Minority shareholders in small to medium sized companies (SMEs) need to take steps to ensure they have an exit route which enables them to sell their shares for fair value. Inserting a put option in a shareholders' agreement can give minority shareholders a much better chance of realising their investment.

No automatic entitlement on exiting a company 

Although most investors in SMEs invest in the hope of realising their investment within a few years, the reality can often be very different.  In the absence of a properly drawn shareholders' agreement, minority shareholders can find themselves locked in with no real prospect of being able to sell their shares at fair value.

The Court of Appeal decision in Larkin v Phoenix Office Supplies Ltd was a good example of how a break up between shareholders in a 'quasi-partnership' company does not give rise to an entitlement of a minority shareholder to a 'no-fault divorce'.  In this case, there was no automatic entitlement to require the majority shareholders to buy out the shares of the minority shareholder at fair value. The minority shareholder wished to leave the company, for entirely his own reasons, but he had no legal or contractual right to 'put' his shareholding onto the other members at its full undiscounted value.  Nor was there found to be any unfairly prejudicial conduct by the majority entitling the minority shareholder to the grant of relief by the Court. 

Shareholders' Agreement

A well drafted shareholders' agreement is a good way to ensure that a minority shareholder receives fair value for his shares on exiting the Company.  Although the Articles of Association will often provide for pre-emption rights, so that a shareholder wishing to sell must first offer the shares to the other shareholders before selling to a third party, the reality usually is that no person outside the company will be interested in acquiring the shares of the SME.  The consequence of this can be that the minority shareholding is not saleable and has little or no value, leaving the shareholder locked in with a worthless investment.  The majority shareholders can use a variety of methods in order to reduce the value of the minority shareholding and force a sale on unfavourable terms.  

While a minority shareholder will have a legal remedy if he can demonstrate 'unfair prejudice' under section 994 Companies Act 2006, such litigation is notoriously expensive and difficult and the costs are usually out of proportion to the value of the shareholding at stake.

Put Option

A well drafted Put Option is an excellent device for dealing with irreconcilable differences.  The shareholder wishing to exit the company gives notice to the other shareholder/s requiring them to purchase his entire shareholding for 'Fair Value' or at a pre-determined formula.  The Shareholders' Agreement will usually contain a dispute resolution clause referring any dispute over the price to be paid for the shares to an independent valuer who could act as an expert in determining the fair price to be paid.

It would of course depend on the ability of the majority shareholders to buy out the departing shareholder, and the shareholders' agreement would provide that failing payment, the Company would have to be liquidated.  The financial burden on the majority shareholders  could be alleviated by providing for payment by instalments over a reasonable period of time.  However, the threat of the nuclear option of a liquidation will often prompt the majority shareholders to act reasonably and reach agreement as to a fair price to be paid for the minority shares.

So it can be that a well drafted put option works in the best interests of both the outgoing minority shareholder as well as the remaining majority, by avoiding costly disputes and the uncertainty of continuing with a minority shareholder who wants out but is, in practical terms, locked into the Company.