Month: December 2020

Introduction

Why does a company need capital?

In order to fund:

• start-up expenses;
• working capital; and
• expansion and growth (e.g. purchasing new premises or another business).

Capital can come from:

• equity (shareholder funds);
• debt;
• hybrids (such as preference shares and convertible bonds); and
• retained profits (also known as ‘retained earnings’).

What is debt finance?

A simple definition is ‘borrowing money’ from banks, other financial institutions or other lenders (such as directors or other group companies).

Types of debt finance

Although there are many types of debt finance available under different names, they can all be classified as either loan facilities or debt securities. In general terms, a loan facility is an agreement between a borrower and a lender which gives the borrower the right to borrow money on terms set out in the agreement.

A debt security (bond) is in many ways similar to an equity security (share). In return for the finance provided by an investor, a company (known as the ‘issuer’) issues a piece of paper acknowledging the investor’s rights against the company. This piece of paper (a security) can either be kept or sold to another investor. However, as we shall see below, investors in debt securities have rather different rights from investors in equity securities. The terms ‘equity security’ and ‘debt security’ should not be confused with a security interest granted by a company to the lender(s) over one or more of its assets.

Some of the basic types of debt are detailed below:

Loan facilities

• Overdraft – This is a form of loan facility that is familiar to most individuals. It is an on-demand facility (which means that the bank can call for all the money owed to it to be paid back at any time) and is usually not used as a long-term borrowing facility. Companies also use overdraft facilities. Interest is paid to the bank on the amount that the customer is ‘overdrawn’.
• Term loan – A term loan is borrowed for a fixed period of time and repaid on a certain date (‘maturity date’). For example, a company may borrow a sum of money to purchase new machinery for the business. The loan is to be repaid in five years’ time. The lender will not be able to call for repayment before the agreed repayment date in five years unless the borrower breaches the terms of the loan agreement. The borrower pays interest to the lender on the amount borrowed for the duration of the loan.

Term loans which are repayable in a single lump sum at the end of the agreement are referred to as having a ‘bullet repayment’. Alternatively, the loan may be repayable in instalments, in which case it is referred to as ‘amortising’.

Debt securities

• Bonds – A bond is a debt security. Each bond is represented by a piece of paper (a security) which records the rights of the investor. As bonds are a form of debt, those rights are similar to the rights of a lender under a loan facility. The issuer promises to repay the value of the bond to the holder of the bond at maturity. Until then, the issuer promises to pay interest to the holder on a periodic basis (often bi-annually).

Bonds are usually issued with a view to being traded. Whoever holds the bond on maturity will receive the value of the bond back from the issuer. The markets on which bonds are traded, whether physical or virtual, are referred to as the ‘capital markets’.

Debt/equity hybrids

• Convertible bonds

Convertible bonds are bonds which can be converted into shares in the issuer. On conversion, the issuer issues shares to the bondholder in return for its agreement to give up its right to receive interest and repayment of the principal amount invested.

Note that a convertible bond has the characteristics of both debt and equity, but not at the same time. It starts off as a debt security: a bond. The investor receives interest. Later on, if the investor so elects (in accordance with the terms of the bond issue) the bond is swapped for shares. The investor then enjoys all the characteristics associated with shares. At that point there is no longer any debt element to his holding: he has become an ordinary shareholder. Therefore, convertible bonds have the characteristics of debt until they are converted into shares. After that, the holders receive shares with all the characteristics of equity.

• Preference shares

Preference shares are an anomaly. In fact, a preference share is wholly equity, but it is often called a hybrid because it has elements that make it look similar to debt. Indeed, depending on the rights attached to the preference shares, the International Financial Reporting Standards (commonly used by many companies today) provide that there are times when preference shares should be treated as debt for accounting purposes.

The holder of a preference share commonly has no voting rights, and will usually get a definite amount of dividend ahead of other shareholders (making it look similar to interest). So, if the preference share has a fixed maturity date on which the company must redeem or purchase the share and/or such preference dividend is fixed (for example, must be paid if the company has sufficient distributable profits), then the preference share actually looks more like debt.

In my previous post, I detailed the considerations applying to companies proposing to issue shares. The following is a very brief overview of the main rules and guidelines that must be considered in addition to the considerations discussed previously, by public/listed companies proposing to issue shares.

Listing, Prospectus, Disclosure and Transparency Rules (‘LPDT Rules’)

The LPDT Rules apply to listed companies (and some of the rules apply to companies applying for listing) and their provisions set out not only procedures for listing but also continuing obligations to which the listed company and its directors are subject from the date of listing. The LPDT Rules need to be considered when a listed company is considering a fresh issue of shares.

Share Capital Management Guidelines (‘SCM Guidelines’) and Pre-emption Group Statement of Principles

Companies will also have regard to (i) the SCM guidelines issued by The Investment Association (formerly known as The Investment Management Association) in relation to the appropriate level of directors’ authority to allot shares, and (ii) the statement of principles issued by the Pre-emption Group, which is made up of representatives from listed companies and their investors in relation to the disapplication of pre-emption rights. A listed company must consider all of these guidelines whenever seeking s.551 CA 2006 authority or the disapplication of pre-emption rights under s.570 CA 2006. Although the guidelines do not have force of law, the effective sanction for non-compliance is that institutional investors may sell their shares or vote the resolution down.

Valuation of non-cash consideration

Under s.593 CA 2006, subject to certain exceptions, a public company cannot receive non-cash consideration on the allotment of shares without ensuring that the consideration has been independently valued, and a report on that valuation produced, in accordance with the provisions of CA 2006 (see in particular s.596 CA 2006 which sets out what the report should cover). Note that this section of CA 2006 applies to all public companies, not just listed companies.

The s.755 restriction

Under s.755 CA 2006 a private company limited by shares is prohibited from offering its shares to the public. As a result, private companies are essentially restricted to offering their shares to targeted investors only and not to the public indiscriminately.

The expression ‘offer to the public’ (as defined in s.756 CA 2006) covers offers to ‘any section of the public’, but excludes offers which are intended only for the person receiving them, and offers which are a ‘private concern’ of the persons making and receiving them. This latter exclusion covers offers made to existing shareholders, employees of the company and certain family members of those persons, and offers of shares to be held under an employee’s share scheme. These excluded offers will not fall foul of the s.755 restriction.

This restriction must be considered carefully when a private company is proposing to allot shares.

The requirement for a prospectus

Every time that a company (private or public) offers shares you will need to consider whether or not it is required to publish a prospectus to would-be investors. Below is a very brief overview of the rules relating to prospectuses.

What are the governing rules?

At the time of writing, the rules on prospectuses are derived from the European Union’s Prospectus Directive (the ‘Directive’), as amended by subsequent amending directives, which affects, amongst other things, the content and disclosure requirements for prospectuses.

The Directive has been implemented in the UK through the Prospectus Regulation (which has direct effect in the UK); the Prospectus Regulation Rules (PRRs) drawn up by the City regulator, the Financial Conduct Authority (FCA) and amendments to the Financial Services and Markets Act 2000 (FSMA).

Where shares are being offered overseas, overseas law must be considered, and you should note that within the European Economic Area (EEA), mirroring provisions will apply.

Note that the rules on prospectuses are also relevant to offers of debt securities.

What is a prospectus?

A prospectus is essentially an explanatory circular giving investors details about the company they are investing in and about the investment itself on which to base their investment decision. A prospectus should contain all the information necessary to enable investors to make an informed assessment of the financial status of the company and the rights attaching to the shares (s.87A(2) FSMA), and preparing a prospectus is therefore an expensive and time-consuming process.

When is a prospectus required?

In an offer of shares by a private company, it will usually be the case that a prospectus will not be required. However you will need to consider the rules each time.

In outline, the legislation sets out two tests. If either test is satisfied then the company will have to publish a prospectus which will need to be approved by the FCA.

In summary, the tests (set out in s.85 FSMA) are whether the shares are:

1. being offered to the public in the UK (s.85(1) FSMA); or
2. being admitted to trading on a regulated market in the UK (s.85(2) FSMA).

The definition of ‘offer to the public’ for the purposes of the first test (set out in s.102B FSMA) is very wide and capable of covering a range of communications that are not intended to be offers to the public (such as a newspaper article by a financial journalist). Note that (because of the differing definitions of ‘offer to the public’) it is possible that a private company could offer shares to investors without contravening s.755 CA 2006, but that a prospectus could still be required. Usually, however, a private company will be able to rely on one of the exemptions set out below.

For the purposes of Test 2, the Main Market of the London Stock Exchange is a regulated market, although AIM is not. A private company will clearly only be concerned with Test 1, not with Test 2.

Are there any exemptions?

There are different exemptions for Test 1 and Test 2. The Test 1 exemptions are referenced in s.86(1)(aa) FSMA and the PRRs 1.2.3R Article1(4).

The exemption most likely to be relied upon by a private company is the exemption for offers made to or directed at fewer than 150 persons (other than ‘qualified investors’), per EEA State. This exemption will cover the vast majority of share offers by private limited companies.

Another exemption of particular application to offers by private companies is that covering offers made to or directed at ‘qualified investors’ (as defined in the Markets in Financial Instruments Directive (MiFID), essentially covering certain professional or institutional investors) only.

Financial Promotions

Under s.21 FSMA a financial promotion is any invitation or inducement (in the course of business) to engage in investment activity (which includes buying shares). Financial promotions are prohibited (for all companies) unless certain requirements set out in FSMA are fulfilled. Clearly this is potentially relevant when a company is considering issuing shares to investors. Communications made by a company when issuing its shares must, either be within an exemption from the s.21 FSMA prohibition, or be issued or approved by an authorised person.

Price for shares

In simple terms, the price of a share is calculated by working out the value of the company as a whole and dividing it between the number of shares in issue. This will give a value per share, which can be used to determine the price.

There are various ways in which a company can be valued. For example: the ‘Balance Sheet’ valuation, looking at the value of the company’s assets minus its liabilities, or the ‘multiplier’ valuation, looking at the average profit of a company and multiplying it by a factor relevant to the particular industry. The value of a listed company (known as its ‘market capitalisation’) can be ascertained by multiplying the number of shares in issue by the share price at a given time.

The price of a share will comprise the nominal value of the share, plus a premium, although shares can trade at a discount to nominal value (which does not contravene the prohibition on their issue at a discount).

Effect of issuing a share for more than its nominal value on the Balance Sheet

Blue Moon Limited issues an additional 100 £1 ordinary shares for 150p each in cash, i.e. at a premium of 50p per share.

Blue Moon Limited Balance Sheet as at [date]
	Before issue	After issue
ASSETS (cash)	100	250
Less LIABILITIES	(0)	(0)
NET ASSETS	100	250
SHARE CAPITAL	100	200
SHARE PREMIUM ACCOUNT		50
RETAINED EARNINGS	(0)	(0)
SHAREHOLDER FUNDS	100	250

The cash received is shown by an increase in the assets. The nominal amount of the new shares is shown by the increase of 100 in the share capital. The premium of 50p per share (totalling £50) is shown in the newly-created share premium account. The share premium must be shown in a separate share premium account pursuant to s.610(1) CA 2006.

Earnings per share

‘Earnings per share’ is a commonly used ratio that can be used to measure the financial performance of a company. It shows the return due to the ordinary shareholders and is calculated by dividing profit after tax by the average number of ordinary shares in issue whilst the profit was generated. An increase in the number of shares in issue will result in a dilution of the earnings per share figure.

Maintenance of share capital

Once a shareholder has decided to invest in shares in a company, that investment cannot normally be returned to the shareholder. In other words, a company is not usually permitted to return capital to its shareholders – all payments by a company to its shareholders should be made out of distributable profits. This is primarily for the benefit of the company’s creditors. In practice, many private companies have only a small issued share capital so this capital maintenance regime is of little relevance. There are some exceptions to the maintenance of capital rule. These include court-approved reductions of capital and a new procedure introduced for private companies to make out-of-court reductions under Part 17 CA 2006 (ss.642 – 644). Such exceptions will be explored later in the module.

Transfer/Transmission of shares

Circumstances

Shares may be transferred by way of sale or gift or transmitted following death or bankruptcy.

‘Transmission’ means that following death, legal title to shares will vest automatically in the personal representative; and, following bankruptcy, title will vest automatically in the trustee in bankruptcy.

Restrictions on transfer

Shareholders are free to transfer their shares subject to any provisions in the articles (s.544(1) CA 2006).

The two most common forms of restriction on the transfer of shares are:

1. Directors’ power to refuse to register

Article 26(5) MA states:

“The directors may refuse to register the transfer of a share, and if they do so, the instrument of transfer must be returned to the transferee with the notice of refusal unless they suspect that the proposed transfer may be fraudulent”

Under s.771 CA 2006, a company must give reasons if it refuses to register a transfer.

2. Pre-emption clauses

Here we are looking at pre-emption rights on a transfer of shares (which should not be confused with pre-emption rights on allotment under s.561 CA 2006). Such rights are usually set out in the articles. CA 2006 and MA do not contain any pre-emption rights on transfer, so they must be specially inserted into the articles of any company wishing to establish them.

Pre-emption rights on transfer will often require that a shareholder wishing to sell shares must offer them to the other existing shareholders before being able to offer them to an outsider.

A listed company must have freely transferable shares. Therefore such restrictions on transfer are not permitted in a listed company.

Method of transfer

1. Instrument of transfer

A transfer of shares must be made by a ‘proper instrument of transfer’ – s.770(1) CA 2006. The usual method is by way of a stock transfer form, which has to be signed by the transferor and submitted, with the share certificate, to the company.

2. Stamp duty

The stock transfer form must be stamped before the new owner can be registered as the holder of those shares. Stamp duty is payable at 0.5% of the consideration rounded up to the nearest £5. Since 13 March 2008 (when the Finance Act 2008 came into force), no stamp duty is payable where the consideration is £1000 or less; but where the consideration is more than £1000, a minimum fee of £5 is payable.

3. Legal and equitable ownership

Legal title to shares passes on the registration of the member as the owner of those shares in the register of members (s.112 CA 2006). Beneficial title passes on the execution of the stock transfer form.

Types of share

In this post, I present a list of a variety of types of share. It should be noted that these are descriptions and not legal definitions. As there are no set types of share and the elements below can be mixed, it will always be necessary to refer to the articles of association of a company in order to ascertain the rights attaching to a specified class of share.
Therefore, it is important when you read through this post that you concentrate not so much on the names but on the features and rights that can be accorded to shares in general.

Ordinary shares

This is the most common form of share and usually carries a right to one vote per share held, a right to a dividend if one is declared and a right to a portion of any surplus assets of the company on a winding-up. A company may have more than one class of ordinary share, with differing rights, and perhaps differing nominal values.

Preference shares

A preference share may give the holder a ‘preference’ as to payment of dividend or to return of capital on a winding up of the company, or both. This means the payment will rank as higher priority than any equivalent payment to ordinary shareholders. Preference shares are normally non-voting.

If there is a preference as to dividend, this will be paid before the other shareholders receive anything. The amount of preferred dividend is usually expressed as a percentage of the par (nominal) value of the share. If the preference shares have been issued at a premium to their par value and it is intended that a fixed dividend will be paid based on the amount subscribed for the share (i.e. par plus premium), the share rights must expressly state that the dividend is to be calculated as a percentage of the total subscription price per preference share.

Example

ABC Limited has shares in issue which carry a right to receive a fixed preferential dividend of 4% of the par value of the shares per annum. The shares have a par value of £1 each.

Assuming that a dividend has been declared, the preference shareholders would be entitled to receive a dividend of 4p per share per annum before the ordinary shareholders receive any dividend.

XYZ Limited has shares in issue which carry a right to receive a fixed preferential dividend of 4% of the total subscription price per share per annum. The shares have a par value of £1 each but were subscribed for at a price of £1.50 per share.

Assuming that a dividend has been declared, the preference shareholders would be entitled to receive a dividend of 6p per share per annum before the ordinary shareholders receive any dividend.

It is presumed that a preference share is ‘cumulative’ unless otherwise stated. This means that if a dividend is not declared for a particular year, the right to the preferred amount on the share is carried forward and will be paid, together with other dividends due, when there are available profits. If this accumulation is not desired, then the share must be expressed to be non-cumulative.

Participating preference shares

‘Participating’ preference shareholders may participate, together with the holders of ordinary shares, (1) in surplus profits available for distribution after they have received their own fixed preferred dividend; and/or (2) in surplus assets of the company on a winding up.

As with preference shares, participating preference shares are almost always issued with a fixed dividend and can be cumulative if stated as such in the articles of association. Participating preference shares with these characteristics are generally called ‘fixed rate participating cumulative preference shares’.

Example

FE Limited has the following shareholders:

* Shareholder A, who holds 500,000 5% participating cumulative preference shares of £1 each in FE Limited; and
* Shareholders B, C, D and E, who each hold 500,000 ordinary shares of £1 each.

FE Limited has issued 2,000,000 ordinary shares of £1 each, so B, C, D and E each own 25% of FE Limited’s ordinary shares. But the cumulative preference shares that A owns are ‘participating’, so that A, B, C, D and E will each be entitled to receive 20% of any ordinary dividend declared by FE Limited.

Assuming the 5% preference relates to the par value of the share and a dividend of £200,000 has been declared, that £200,000 would be distributed as follows:

1) Shareholder A would receive £25,000 from his participating cumulative preference shares (5% of his investment in the 500,000 shares of £1 each).
2) As a participating preference shareholder, Shareholder A has the right to participate in surplus profits available for distribution to the ordinary shareholders after he has received his own fixed preferred dividend.
3) As a result, the remaining amount of the dividend (£175,000) would be divided equally among all the shareholders, including Shareholder A (so each of A, B, C, D and E receive £35,000).

In total, Shareholder A would receive £60,000 (comprising £25,000 from his participating cumulative preferences shares and £35,000 from his entitlement to share in the surplus profits available to the ordinary shareholders) while Shareholders B, C, D and E would each receive £35,000.

Deferred shares

These carry no voting rights and no ordinary dividend but are sometimes entitled to a share of surplus profits after other dividends have been paid (presuming there is a surplus); more usually ‘deferred’ shares carry no rights at all and are used in specific circumstances where ‘worthless’ shares are required (for example in what is known as a ‘ratchet’ provision in a private equity transaction).

Redeemable shares

Redeemable shares are shares which are issued with the intention that the company will, or may wish to, at some time in the future, buy them back and cancel them.

Convertible shares

Such shares will usually carry an option to ‘convert’ into a different class of share according to stipulated criteria.

Class rights

A company may issue different classes of share, as seen above. The rights attaching to each class are usually set out in the company’s articles of association. In relation to any type of share, you should always refer to the articles of association to find the relevant rights attaching to a share, since there are no formal, universal definitions of different types of share.

If an attempt is made to alter the articles of a company such that existing class rights are varied, the resolution in question will not be effective unless varied in accordance with provisions in the company’s articles for the variation of those rights or, where articles don’t contain such provisions, by consent in writing of holders of at least 75% of the issued shares of that class or by means of a special resolution passed at a separate general meeting of holders of that class (s.630 CA 2006). In addition, shareholders holding 15% of the relevant shares may (provided they did not vote in favour of the variation) apply to court within 21 days of the resolution to have the variation cancelled (s.633(2) CA 2006). Following such application the variation will not take effect unless and until it is confirmed by the court. The court will not confirm the variation if it feels that the variation unfairly prejudices the shareholders of the class in question.

The diagram below illustrates the procedure that a company must follow in order to issue new shares. The remainder of this post sets out the steps in detail.

Step 1: Any cap on the number of shares that may be issued?

Before issuing new shares you must check the company’s articles for any cap or limit on the number of shares that may be issued. If this is to be exceeded, the cap must be removed or the limit increased.

Is there a cap?

A company incorporated under the Companies Act 1985 will originally have had an authorised share capital, which acted as a ceiling on the number of shares it could issue.

A typical share capital clause in the memorandum of association of a company incorporated under CA 1985 might look like this:

“The authorised share capital of the Company is £100 divided into 100 ordinary shares of £1 each.”

The authorised share capital of a company was the maximum amount of shares available for issue by the company. In the example above, the authorised share capital is 100 ordinary shares of £1 each. You will still see references to authorised share capital (ASC) in the articles of association of companies incorporated under CA 1985.

The requirement for a company to have an ASC no longer exists under CA 2006. Therefore, companies incorporated under CA 2006 will not have an authorised share capital and shareholders wishing to impose a cap to restrict the number of shares which such a company can issue will need to amend the articles of association (by special resolution) to include suitable provisions.

For companies which were incorporated under CA 1985, since 1 October 2009 (when the relevant CA 2006 provisions came fully into force), there has been a deemed restriction in their articles, derived from the authorised share capital with which they were registered under CA 1985 (see s.28(1) CA 2006 and Companies Act 2006 (Commencement No.8, Transitional Provisions and Savings) Order 2008 (SI 2008/2860), Schedule 2, paragraphs 42(1) and 42(2)(a)). Therefore, companies incorporated under CA 1985 will continue to have a ceiling on the number of shares that can be issued, unless such cap is removed from their articles.

Therefore, to see whether a cap exists a company’s memorandum, articles and any resolutions that have altered such documents should be checked.

How can the cap be removed?

For companies incorporated under CA 1985

Under s.121 CA 1985 companies could increase their authorised share capital by ordinary resolution.

To preserve the status quo which used to exist under s.121 CA 1985, SI 2008/2860, Schedule 2, paragraph 42(2)(b) provides that, for companies incorporated under CA 1985, shareholders wishing to remove or amend the deemed restriction from a company’s articles under CA 2006 may do so by ordinary resolution. This is despite the fact that removing such a deemed restriction involves changing the articles, which would normally require a special resolution under s.21(1) CA 2006.

Any such deemed restriction will also fall away as a consequence of the company adopting, wholesale, new articles (such as MA) which do not include provision for any cap (applying s.21(1) CA 2006).

Companies incorporated under CA 2006 will not have an authorised share capital. For such companies, therefore, there will be no bar to issuing shares under step 1 – the step will usually be satisfied. The only exception would be if the company has placed a provision in its articles limiting the number of shares that may be issued. If such a restriction exists, it can be removed, or the limit increased, by special resolution under s.21(1) CA 2006. Under s.617(2)(a) CA 2006, each time a company issues shares, its share capital increases automatically.

For step 1, you must therefore check:

• whether any resolutions to remove, impose or change any cap, or increase the share capital, have been passed, and ensure that you have up-to-date information (particularly checking the company’s constitution); and
• whether any shares have been issued by checking the register of members or the most recent confirmation statement filed at Companies House and any subsequent forms filed on allotments of shares (using Form SH01 under s.555 CA 2006))

If the company does not have a limit on its share capital or if there are sufficient unissued shares available within any cap for a proposed new issue, the company can proceed to step 2.

The Confirmation statement – ss.853A-853F CA 2006

Since July 2016, companies have been required to file an annual confirmation statement. This confirmation statement states (‘confirms’) that the company has filed all necessary returns in the previous 12 month period (e.g. changes to registered address, changes to directors or company secretary etc.). It also sets out any changes to share capital. In addition, under s.853F CA 2006, information relating to shareholdings (including information relating to the names of shareholders and number of shares held) must be provided along with the confirmation statement.

Before July 2016, similar functions were fulfilled by a company’s Annual Return (a filing which is now not required).

Step 2: Do the company’s directors need authority to allot?

Directors are responsible for the actual allotment of shares to a shareholder and they must resolve by board resolution to make an allotment. However, they may need to have the prior authority of the shareholders to be able to do this.

Section 549 CA 2006 provides that the directors of a company must not exercise any power of the company to allot shares in the company except in accordance with s.551 CA 2006 (authorisation by the company), or s.550 CA 2006 (private company with only one class of shares).

In private companies with only one class of share, s.550 CA 2006 provides that directors have the power to allot shares of that same class, unless they are prohibited from doing so by the company’s articles. This helps many smaller companies to simplify the process of issuing shares. In relation to companies incorporated under the CA 1985 only, SI 2008/2860, Schedule 2, paragraphs 43(1) and (2), provide that an ordinary resolution is required to authorise the directors to rely on s.550 CA 2006.

Otherwise, directors require authority under s.551(1) CA 2006, which provides that authority may be given by a provision in the company’s articles of association or by shareholder resolution. Under s.281(3), this means an ordinary resolution unless the articles require a higher majority. You would therefore need to check the latest version of the company’s articles and any resolutions that have been passed giving the directors authority, in order to establish whether further authority is required.

Authority to allot under s.551(1) CA 2006 can only be given subject to limits in terms of both time and number of shares (s.551(3)). This means that if the company has already granted its directors a s.551(1) CA 2006 authority, it must be checked to ensure it is still valid.

If a cap exists in the articles (see step 1 – e.g. where a company has not removed the cap transferred from the company’s authorised share capital in its memorandum), authority to allot can only be given up to the amount of the cap, which may need to be amended (as per paragraph 3.1(ii), to provide for the intended allotment) or removed altogether.

Authority to allot was also needed under CA 1985. It was given by ordinary resolution or set out in the articles.

You may see references to a “s.80 authority” in CA 1985 documents (i.e. an authority to allot under s.80 CA 1985).

Such an authority was required for private companies (even those with only one class of share). There was no equivalent position to s.550 CA 2006 mentioned above. Older companies wishing to take advantage of the flexibility provided by s.550 CA 2006 must resolve accordingly, as explained above.

Step 3: Must pre-emption rights be disapplied on allotment?

What does a ‘pre-emption right’ mean? It means the ‘right of first refusal’. New shares should be offered pro rata to existing shareholders before any new investor.

This is because, when a company allots shares to new shareholders, there is an effect on the proportionate ownership of the company held by the existing shareholders. Their ownership is diluted, and therefore their entitlement to dividends and voting power is also diluted.

Due to the potential dilution, s.561 CA 2006 contains pre-emption rights, which give protection to existing shareholders.

Consider the following example:

Example:

Blue Moon Limited has issued share capital of 100 ordinary shares of £1 each. The shares are held as follows:

Sally holds 20 shares, which equals 20% of the issued shares
Mary holds 80 shares, which equals 80% of the issued shares
100 shares issued in total (100%)

Mary, on a poll vote, has the power to pass ordinary and special resolutions without Sally’s support. This means, for example, that Mary, acting alone, can change the constitution of Blue Moon Limited by altering its articles, and has control of the board of directors as she has the power to appoint and remove directors. In addition, Mary is entitled to larger dividends than Cathy.

If Blue Moon Limited now issues a further 100 ordinary shares of £1 each to a new shareholder, James, the position is as follows:

Sally holds 20 shares, which equals 10% of the issued shares
Mary holds 80 shares, which equals 40% of the issued shares
James holds 100 shares, which equals 50% of the issued shares
200 shares issued in total (100%)

On a poll vote, each of the shareholders now needs the support of at least one other shareholder to be able to pass an ordinary or special resolution. The only control that any of them has is that Mary is able to block special resolutions and James is able to block both ordinary and special resolutions. In addition, both Mary and Sally are now entitled to lower levels of dividends.

Section 561 CA 2006 states as follows:

1. A company must not allot equity securities to a person on any terms unless –
   1. it has made an offer to each person who holds ordinary shares in the company to allot to him on the same or more favourable terms a proportion of those securities that is as nearly as practicable equal to the proportion in nominal value held by him of the ordinary share capital of the company …

As a result, any new ‘equity securities’ (defined in s.560 CA 2006) must be offered to the existing shareholders of a company (holding ordinary shares), in proportion to their existing shareholdings, before they can be offered to anyone outside the company.

Under s.560(1) CA 2006, ‘equity securities’ are (i) ‘ordinary shares’ or (ii) rights to subscribe for, or convert securities into, ordinary shares. Take care, because this in turn leads to a special statutory definition of ‘ordinary shares’ for the purposes of s.560(1) CA 2006, the meaning of which is wider than we are accustomed to in everyday parlance. Shares ‘other than shares that as respects dividends and capital carry a right to participate only up to a specified amount’ are ‘ordinary’ for this purpose. This means that if a class of shares carries a right to receive dividends and, on a winding up, capital payments, and these rights are both capped, the shares will not fall within the definition of ‘equity securities’ and will not need to be offered pre-emptively. In every other case, the shares will fall within the definition of ‘equity securities’ and be subject to pre-emption rights under s.561 CA 2006.

Example:

XYZ Limited has a class of shares in issue which carry a right to receive a fixed preferential dividend of 5% of the nominal amount of the shares. In addition, the shares carry a right to share pari passu with the ordinary shareholders in any surplus assets on a winding up.

These shares are equity securities for the purpose of s.560(1) CA 2006 because even though the right to receive dividends on the shares is capped (at 5%) they carry an uncapped right to participate in capital payments on a winding up.

Can a company disapply pre-emption rights?

Yes. The procedure for giving effect to pre-emption rights (which can be found in s.562 CA 2006) can be lengthy and, especially for companies with numerous shareholders, complicated to carry out. On many occasions it will not be appropriate or desirable to follow the pre-emption rights procedure set out in CA 2006: for example where all shareholders agree that the company ought to bring in a new shareholder. In such a case, the company would want to disapply or exclude the pre-emption rights. This is permitted in CA 2006, with the permission of the company’s existing shareholders. There follows an explanation of the different means by which pre-emption rights can be dispensed with; in practice, companies usually use one of the first two methods on the list, depending on the source of the directors’ authority to allot the shares.

General disapplication of pre-emption rights:

A company may disapply pre-emption rights where the directors are generally authorised for the purposes of s.551 CA 2006 by passing a special resolution or by including the disapplication in its articles, both under s.570(1) CA 2006. This is not a permanent disapplication, but attaches to a particular, pre-existing s.551 authority. In practice, this is the most common means by which companies dispense with pre-emption rights on allotment.

Private companies with one class of share – disapplication by special resolution:

Section 569 CA 2006 provides for disapplication of pre-emption rights for private companies with only one class of share by special resolution. Such a disapplication presupposes the directors’ authority to allot the shares derives from s.550 CA 2006 and therefore can apply for so long as the company has in issue, and allots, shares of only one class.

Specific disapplication of pre-emption rights:

It is possible, although uncommon in practice, for a company to disapply pre-emption rights in relation to a specific allotment of shares (for example, in relation to shares being issued to a particular person or as consideration for a specific purpose) by passing a special resolution under s.571 CA 2006 (rather than s.570 CA 2006). The procedure for specific disapplication is more cumbersome than that for a general disapplication. Directors will need to provide the company’s shareholders with a written statement explaining (i) the reasons for the specific disapplication, and (ii) the amount to be paid to the company pursuant to the allotment along with justification for the amount, under s.571(6) CA 2006. A specific disapplication under s.571, like a general disapplication under s.570, attaches to a particular, pre-existing s.551 authority.

Private companies – exclusion of pre-emption rights in articles:

Section 567 CA 2006 allows private companies to exclude statutory pre-emption rights permanently, by way of a provision in its articles of association. However, companies rarely exclude pre-emption rights on a permanent basis because this would give existing shareholders no protection from dilution (there is no such provision in MA). In practice, only subsidiary companies commonly exclude statutory pre-emption provisions in their articles.

Private companies with one class of share – disapplication in articles:

Section 569 CA 2006 provides for disapplication of pre-emption rights for private companies with only one class of share under the articles. This is unusual in practice because it leaves existing shareholdings no protection from dilution.

The provisions of CA 2006 relating to pre-emption rights and their disapplication apply in the same way as described above to companies incorporated under CA 1985.

You may see references in CA 1985 documents to a ‘s.95 disapplication’ of pre-emption rights, which was the equivalent provision of s.570 CA 2006 under CA 1985 and (as under CA 2006) required a special resolution.

Step 4: Must new class rights be created for the shares?

When issuing new shares, a company may also wish to create a new class of shares, such as preference shares.

In order to create a new class of shares, it is necessary for the company, in addition to taking some or all of the steps set out above, to insert new provisions in its articles of association dealing with the rights attached to those new shares. An alteration to the articles of association, you will recall, requires a special resolution of the shareholders under s.21 CA 2006 (except if removing a cap transferred from a company’s authorised share capital in its memorandum).

Step 5: Directors must pass a board resolution to allot the shares

It is the responsibility of the directors to resolve by board resolution to allot new shares on behalf of the company. Any requirements for shareholder resolutions must be dealt with in a general meeting before the board meeting is held at which the new shares are allotted.

A general meeting will not be needed in advance of the board meeting if the company:

• has no limit in its constitution on the number of shares which can be issued by the company;
• does not require directors’ authorisation because the company is a private company with only one class of shares and there is no restriction in the company’s articles – s.550 CA 2006) or has already given the directors authority to allot shares;
• is issuing the shares to existing shareholders in proportion to their existing shareholdings and follows the procedure in s.562 CA 2006 or has already disapplied s.561 CA 2006 or is a private company and has taken advantage of s.567 CA 2006; and
• has the relevant class rights in its articles of association.

Post-meeting matters

Having issued shares, the company must deal with post-meeting matters, as applicable:

If removing the cap on the number of shares that can be issued:

• file new articles (s.26(1) CA 2006);
• for CA 2006 companies, file resolution (SR to amend articles – s.29(1)(a) and s.30(1) CA 2006); and /or
• for CA 1985 companies, file OR to remove cap (SI 2008/2860, Schedule 2, paragraph 42(3); ss.29(1)(e) and s.30(1) CA 2006).

If granting directors’ authority to allot:

1. Authority given under s.551 CA 2006: A company must file any OR granting directors authority to allot the shares at Companies House (s.551(9), s.29(1)(e) and s.30(1) CA 2006) within 15 days.
2. Authority arising under s.550 CA 2006: A company incorporated under CA 1985 must file any OR granting directors of CA 1985 companies authority to rely on s.550 CA 2006 at Companies House (SI 2008/2860, Schedule 2, paragraph 43(3), s.29(1)(e) and s.30(1) CA 2006) within 15 days. No action is required on the part of a company incorporated under CA 2006.

If disapplying pre-emption rights:

A company must file the SR disapplying pre-emption rights at Companies House (s.29(1)(a) and s.30(1) CA 2006) within 15 days after it is passed.

If creating class rights:

A company must file the following at Companies House:

• SR amending articles of association (s.30(1) CA 2006) within 15 days after it is passed; and
• amended articles of association (s.26(1) CA 2006) within 15 days after it is passed.

Allotment of shares by board resolution:

A company must:

• file the prescribed form (Form SH01) at Companies House (under s.555(2) CA 2006) within one month of the allotment;
• file a statement of capital under s.555(3)(b) CA 2006;
• update its register of members (ss.112 and 113 CA 2006) within two months (s.554 CA 2006);
• send a share certificate to new members (s.769 CA 2006); and
• consider whether the position in respect of the company’s persons with significant control (‘PSC’) has changed – in which case it should update its PSC Register.

Nominal or par value

Section 542(1) CA 2006 provides that the shares in a limited company having a share capital must have a fixed nominal value. Section 542(2) CA 2006 provides that any allotment of a share that does not have a fixed nominal value is void. The nominal or par value of a share is the minimum subscription price for that share. It represents a unit of ownership rather than the actual value of the share. Common nominal values for ordinary shares are 1p, 5p or £1.

Section 580 CA 2006 provides that a share may not be allotted/issued by a company at a discount to its nominal value. However, it may be allotted/issued for more than its nominal value, and the excess over nominal value is known as the ‘premium’. The market value will often be much higher than the nominal value of the share.

Issued, allotted, paid-up and called-up shares

The amount of shares in issue at any time is known as the issued share capital (ISC). This is the amount of share capital that will be shown in the company’s balance sheet in its accounts. This was the same under CA 1985.

A company’s ISC is made up of:

• shares purchased by the first members of the company, known as the ‘subscriber shares’; and
• further shares issued after the company has been incorporated, to new or existing shareholders. New shares can be issued at any time provided that the correct procedures are followed.

Allotment is defined in s.558 CA 2006. Shares are said to be allotted when a person acquires the unconditional right to be included in the company’s register of members in respect of those shares. This term is often used interchangeably with the issue of shares but the terms have different meanings. There is no statutory definition of ‘issue’ but it has been held that shares are only issued and form part of a company’s issued share capital once the shareholder has actually been registered as such in the company’s register of members, and his title has become complete (s.112(2) CA 2006 confirms that full legal title to shares is only achieved once a person’s name is entered in the company’s register of members).

It is not necessary for shareholders to pay the full amount due on their shares immediately. The amount of nominal capital paid is known as the ‘paid-up share capital’. The amount outstanding can be demanded by the company at any time. Once demanded, the payment has been ‘called’. It is increasingly rare for shareholders not to pay the full nominal value of their shares on issue.

The definition of ‘called-up share capital’ in s.547 CA 2006 is the aggregate amount of the calls made on a company’s shares and the existing paid-up share capital. Given that shares are rarely not fully paid up, this term is not regularly used.

What is the difference between allotting and transferring shares?

An allotment of shares is a contract between the company and a new/existing shareholder under which the company agrees to issue new shares in return for the purchaser paying the subscription price.

A transfer is a contract to sell existing shares in the company between an existing shareholder and the purchaser. The company is not a party to the contract on a transfer of shares.

It is crucial to remember the difference between an allotment and a transfer of shares as the procedure to effect an allotment and a transfer of shares is different.

Treasury shares

These are shares that have been bought back by the company itself and are held by the company ‘in treasury’. Treasury shares are issued shares being held by the company in its own name, and the company can subsequently sell those shares out of treasury. Note that although such a sale of shares is a transfer, not an issue, of shares, s.561 CA 2006 pre-emption rights (see s.560(3)) and s.573 CA 2006 disapplication of pre-emption rights will apply. The company can also choose to cancel treasury shares at any time or transfer them to an employee share scheme.

What is capital?

The general term ‘capital’ is used to refer to the funds available to run the business of a company. For example, you may hear in the media, professionals advising that a business needs an ‘injection of capital’. All it means is that the company requires more finance or funding to run its business.

In company law, the term ‘share capital’ relates to the money raised by the issue of shares. The share capital is contributed by investors in the company and is represented by shares that are issued to such investors.

Why does a company need funds?

When a company is set up, funds are needed to get the business started, e.g. to pay rent, buy stock and machinery, etc.

Funds are also needed to keep the business going – this is commonly known as ‘working capital’.

Funds are also needed for expansion and growth, e.g. by taking on new premises or buying other businesses.

How does a company fund its business?

There are various ways in which a company can raise funds, including by:

• issuing shares, i.e. ‘equity finance’;
• borrowing, i.e. ‘debt finance’;
• issuing a ‘hybrid’ investment which has the characteristics of both debt and equity (for example a convertible bond or a preference share); and/or
• retaining its profits for use in the business (rather than paying the profits to the shareholders).

Equity finance: what are shares?

A share is often described as a ‘bundle of rights’. By investing in the share capital of any company, the investor becomes a part owner of the company and will often have voting rights in shareholder meetings. In the case of a private company, most investors make a long-term investment and will only usually get their investment back on a sale of their stake, a sale of the company itself, on a flotation, or when the company is wound up (provided sufficient funds are available). The incentives for investing would be the receipt of income (by way of dividend) and a capital gain (by way of the growth in the value of the company, and therefore the individual shares), although neither are guaranteed.
Different classes of shares may carry different rights and entitlements. All rights and entitlements in relation to shares of all classes are set out in the articles of association. It is imperative to check these.

Equity finance: effect on the Balance Sheet

Blue Moon Limited, a new company, issues 100 ordinary shares of £1 each for cash on incorporation. The effect on the Balance Sheet of the company is set out below.

 

As you can see, the entry for the issue of the shares is as follows:

1. increase share capital to show the nominal value of the shares issued; and
2. increase the cash (current assets) to show the cash received for the shares.

i.e. the top half of the balance sheet shows you what the company owns and the bottom half shows you where it came from.

Debt finance

Companies will often borrow funds for their business. Money can be borrowed in a variety of different ways, for example by way of overdraft, term loan and bonds.

On a transaction involving a Shareholders’ Agreement, alongside the Shareholders’ Agreement and the Articles, lawyers may be involved in drafting various additional documents as discussed below. This is not an exhaustive list and neither are they all required in all circumstances.

Please also note that some of these documents may also be required even when there is only one shareholder, but they are most common in the context of companies with two or more shareholders.

Management Agreement

These are sometimes used in companies where one of the shareholders agrees to be responsible for the day to day management of the business. Such an agreement would be likely to cover the following issues:

1. the manager’s role;
2. limits on the manager’s powers;
3. any fee payable to the manager; and
4. provisions for terminating the manager’s role.

Asset/Business Purchase Agreement

The parties may be contributing parts of their existing business to the company or the company may be acquiring a business or assets from a third party. In either instance the transaction will be documented by a purchase agreement.

Such an agreement may include warranties in relation to the business or assets to be acquired. If there are, this might allow the company a right of recovery if the business or assets turn out to be less valuable than warranted or subject to an undisclosed liability. We will look at warranties in more detail in the Acquisitions zone later in the module.

Secondment Agreement/Employment Agreements

If directors and senior management are seconded from the shareholders (if they are themselves businesses or companies), it is important to decide whether the company or the shareholders will be responsible for their remuneration. A Secondment Agreement would cover these issues.
Any employees of the company would require employment contracts.

Intellectual property licences

As part of their contribution, the shareholders may license intellectual property rights to the company and/or it is possible that the company will agree to license back to the shareholders any intellectual property which it develops.

Contracts for the supply of goods and services

It may well be that the shareholders are to supply goods and/or services (other than those already mentioned above) to the company, in which case issues such as the price and other terms of such goods/services will need to be determined and documented.

Guarantees

Third parties such as banks may require the shareholders to provide guarantees in relation to the company’s obligations.

The provisions of a Shareholders’ Agreement will always be subject to negotiation and the outcome of those negotiations is likely to be governed by the parties’ relative bargaining power. However, Shareholders’ Agreements will commonly include the following provisions.

Veto rights

It is common for a Shareholders’ Agreement to include a list of matters that require the consent of all (or a certain number or a majority) of the shareholders. Such provisions may also reserve particular matters concerning the day to day running of the business to the shareholders (i.e. matters that would usually be decided by the board of directors).

Examples of matters which commonly require the consent of all shareholders include:

• increases in authorised share capital (if relevant);
• change of the company’s name;
• changes to the Articles;
• variation of any rights attaching to the shares in the company;
• entering into any borrowing or entering into any borrowing over a certain threshold;
• acquiring shares in, or other property from, any other company – sometimes this has a de minimis amount set such as £20,000 (i.e. acquisitions costing more than £20,000 require the consent of all shareholders);
• change of registered office;
• change of auditors;
• change of accounting reference date;
• matters of policy (i.e. the commercial direction of the business); and
• appointments or changes of bankers.

Where some formal procedure for decision-making is set out in a Shareholders’ Agreement but the shareholders fail to follow that procedure, provided that all the shareholders agree, their decision will be binding, notwithstanding the failure to follow the stipulated procedure.

Provisions relating to directors

These provisions deal with the appointment and removal of directors and also procedural issues relating to the day to day management of the company by the directors.

Such provisions may include quorum, notice and voting provisions (these provisions may also be repeated in the Articles). For example, above a certain percentage of shareholding, each shareholder is likely to be entitled to appoint a representative or representatives to the board or it may be provided that no director shall be appointed to the board or removed from the board except with the consent of all of the shareholders.
If the company is deadlocked, each shareholder will normally be entitled to appoint the same number of directors or representatives. They will also have the right to appoint the chairman of the board without a casting vote but probably on a rotational basis for a fixed period.

Quorum requirements for shareholder meetings

Though the Model Articles do set out quorum requirements for company meetings, it is common in a Shareholders’ Agreement, especially in joint venture arrangements, to set overriding quorum requirements that provide that certain persons (or their representatives) from each party to the Shareholders’ Agreement must be present in order for a quorum to be reached.

A deadlocked company often provides that no decision of a meeting can be taken unless a representative of each shareholder is present throughout the meeting. If the company is not deadlocked, it may be the case that a representative of the minority shareholder will be required to be present for the meeting to be quorate or have the right to receive notice of the meeting and decide whether to attend or not. If the minority shareholder’s representative is required to be present before the meeting is quorate, this can effectively give it a right of veto over decisions. This position is naturally resisted by a majority shareholder.

Financing the Company

Provisions may be included which set out how the company is going to be financed. In an investment arrangement or a joint venture arrangement, the Shareholders’ Agreement is often made conditional upon receipt of the financing. The types of provisions will depend upon the reason for which the Shareholders’ Agreement is being entered into.

If the parties are entering into a joint venture arrangement, the parties often contribute different assets, equipment and property to the venture as well as capital in return for shares. The Shareholders’ Agreement will need to describe who is contributing which assets, equipment and property and what will happen to these items (if anything) when the joint venture terminates or any of the parties exit the joint venture.

If on the other hand the Shareholders’ Agreement is being entered into in connection with an investment or as a result of a private equity buy-out, the Shareholders’ Agreement will detail the precise share subscriptions of the parties and the rights attaching to the shares as well as any loan financing that is being provided by the parties.

These provisions should also include what is to happen if a shareholder leaves and, for example, a loan is still outstanding.

As mentioned above, Shareholders’ Agreements also have the advantage of confidentiality. Unlike a company’s Articles, they do not have to be filed at Companies House and are therefore not open to public inspection. Nor are Shareholders’ Agreements open to inspection by a company’s creditors or employees. Shareholders may feel that they do not want provisions dealing with funding to be public. The same issue is also likely to arise with other provisions such as those relating to directors’ remuneration which the parties will want to keep confidential (subject to any company law or accounting regulatory requirements).

Pre-emption rights on transfer

S.561 CA 2006 gives statutory pre-emption rights on the allotment and issue of new shares in a company, whereby statute gives existing shareholders a statutory right of first refusal to take up new shares that are being issued by a company. I will cover this in more depth in a later post.

One important clause for all shareholders in a Shareholders’ Agreement will be the clause relating to pre-emption rights on the transfer of existing shares in the company. This is because there is no statutory provision giving existing shareholders a right of pre-emption on a transfer of shares from an existing shareholder to a new or another existing shareholder. A Shareholders’ Agreement provides for contractual pre-emption rights. Contractual pre-emption rights in a Shareholders’ Agreement give existing shareholders a right of first refusal to accept a transfer of shares from a departing shareholder. In a joint venture or private equity buy-out scenario, the nature of the business depends on the expertise of the joint venture parties or (in the buy-out scenario) the management team (who will also be shareholders), so shareholders will very often not want shares in the company to fall into the hands of people other than the original shareholders to protect their investment.

A Shareholders’ Agreement will therefore often provide that the shares belonging to the exiting shareholder must be offered to the remaining shareholders pro rata and that the consent of all shareholders will be required in order for the transfer of existing shares to be registered by the directors. It is also common for these provisions to be repeated in the Articles of the company. On a major investment or private equity buy-out where the majority shareholders are an institutional investor or private equity house, the transfer provisions may provide that the departing shareholders’ shares must first be offered to the majority shareholders before they are offered to other shareholders.

If there is a majority shareholder there may be so-called drag-along provisions which require the minority shareholders to sell their shares in the event that the majority shareholder wants to sell to a third party. The majority shareholder can force the minorities to sell.
You may also find so called tag-along provisions which state that a majority shareholder wishing to sell to a third party cannot do so unless he procures an offer by the third party to purchase the minority shareholders’ shares on matching terms – the smaller shareholder can tag along with the sale.
Whatever is agreed, it is often the case that there will be exceptions for certain transfers, the most common being intra-group and intra-family transfers. For clarity, and to avoid conflict in the future, the permitted transferees are often specifically defined in the Shareholders’ Agreement.

Anti-dilution provisions/Rights on allotment of new shares

Shareholders may also not want their current shareholdings to be diluted by the issue of new shares. Although the CA 2006 provides for pre-emption rights on the allotment of certain types of shares (“equity securities” defined in s.560 CA 2006), this only protects shareholders from the dilution of their shareholding in respect of these types of shares, if they can all afford to and wish to take up those new shares. A Shareholders’ Agreement may therefore provide that the consent of all shareholders will be required in order for any new shares to be allotted at all.

Dividend policy

A Shareholders’ Agreement will almost always set out some kind of policy on whether to declare dividends or not and in what proportions those dividends will be paid. The Shareholders’ Agreement may for example state that a dividend is not to be declared for a certain period of time and/or that a dividend is not to be declared until such time as certain financial milestones have been reached by the company (e.g. the repayment of all loans).

Pre-completion obligations

It may be the case that certain arrangements need to be entered into before the parties agree to set up the company or subscribe for shares in the company. The idea behind this is that all parties’ initial obligations will be subject to each other so that the company will only be established once all initial obligations have been fulfilled. Such matters are often set out in a Shareholders’ Agreement. For instance, prior to completion each party would be obliged to subscribe for a certain number of shares in the company at a certain price or to transfer certain property into the name of the company.

Restrictive covenants

Restrictive covenants exist to protect legitimate business interests which include trade secrets, confidential information, etc. It is common to have restrictive covenants dealing with the period during which a party is a shareholder and also for a period following the shareholder’s departure to protect a company’s legitimate business interests.
Such covenants often prevent former shareholders from competing with the business of the company or from soliciting customers, suppliers and employees from the company. As such these covenants can be regarded as a critical issue to negotiate (from the outset) where, on departure of a shareholder, the company is intended to continue as an ongoing business.

Deadlock

Deadlock provisions will always be included in a Shareholders’ Agreement to provide for what is to happen in the event of the company becoming deadlocked either at board or shareholder level – although it is usually the case that if the company is deadlocked at board level it will be referred up to shareholder level.

Deadlock occurs when, for whatever reason, it is not possible for the board or a meeting of the shareholders to pass resolutions (e.g. because certain directors or shareholders refuse to attend meetings so that they cannot become quorate).

Deadlock may also occur if a party wants to sell its shares and leave the company and the other shareholders are not willing to buy its shares but it is not permitted to sell the shares to a third party as mentioned above.

In practice you may come across deadlock resolution procedures referred to as Russian Roulette or Mexican/Texas Shootouts, where the end result is that certain shareholders buy the shares of others.

A “Russian Roulette” mechanism typically provides that a shareholder (A) can serve notice on another shareholder (B) offering to buy all of B’s shares in the company at a price specified by A (or to sell its shares to B at the stated price). B must accept A’s offer and sell its shares to A at the stated price or must buy A’s shares at the same price per share.

A “Mexican/Texas shoot-out” is a variation of the Russian Roulette provision in that either party can serve notice on the other party to buy the other’s shares or to sell its own shares to the other party at a specified price. This type of mechanism generally occurs where both parties are interested in buying the company, and provides that in this case they both submit sealed bids to an ‘auctioneer’ and the party who makes the higher bid is entitled to buy the company at that price.

These procedures are not the only remedy in all deadlock situations. It may not be appropriate or workable in certain circumstances to follow these procedures. As such, a deadlock provision can also provide for the company to be wound up. Whilst liquidation may appear to be an obviously drastic result for a deadlock situation, the clear benefit is to focus the shareholders’ minds as to whether the deadlock is irretrievable or whether they wish to continue with the company.

Deadlock provisions may also provide for a period of arbitration, mediation or other form of alternative dispute resolution in order to settle the dispute before any of the more serious steps, as identified above, are taken. In any event, when drafting deadlock procedures it is important to ensure that they clearly provide for what circumstances will constitute a deadlock and for the procedure to be followed once the deadlock situation has arisen.

Termination other than by Deadlock

As well as providing for termination in the event of deadlock, it is usual for Shareholders’ Agreements to be terminable on the happening of any of the following events:

1. a shareholder committing a material breach of the agreement which it has failed to remedy within a specified time;
2. the company or a shareholder becoming insolvent;
3. change of control of a shareholder (if it is itself a company);
4. the expiry of a definite term or completion of or failure of a particular project undertaken by the company; or
5. service of notice by a shareholder or shareholders.

The above ‘termination situations’ can be categorised into two categories: termination by default (points 1-3) and termination by consent of the parties (points 4 and 5).

Where termination by default occurs, the Shareholders’ Agreement will usually specify a mechanism by which (1) the other party is put on notice that such a breach has occurred; (2) the breach is verified by a third party; (3) the infringing party has had an opportunity to remedy the breach; and (4) the infringing party’s shares are purchased by the other innocent party. Termination by consent is, of course, the more straightforward scenario.

Provisions dealing with termination (including termination by deadlock) must provide for how the company assets are to be allocated. Such assets will include any intellectual property rights generated by the company.

Where there is termination other than as a result of deadlock, termination provisions can be drafted to provide that the shareholder who has not defaulted is then able to force the sale to itself of the defaulting shareholder’s shares in the company. These are known as compulsory transfer provisions. Similarly, options can be put in place for a non-defaulting party to exercise (put or call options). These allow the non-defaulting party to buy the defaulting party’s shares, or to sell its shares to the defaulting party. The price at which the shares will be purchased will either be expressed as being a fair value or will be ascertained by reference to a pre-agreed formula.

New shareholders

It must be remembered that the only parties to a Shareholders’ Agreement are those shareholders who have signed up to its provisions (and perhaps also the company itself). Unlike the Articles where every person is automatically bound upon becoming a shareholder, with a Shareholders’ Agreement shareholders must actively enter into the Shareholders’ Agreement in order to be bound. New shareholders are often signed up to the provisions of Shareholders’ Agreements by entering into a Deed of Adherence. A proforma Deed of Adherence is usually appended to the Shareholders’ Agreement.

Note that the provisions of a Shareholders’ Agreement dealing with pre-emption rights on allotment and/or transfer may make new or additional shareholders an unlikely proposition. In any event no person is likely to be permitted to become a shareholder unless they enter into a Deed of Adherence.

Departing shareholders

As stated earlier, it is often the case that restrictive covenants are entered into between the parties to a Shareholders’ Agreement. Restrictive covenants require careful drafting as they must be drafted no more widely than is reasonably necessary to protect the legitimate business interest of the company concerned. A restrictive covenant which is unreasonable in its scope will be held to be void and unenforceable.