Removing a Shareholder
TABLE OF CONTENTS
I want to get rid of a shareholder. How do I go about this, and will there be any consequences?
It happens often in companies ranging from startups to medium size that the business partnership sours. The founding partner starts wondering if they can get rid of their minority shareholding partner. But recovering shares is not so easy. Here we discuss the pro’s and cons of forfeitures, buy-backs, share dilutions and court-ordered share transfers.
Related topics:
Share dilution - Removing shareholders - Passing resolutions - Memorandum of Incorporation - Shareholders Agreements - Sweat Equity - Capital Contributions - Death of a shareholder - Divorce of a shareholder - Insolvency of a shareholder - Fiduciary duties of shareholders
How can I remove a Shareholder from my company?
We’ve written before about the nature of shares here – and it is important to understand that shares are intangible assets – part ownership in the company. Shares are not temporary rights loaned out to partners. Shares cannot normally be seized back from a shareholder except under very specific circumstances.
How to get rid of a shareholder?
The ability to remove a shareholder depends on prior preparation in the company’s Memorandum of Incorporation (MOI) and Shareholders Agreement. The Shareholders Agreement needs to include specific clauses that provide for some mechanism for forfeiture of the shares. A template Shareholders Agreement will often not suffice.
A business owner should first consider the reasons for wanting to remove a shareholder. Some reasons may be valid cause for removal – but others not.
1. You agreed they would contribute sweat equity in exchange for shares, but now your partner isn’t pulling their weight
One of the most common scenarios – you start a business with a partner, or they join later, and you issue shares to them in exchange for “sweat equity” – i.e. their work contribution – instead of funding. But, sometime after receiving shares, they stop working so hard, or at all.
In such scenarios, it is essential to provide for some form of continuous performance monitoring linked to retention of shares in the Shareholders Agreement. If your Shareholders Agreement isn’t drafted correctly – or worse – if you haven’t executed one – your options are more limited.
2. You issued shares in exchange for a capital contribution
In this, the most common shareholding scenario, the shareholder has purchased a share (and a corresponding expectation of eventual repayment and a proportional share of dividends) in exchange for issue of shares.
In this scenario, there is not usually an additional requirement that the shareholder also contribute work – so a complaint that they are not contributing to the company is missing the point. Remember that shareholders are owners of the machine – they are not responsible for making the machine run.
If your understanding with your business partner was that they were to make a capital contribution and work for the company, the question of their performance may be more one of a labour law issue.
3. The shareholder has started a business that is directly competing with yours
There is no provision of law nor inherent principle preventing a Shareholder from owning shares in two competing companies, nor do they have a formal duty on them to prevent a conflict of interest in the same way that directors do.
However, like many shareholding scenarios, this issue could have been prevented or at least mitigated by a carefully drafted Shareholders Agreement, providing for penalties on Shareholders who have interests in competition with the company.
4. What if your partner has harmed the business or caused loss?
If your business partner has caused the company to suffer losses, you may have some recourse against them. However, this does not necessarily mean that they can be made to forfeit shareholding. In the same way that you damaging your car does not mean you forfeit ownership of it, making mistakes in running the company does not mean a shareholder loses their shares. It is important here to distinguish between directors and shareholders. In smaller companies, directors are often also shareholders. But shareholders do not run companies – directors do. Therefore, if your partner has damaged the business, they have done so in their capacity as director or other employee – not as shareholder – and they do not forfeit their shares.
You may however have other options to consider. Contact us to discuss what to do in this specific scenario.
KINGMAKERS AND KING-BREAKERS.
We specialise in Shareholder and Director disputes, company hijackings, oppressive Shareholder conduct and Section 165 Applications.
5. What if you can no longer get along with your business partner?
Your partner is blocking decisions, it’s impossible to pass important resolutions, and your company is stagnating.
The majority shareholder often finds themselves in a position where they have given away too much shareholding, and are now unable to pass special resolutions (usually requiring 75% of a vote) to make important changes in the company.
Removing a shareholder as a punishment or revenge is usually not the appropriate response, and can result in a claim of oppression by minority shareholders. The Companies Act 71 of 2008 has mechanisms to protect minority shareholders from oppressive conduct by majority shareholders.
The majority shareholder must consider negotiating with the minority, or otherwise instituting legal action.
6. You want to sell the business, but other shareholders don't
The Companies Act and the Shareholders Agreement both provide for notice to all shareholders when the majority shareholders are considering sale of the business. An attempt to sell the business without notice and consent of all shareholders will inevitably result in costly litigation to turn back the clock.
Shareholders should follow the prescribed processes and ensure compliance with all technical / administrative requirements in giving adequate notice to all shareholders when considering a sale.
If shareholders are blocking a resolution to sell the business, it may be necessary to obtain a High Court order in terms of Section 163 of the Companies Act to resolve the dispute.
Buying or selling a business?
Read more on documentation, steps and pitfalls to look out for.
7. Death / insolvency / sequestration / divorce of a Shareholder
A change in status of a shareholder, like death, insolvency or divorce, can result in legal complications for the company. Since shares are assets owned by the shareholder, upon such a status change the shares may fall into an estate and be taken over by a person who may not have the appropriate experience or capacity to run the company (or who may cause a clash of personalities).
To deal with this, your Shareholders Agreement should include a Deemed Offer clause creating an offer of sale of shares to the company, deemed to have occurred at or before the change in status of the shareholder – which the company must accept to avoid a spouse or executor from gaining control of those shares.
For the same reasons, in the case of shareholders married in community of property, it may be wise to engage in some asset protection and structuring exercises to protect shares where possible. Contact us to discuss your options in this regard.
What happens when a Shareholder dies?
The death of a shareholder results in their shares falling into their deceased estate, controlled by the executor, with their distribution to one or more beneficiaries. This is often not suitable to the rest of the shareholders. A deemed offer clause in a Shareholders Agreement will go some way to addressing this issue.
Shareholders should also consider procuring Key Man insurance and Buy/Sell agreements for all shareholders, to ensure access to funding to buy back shares when these scenarios arise.
Protect your business from shareholding disputes.
8. Unethical or criminal conduct by a Shareholder
Similar to the above scenarios, it bears repeating that a person’s conduct does not necessarily result in forfeiture of their assets, except in circumstances where these have been provided for by legislation (for example, forfeiture of assets when falling afoul of tax or exchange control laws).
For example: a person may be fined for driving above the speed limit, but that does not automatically result in them forfeiting their car.
Similarly, criminal conduct by a shareholder does not automatically result in forfeiture of their shares by law. Shareholders should provide for these circumstances by including strictly-worded forfeiture provisions in the Shareholders Agreement – but it may be preferable to rely on a Deemed Offer clause instead, as the latter represents a less severe consequence than the former.
THE PAPERWORK
The Paperwork needed for Shareholding
To set up shareholding correctly, the following documents are needed:
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Memorandum of Incorporation (MOI) - the founding document of the company. It prescribes, among other things, the rules for calling meetings and passing resolutions.
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Shareholders Agreement - an essential contract between Shareholders, prescribing the powers, and responsibilities of Shareholders. Every Shareholder must sign the Agreement.
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Share Purchase Agreement - separate from the Shareholders Agreement, this contract contains the mechanism for purchase and sale of shares.
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Share Certificates - for share allocation to be complete, the company must issue official share certificates to Shareholders.
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Securities Register - A list tracking all the authorised shares, issued shares, purchases of shares and transfer of shares, and Shareholder details.
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Company Resolutions - relating to issuance, sale or transfer of shares.
Why is the Shareholders Agreement so important?
The Shareholders Agreement is a crucial document every company needs if it has more than one Shareholder:
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Decision process - It specifies how decisions are made, including voting rights and procedures for approving major decisions.
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Dispute resolution - It provides mechanisms for resolving disputes between Shareholders.
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Transfer procedure - It specifies the mechanism for transfer of shares, such as right of first refusal, drag-along rights, and tag-along rights.
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Minority rights - It contains fair and balanced protections for both majority shareholders and minority shareholders.
One of the most common legal disputes arising from shareholding is a dispute between majority and minority shareholders, relating to a buyout, breakdown of relations, share dilution or other oppressive conduct by majority shareholders.
Where interests conflict, disputes are inevitable.
Read more about our experience in resolving Shareholder disputes.
Frequently Asked Questions about Shareholding
The minority shareholder is also a director. Will firing them also remove them as shareholder?
No. Terminating their appointment as director, while shifting control of the daily functions of the company, will not automatically remove them as shareholder as well. Shareholders will need to take separate action to recover shares from the shareholder.
If I can’t get rid of the shareholder, can’t I just reduce their influence by diluting their shareholding?
No. Share dilution can be an exercise undertaken under the right circumstances - the right circumstances being to attract more financial investment in the company by way of authorising and issuing new shares to investors in return for capital.
However, it should not be used for the purpose of diluting the shareholding of existing shareholders, and in any event, if done properly, cannot escape the notice of existing shareholders. Both the Companies Act and the Shareholders Agreement require that the company give adequate notice to existing shareholders of its intention to authorise and issue new shares – and the company must first offer these new shares to existing shareholders before being able to offer them to outside investors.
In circumstances where companies issue shares to outside persons without first offering them to existing shareholders, fierce and costly litigation usually ensues to reverse these actions, placing the company and its directors at risk.
Can I reduce the shareholder's influence by moving assets into a new company where I'm the only shareholder?
No. This action falls squarely within oppressive conduct against shareholders. Do this and you are likely to face severe consequences, costly litigation, potential personal liability and other penalties.
Can I avoid paying the shareholders by just deciding not to pay dividends?
While it is technically possible to not pay dividends, the decision to pay dividends or not will firstly have to be considered and decided on at an Annual General Meeting of Shareholders - so the shareholders wishing not to pay dividends will have to have a significant majority to pass that resolution in the first place.
A decision not to pay dividends has implications on tax, shareholder relations, and the company's attractiveness for investment, to name a few. Further, it is highly likely that such a decision, if taken without proper financial basis, will result in a claim of oppressive conduct by shareholders. It should therefore not be used to avoid paying money to shareholders with whom you have a dispute.
SUMMARY OF OPTIONS - REMOVING SHAREHOLDERS
Buyout
The cleanest and best way to remove a shareholder. Assuming the shareholder is willing to sell, pay them fair value for their shares and go your separate ways. Buying out a shareholder is a complex process, involving legal, financial, and strategic considerations.
Buyouts require:
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Willing buyer and willing seller
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Check first for applicable provisions in legislation like the Companies Act, as well as the Shareholders Agreement.
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Following company secretarial requirements
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Independent valuation of shares
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Share sale negotiations and related legal paperwork
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Funding the buyout
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Updating of company records
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Amendment to corporate documents if necessary
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Communication with stakeholders
Court Order
If a buyout is not an option, you may need to approach the High Court for an order directing that shares be sold, or another appropriate order.
Forfeiture of shares
An extreme option and should be your last resort. Forfeiture of shares is a move which is contractual in nature, requiring the shareholder to have signed a Shareholders Agreement containing such provisions beforehand. For a shareholder to forfeit shares, they must have exercised unforgivable conduct and caused damage to the company, and it is unclear whether even this is enough justification. Forfeiture of shares is not provided for in legislation and it is uncertain whether such an action would withstand scrutiny by the Courts. We wouldn’t bet on it.
Recover your shares by way of Deemed Offer clause
The Deemed Offer clause should be standard if you have a proper Shareholders Agreement. It creates a legal fiction that the shareholder offered to sell the shares back to the company just before a change in their legal status took place. This clause is an important addition to a Shareholders Agreement but it is not bulletproof. Contact us for more information.
This mechanism does not allow you to recover shares at your own convenience, but rather, when a change of status in the shareholder takes place.
Share dilution
An action which should only be undertaken with the purpose of attracting investment to the company in exchange for shares – not for the purpose of reducing a shareholder’s influence. In any event, share dilution requires the authorisation and issuing of new shares, in turn requiring notice to, and consent of shareholders, by way of a special resolution at a properly constituted meeting of shareholders. Therefore, if done in compliance with the law, such an action cannot escape the notice of shareholders.
DISCLAIMER
The above information is for illustrative purposes only and does not take into account your specific circumstances. It therefore cannot constitute legal advice. Please contact us for comprehensive advice to address your circumstances. Under no circumstances should any person use the above information in an attempt to circumvent the provisions of legislation or contract, or to cause damage to any other person. Always ensure you and your company are in compliance with the law in all dealings.
