stated in the option or the price calculated using the formula provided. Once A exercises his option to sell, B cannot decline to purchase A’s shares.
The shareholder agreement would have to provide that the pre-emption provisions (if any) do not apply in the event of the exercise of the put option or a waiver could be given in advance by other shareholders who are not party to the put option arrangement.
“Tag-along clause”
A “tag-along clause” gives a minority shareholder the right to have his shares bought on the same terms, including price, as the majority shareholders. It imposes the restriction on majority shareholders from selling their shares in the company to an outsider without first procuring the outsider to make an offer for the shares of the minority shareholders on the same terms.
It provides that if the majority shareholder wishes to sell his shares, he must first offer the shares to the minority shareholders. If the minority shareholders decline to purchase those share, it can decide to “tag along” with the selling shareholder and together, they sell their shares to a third-party. Safeguards that could be put in place include:
- Stipulating a minimum price for the shares so that the majority shareholder cannot force a sale below a fair price;
- Provisions restricting the time when the main shareholder can use the “tag-along clause”, such as the expiry of a time period or only after the Company achieves a certain level of profitability, to ensure minimum share value;
- To allow the minority shareholder a certain period of time to find an alternative buyer for all shares at a higher value before the minority shareholder decides whether to exercise his option to “tag along”. If this provision is included in the shareholder agreement, the shareholder agreement must also allow the minority shareholder to require the majority shareholder to sell the shares to the highest bidder should the minority shareholder decides to “tag along”; and
- Provisions that in the event of a sale, it is only the majority shareholder who makes and is responsible for the representations and warranties on the company to the purchaser as the majority shareholder is in control of the management and operations of the company.
The “tag-along clause” allows minority shareholder to piggy-back on the majority shareholder’s ability to find a buyer at an attractive price. Minority shareholders, especially when they are involved in running the business, generally lack the resources to find such buyers. It is also beneficial to the majority shareholders because it gives the minority shareholders a sense of fairness in the transaction, which would make them less resistant to the possibility of an outright sale.
“Drag-along clause”
A “drag-along clause” gives the selling shareholder the right to compel all the other shareholders to sell their shares to a third-party purchaser on the same terms as the shareholder who approves of the sale. It prevents minority shareholders from refusing to sell their shares if the majority shareholders wish to sell to a third-party purchaser interested in buying out the company.
The same safeguards for “tag-along clauses” stated above may also be put in place for the “drag-along clause” in the shareholder agreement.
Why are Exit Clauses Important?
Exit clauses are important to shareholders, especially for minority shareholders who usually lack the ability to decide the direction the company is taking or possess the resources to secure a better buyer for their shares when they wish to exit the company.
By incorporating exit clauses within the shareholder agreement, it allows for easy exit of shareholders. The exit clauses provide some measure of protection for minority shareholders by ensuring that they are treated fairly and have their benefits maximised when the majority shareholders wish to sell their shares. Furthermore, it ensures that the minority shareholders are less likely to object to an outright sale of the company.
Documentation Required
When shareholders exercise their exit rights and transfer their shares to a buyer, the company would have to lodge the notice of transfer of shares in writing with the Registrar. The company will only be able to lodge the transfer of shares after the proper instrument of transfer have been delivered to the company.
Before investing in a company, it would be prudent to review and examine both the company’s constitution and shareholder agreement to ensure that the exit rights of the shareholders are properly drafted. To this end, it is advisable to consult a corporate lawyer to review these documents before jumping into the investment.
You may also read more about shareholder rights in general in our other article.
