Getting it right when it comes to getting out

The coming of budget season often leads to speculation on the part of many and in particular business owners/entrepreneurs, around prevailing tax rates, be it on personal or corporate income, as well as taxation on the disposal of assets.

With that, many business owners and shareholders turn their focus to potential tax liabilities that would arise if they were to dispose of their interest in their business or trading company. However, in the midst of this speculation and potential planning around disposals, oftentimes too little focus is given to the mechanisms by which such individuals may exit their business particularly if there are other shareholders involved.

The issue of corporate governance is one that many shareholders/business owners often do not take enough time to consider. In many cases, the focus is primarily on early-stage growth and development of the business, perhaps followed by a focus on scaling the business once it is established. There may indeed be some focus on optimising the corporate structures that hold the business, but the issue of corporate and shareholder governance may not be a priority for many.

As the business grows and becomes well established, issues around decision-making, share ownership, appointments to the board of directors, who may be entitled to become a shareholder, and possible exit mechanisms for existing shareholders may take on greater significance.

It may be the case that the business is owned by family members or perhaps by unrelated founder shareholders who have worked well together for several years to build the business. These individuals may wish to continue working together for several more years or there may be a possibility that in the next number of years one or more of them may wish to step back from the business and focus on other matters.

In those situations, it is important that there is a governance structure in place that will regulate the relationship between the existing shareholders and potential incoming shareholders, as well as providing a mechanism for a shareholder to exit.

Scope of the agreement

A shareholders’ agreement can cover a broad range of issues. Primarily it should clearly set out the framework for control and decision-making, as well as prescribing how shareholders deal with each other in the context of their common shareholdings in the company.

For example, in relation to day-to-day business decisions, the shareholders agreement could outline what level of decision-making is permissible at the various levels of governance within the company. The agreement can prescribe the extent to which the management group within the company can make decisions and outline what issues should be reserved for the board and lastly, what issues must be referred to the shareholders.

The determination as to what decisions can be made at each level can be based on various factors, but in many cases, it may be determined on a value or leverage basis. Having a prescribed framework for decision-making can allow the business to carry on in a more efficient manner day to day without having to continually defer to the board or the shareholders. This in turn should allow the shareholders themselves to step back from the business and allow their appointed management team to run the business in an efficient manner.

In addition to decision-making, issues such as board appointments and permitted share transfers would often be addressed in the agreement. The question of who is entitled to become a shareholder is often an emotive one in the context of a family company.

In the absence of a shareholders’ agreement, in either the case of a family company or a company owned by a small number of unrelated parties, any shareholder could simply dispose of their shares to an unknown third party without any reference to the remaining shareholders. This may cause a degree of difficulty or friction between shareholders, as they have no input on who they will be in business with.

It may be the case that in a family company the founding shareholders may wish that shares should only pass to their descendants, thereby ensuring the company remains a family company. While such a provision in the agreement might be seen as restrictive, the agreement could also provide a mechanism for any family member shareholder to exit the business in a manner that retains overall ownership within the family.

This mechanism might take the form of a requirement to firstly offer the shares to the other family member shareholders, and if they are not in a position to purchase the shares, then the company itself may buy back the shares (subject to it being in a suitable financial position to manage such a buyback).

As businesses transition to the next generation, having a clear governance structure and decision-making process outlined in a binding legal document provides a clear path for the incoming shareholders as to how the affairs of the company can be managed. Any future shareholders would need to sign a deed of adherence to the shareholders agreement

before they can become shareholders. By putting an agreement in place before shares transition to the next generation, the founding shareholders can ensure that their vision for the future of the business and how it might be run, as well as their principles and values can be incorporated into that document.

Non-active shareholders

In many family companies, some future shareholders may not be actively involved in the business and as such, consideration as to how such individuals would derive value in the future should be considered, as well as deciding whether such individuals should be entitled to sit on the board.

With regard to accessing value, a clear dividend policy might be set out in the agreement to ensure some value does pass to these non-active shareholders. Safeguards might also be put in place for those shareholders that are active in the business, so as to regulate their level of reward from the business. This might take the form of an independent remuneration committee which could periodically review and set the appropriate level of reward for shareholders that are actively involved in the business.

The future composition of the board, particularly after the founding shareholders may have stepped back from the business, is another area that should be addressed. The agreement could set out the criteria required for shareholders to sit on the board, which might include relevant business, legal, or financial experience.

It may be the case the board is made up of a mix of shareholders (or their nominees) and independent non-executive directors. The appointment of independent directors can bring a level of independent thinking to the decision-making process and can also provide one or more voices on the board that are not influenced by any emotive family issues.

Exiting shareholders

Once a suitable agreement is in place the issue of the exit mechanism for existing shareholders, otherwise than in the case of a full disposal of the company by all shareholders, will be clearly set out.

Therefore, if one or more shareholders wish to exit the business there will be a clear pathway for them to do so while still ensuring the integrity of the shareholder group and the decision-making process for the business into the future. The funding of any exit, if it is to be facilitated by way of a buy back, could be structured such that it is phased over several years with the initial payments covering the tax arising for the exiting shareholder on the disposal.

It will be necessary to carry out a detailed tax analysis on the share disposal at the time of exit to determine whether the disposal will be treated as an income tax event or capital gains tax event for that shareholder.

The prevailing tax rates at the time may also determine how the exit may be structured, but having a well-drafted shareholders agreement in place does give a pathway for some shareholders to exit and ensures company ownership transitions as smoothly as possible.

Jonathan Ginnelly is tax director for Deloitte in Ireland