Executive Summary
A minority shareholder in a private company is in a complex position.
At first glance, a minority shareholder has no ability to influence significant processes within the company, and certainly no ability to influence decision-making. In the absence of specific arrangements with respect to the shareholder’s shares in the company (as detailed below), the ability to derive significant value from such shareholding is difficult, if not virtually impossible, and depends to a significant extent on decisions in which the minority shareholder has no part.
In this article, and following our experience advising dozens of companies, in most cases from the perspective of the controlling shareholders of the company, but at times specifically from the perspective of minority shareholders, we seek to provide substance and describe the appropriate mechanisms that should be established within a company in order to enable the minority to participate (even if as a junior stakeholder) in decision-making and value creation within the company, while preserving the majority’s ability to manage the company effectively.
Minority Shareholdings in a Private Company – An Inherent Difficulty in Creating Value
At the outset of this article, we thought it would be appropriate to explain the difficulty through the structuring of a transaction for the sale of a minority shareholding. In other words, how does the seller of the shares describe to a potential purchaser (a third party) the value that will accrue to such purchaser from acquiring a minority shareholding in a private company?
This can, presumably, only be done where there are classic mechanisms that are expected to generate value in the company:
* Is there an expectation that the company will be sold (or that a similar transaction will take place)?
* Is there an expectation of an initial public offering of the company?
* Is the company expected to distribute dividends in the foreseeable future?
* In addition to dividends, do the shareholders receive other payments from the company on an ongoing basis?
* Do the minority shareholders have a way to significantly influence the foregoing decisions?
In a substantial number of cases, the answer to all of these questions is negative (for various reasons). Therefore, the question arises: when a potential purchaser comes to acquire the shares, what does such purchaser see before them? Can the purchaser change the situation and create some value for itself in the future?
Influence Over Decision-Making
The decision-making process in a company, in most cases (certainly in private companies), is conducted by the company’s board of directors. The ability of shareholders to influence each of the matters set forth above (a sale, an initial public offering, a dividend distribution, etc.) does not practically exist in the absence of representatives with an effective ability to influence the company’s board of directors.
Our unequivocal recommendation is to require the appointment of representative(s) to the board of directors with the ability to influence decision-making and, in appropriate cases, even to determine a number of material decisions that may not be made without the consent of the minority shareholders. In many cases, even obtaining the right to appoint an observer may be helpful (for obvious reasons).
It is important to note that decisions will still be made by representatives of the majority shareholders in the company. However, the discussions at the board level are important, as are the receipt of reports regarding significant transactions, issuances, and potential mergers and acquisitions. These are precisely the processes in which the minority wishes to participate, alongside receiving significant financial materials and data concerning the company.
Additional Specific Rights
The management of the company by a controlling shareholder holding the overwhelming majority of the company’s shares is, in most cases, significantly (and understandably) biased toward the interests of the controlling shareholder. In certain cases, minority shareholders may request additional rights that will provide them with the ability to maximize their shareholdings:
(1) Preemptive Right to prevent future dilution upon the issuance of additional securities and to maintain their percentage of holdings in the company; (2) Tag-Along or Co-Sale Right, which will provide the minority with the ability to receive value as though they were holders of a control premium in the company; and sometimes even (3) Right of First Refusal, which will grant minority shareholders the right to purchase the shares of the majority shareholders in the event that the controlling shareholders offer shares in the company for sale; (4) Adoption by the Company of an Agreed Dividend Distribution Policy.
In extreme cases, the minority may establish for itself more significant rights, such as: (1) a Put Option (PUT) to sell its shareholdings in the company to the controlling shareholders pursuant to an agreed pricing mechanism; (2) the right to prepare the company for and require it to pursue an initial public offering (IPO), or alternatively, the sale of the company in its entirety to a third party; (3) the right to conduct a Buy-Me-Buy-You (BMBY) process vis-à-vis the controlling shareholders of the company.
Shareholders’ Agreement and Constitutional Documents
It is important to note that the Israeli Companies Law (the “Companies Law”) leaves significant room for shareholders in a private company to structure their relationship with one another as they see fit, inter alia, in accordance with the principle of freedom of contract, which allows shareholders to structure their relationship as they deem appropriate. The cases in which the law will intervene are reserved for extreme circumstances and relate to the duties of fairness and good faith applicable to shareholders and controlling shareholders in the company, as well as protections against oppression afforded by law to minority shareholders in extreme circumstances (Sections 191, 192 and 193 of the Companies Law). Of course, the purpose of the law is not to create value or the ability of shareholders to influence material decision-making processes within the company, but rather to safeguard the basic rights of shareholders in the company.
From a legal perspective, it is of course highly important to ensure that all of the rights set forth above, the purpose of which is to maximize the shareholdings of minority shareholders, are set forth in substantial detail in the company’s constitutional documents, and first and foremost in the company’s Articles of Association, thereby establishing an effective legal right vis-à-vis the company itself and, of course, vis-à-vis third parties (future shareholders, etc.).
In most cases, these rights are also detailed in additional documents, such as a Shareholders’ Agreement and other agreements, all of which are intended to establish these rights between the shareholders from a legal perspective.
Conclusion
There is a significant difficulty in creating for minority shareholders in a private company the ability to generate real value from their shareholdings in the company.
On the other hand, fair and balanced mechanisms can be created vis-à-vis the controlling shareholders of the company, pursuant to which the majority will not relinquish its ability to direct the company and make decisions at the company’s board level, while sharing with the minority in significant processes that will operate for the benefit of the company as a whole and its shareholders.
For Further Information, Please Contact:
Hanan Efraim, Adv.
Office: 03-691-6600
Email: Hanan@ekw.co.il
Amit Kovos, Adv.
Office: 03-691-6600
Email: Amit@ekw.co.il