Power and control in a company ultimately depends on a shareholder’s equity interest in the company and their representation in the board of directors. As such, minority shareholders face a continued risk of being out-voted by the majority shareholders at the shareholder level and often at the board level. As a result, minority shareholders typically do not have any meaningful control on the overall direction and decisions of the company, whether in good times or bad.
While the law does prescribe minimum voting thresholds required for specific corporate actions and provide remedies for minority oppression, a minority shareholder can nevertheless negotiate for contractual protections to be tailored into a shareholders’ agreement (“SHA”) befitting of their bargaining power and objectives, and for such clauses to be entrenched in the company’s constitution. We will explore some common minority protection clauses below.
Rights to Appoint a Director
Generally, the directors run the company and make the day to day business decisions, not the shareholders. Therefore, it will be beneficial for a minority shareholder to negotiate for a right to be appointed as a director, to nominate a director, or at the very least appoint an observer (who cannot vote) at board meetings. The right to appoint a director can be complemented with provisions in the SHA which limits the size of the board, protections against removal, rights to be heard, veto rights or even weighted votes of the appointed director.
Shareholders who are without a representative director on the board may often find themselves powerless to access the company’s financial information and books. Minority shareholders can therefore negotiate for a specific right to access information and documents relating to the company with reasonable notice and frequency.
The SHA can also provide for a laundry list of reserve matters that the directors or the company cannot do without first obtaining the affirmative vote of the minority shareholders. Reserve matters typically include corporate actions such as expenditure above specified amounts, expanding the business into new markets, or other significant decisions such as hiring of key management positions.
Pre-Emptive Rights and Rights of First Refusal
Pre-emptive rights ensure that any newly issued shares shall first be offered to existing shareholders including the minority shareholders, on a pro-rated basis, and not just to a selected few. Similarly, right of first refusal ensures that any shares sold by an existing shareholder shall first be offered to other shareholders on a pro-rated basis. Both the above are anti-dilution mechanism which allow the minority shareholders to retain their percentage of equity in the company, or even to increase their equity ownership if desired.
Tag-along rights compel the majority shareholders who are selling their shares to allow the minority shareholders to participate in or ‘piggy-back’ onto the sale of shares on the same terms and conditions as the majority shareholders. Typically, the rights can be exercised at the election of the minority shareholders, particularly in situations where the minority shareholders do not wish to remain in the company with an unknown new shareholder.
A put option gives minority shareholders the right to sell their shares to another shareholder in certain situations, such as in deadlocks, or upon the company’s failure to achieve certain agreed milestones. In essence, it would compel another shareholder to buy out the minority shareholders. This is particularly important for private companies limited by shares, given the lack of liquidity for minority shareholders to dispose of their shares to third parties or in the open market.
A put option clause should address when the option can be exercised (upon the occurrence of any event or at a predetermined date), when it expires, and the price in which the shares will be acquired from the minority shareholder at.
When the minority shareholder has decided to exit the company, the minority shareholder will need to dispose of the shares held. It is useful for a valuation method to be specified in the SHA for the sale of shares by a minority shareholder to properly reflect the contributions of the minority shareholder and the value of the company at the point of sale. By failing to do so, a minority shareholder may even face an unexpected discount to its share value due to the lack of third party buyers who are interested in acquiring a minority interest.
Entering into a business relationship or investing in a company as a minority can be a cause of concern for many. However, such concerns can certainly be cushioned with reasonably negotiated protections while preserving the majority’s inherent right to decide on the company’s business and affairs.