As the business evolves, disputes may arise due to diverging interests or expectations among team members. Growth may bring tensions usually among founders, investors, or employees as they grapple with differences in vision or priorities among the stakeholders.
This post looks at the common legal tools and instruments that can be agreed among the shareholders to resolve disputes, and provide a line of sight for a business continuity. Understanding these deadlock clauses are critical for founders and investors alike, as they offer upfront mechanisms when it comes to resolving disagreements to exit strategies.
Aligning expectations early
Our usual advice to any aspiring founder before onboarding any new shareholder is to align expectations among themselves (especially before forming a company). Clauses that outline key issues include the roles and responsibilities of each founder, how decisions will be made among the founding team, and the strategic direction that can help avoid conflicts in the first place.
In situations where shareholders cannot agree on key decisions (such as when two shareholders own an equal stake in a 50/50 ownership structure), deadlock clauses are essential to address likely impasses that may otherwise paralyse the startup’s operations.
Casting vote
In the event of a deadlock when it comes to a decision making (usually by the board in a tie vote), the chairperson of the board is usually given a casting vote to a deadlock event. Ordinarily, a majority shareholder or a lead investor nominee may be designated to act as the chairperson for this purpose.
“Shotgun” or “Russian Roulette” clause
In a “Shotgun” or a “Russian Roulette” mechanism one shareholder offers to purchase the rest of the existing shareholders’ shares at a certain price. As it is a more aggressive approach of a buy-sell agreement, the recipients involved must either accept the offer or buy the offering shareholder’s shares at the same price.
Also Read: Navigating startup funding: A primer on 10 investor types every entrepreneur should understand
In our experience, it may be rare to find this clause included in a shareholders’ agreement involving a startup. This may likely be due to the practical aspect of the mechanism i.e. the shareholders involved are expected to have the necessary liquidity to complete the transaction at the shares’ valuations.
Arbitration or mediation clause
If there is no casting vote or even an agreed independent party to assist in the deadlock, an arbitration or mediation clause in the shareholders’ agreement may allow for the parties to engage a neutral forum for dispute resolution.
Arbitration clauses mandate that disputes be settled by an arbitrator or arbitration panel, while mediation clauses encourage parties to engage in facilitated negotiations before pursuing litigation.
Both methods seek to offer an alternative method when it comes resolving shareholder conflicts, while maintaining confidentiality as the proceedings are held behind closed doors unlike a normal court process. In practice, exercising this clause may or may not be practical as the parties involved are expected to incur fees and charges when it comes to agreeing on the appointment of a mediator or arbitrator (as the case may be) and also legal representation to act for them in the relevant alternative dispute resolution process.
Put and call options
A put and call option is a mechanism that can be used to force a buyout of a shareholder in certain situations. A put option gives one shareholder the right but not an obligation to require another shareholder to buy their shares at a predetermined price or based on a valuation formula.
Conversely, a call option allows a shareholder to compel another shareholder to sell their shares under specific circumstances, such as after a deadlock or a breach of the shareholders’ agreement.
In practice, we may likely find these clauses exercised and often triggered in events such as a shareholder’s death, incapacity, bankruptcy, or breach of contract. The different option strategies aim to provide flexibility in dealing with disputes and ensuring that the company can continue without the presence of unwilling or uncooperative shareholders.
Exit through a sale of the startup
If the dispute cannot be resolved, the shareholders’ agreement can outline an orderly process for the sale of the company as a whole.
An exit is usually by a trade sale i.e. a third party buyer acquires the shares of the existing shareholders to unlock value for all shareholders (in practice, the acquisition price may also be tied to the timing of the exercise). In this case, drag-along rights (as stated above) may also be useful, ensuring that the sale occurs without obstruction from any likely dissenting minority shareholders.
Voluntary winding up/liquidation
As a last resort, the parties may agree to voluntary winding-up of the company in the event of a serious and irreconcilable shareholder dispute. This allows shareholders to recover value from the sale of assets and distribution of proceeds, albeit often at a discounted value due to the timing of the exercise.
Also Read: The future of finance: ESG integration in tokenised funding
In practice, winding up is generally discouraged and should be viewed as a measure of last resort when other dispute resolution methods have failed.
Final thoughts
Shareholder disputes, especially involving a key figure in the startup, would likely affect the stability and continuity of the business. Disputes are usually managed effectively when the parties involved have agreed at the outset with the right legal mechanisms in place.
A startup lawyer can guide you to include any or a mix of the different mechanisms above such as the casting vote, “shotgun” or “Russian Roulette” clause, or put and call options to allow for an orderly exit from the company. This way founders and investors can better protect their interests and ensure that the company may continue to run even during times of conflict.
—
Editor’s note: e27 aims to foster thought leadership by publishing views from the community. Share your opinion by submitting an article, video, podcast, or infographic
Join our e27 Telegram group, FB community, or like the e27 Facebook page
Image credit: Canva Pro
The post Navigating shareholders’ disputes in startups: Different exit strategies and mechanisms explained appeared first on e27.