What are these clauses?
Deadlocks provisions are terms that are incorporated into shareholder agreements in order to provide methods for resolution of issues over which owners cannot agree.
Because we are dealing with shareholder agreements, typically these issues relate to the management, control, direction or strategy of the company. They are important enough to all owners such that no individual is willing to move from his position and compromise.
These decisions should also be so important that the business becomes paralysed without a decision having been made. The principle behind them is that the ability of a company to trade (and therefore its value) should not be allowed to deteriorate because of indecision.
When are they used?
A shareholder agreement might limit the circumstances in which certain deadlock provisions can be used, for example, only on issues relating to the sale of shares to a third party, or they might be able to be called upon for any matter. Sometimes, the provisions are so severe to one side that the threat of being used is sufficient to change the stance of one owner and for the issue to be resolved.
Deadlock can usually only be announced after a number of votes have been taken, and the outcome of those votes is indecisive. For example, a key matter might have to be raised (and voted on) in three consecutive meetings before deadlock clauses can be brought into play.
Just as in any dispute, before a severe solution is forced, alternative methods of resolution should be encouraged. Mediation – a process where an independent third party leads discussions between the parties with the aim of finding a solution – is often a requirement before deadlock provisions can be invoked.
Different types of deadlock provision
Deadlock clauses usually require one shareholder to sell his or her shares to the others so that he or she no longer has control over the company, allowing the remaining owners to vote through a decision.
These are types of conditional termination provisions, and there are as many different variations for different situations as lawyers can invent. However, there are some common ones:
Russian Roulette is where one owner names an all-cash price at which he values his share of the company. The other shareholder (or shareholders) must then either buy the first owner out at that price, or sell his own shares.
A Texas shootout is effectively an auction, where the owners send sealed bids to an adjudicator. The sealed bids are opened at the same time, and the shareholder who has stated the highest price (i.e. the one who values the shares most highly) must buy the other out.
A Mexican shootout is a dutch auction. The shareholders make sealed bids stating the minimum price for which they would sell their shares. The owner who values the shares most highly must buy the shares of the other, but at the price set by the loser.
Multiple choice procedures are those where the shareholder agreement gives the shareholders many options for resolving disputes, and allows them to agree on the use of one for the particular situation. The idea is that agreement might be found in choice of method, and with the severity of the means of resolution in the minds of the shareholders, compromise on the issue at deadlock might be found. Multiple choice procedures get owners back to a position of agreement (at least on one issue).
Should you include deadlock provisions into your shareholder agreement?
Deadlock provisions are effective in so far as they break deadlock.
However, resolving a deadlock by using one of these provisions is rarely valuable for a company, and this is especially so for a small or young company.
The shareholders are likely also to be directors of the company on a day to day basis. Founders who are directors are likely to have key skills that the business needs to grow. Take one away through forced buyout, and the company could suffer more than if a decision on some matter hadn’t been made.
If there is such severe disagreement, founders are likely to seek other ways out of the business without having to resolve to using draconian deadlock clauses. In other words, if the going is so bad, so early on, it is unlikely that founders will want to remain shareholders.
These sorts of terms are often designed to “punish” one side over the other in order to be deterrence. That isn’t always fair, especially when both sides think that their position is principled. Shareholders will take a stand on an issue because it is important to their vision of what the company should be doing. Because the idea of using deadlock clauses is to prevent a deterioration in value – to keep the business running – shareholders, and especially founders aren’t going to put their company in a dangerous position unless the alternative was perceived to be worse.
Lastly, a shareholder may not have the money to buy the other out. It is all very well to fix a price on the company at which you will be willing to sell your shares, but if the other side doesn’t have or cannot raise the capital to purchase there isn’t a lot that can be done.
So what should you do instead?
A better way to resolve dispute, rather than include deadlock provisions, is to make sure that deadlock cannot occur. The ways of doing that include:
- making sure that one or more owners always have more shares and therefore more voting rights than others (for example, splitting the ownership of the company in a ratio of 51:49 rather than 50:50)
- making sure that the basis on which certain decisions are made is not based on shareholdings (for example, in a company where two founders own the equity 50:50, a shareholder who has invested debt as well as equity might have 2 votes on any issue relating to capital purchases over a certain amount, whereas the other shareholder would have 1 vote)
- appointing a third party to have a casting vote (such as a director trusted by both shareholders, who herself is not a shareholder)
Share ownership cannot be controlled through a shareholder agreement, but these other solutions can.
The short is that while deadlock provisions have intriguing names that suggest a sophisticated agreement (great If you are a lawyer working on behalf of a client you want to impress), you don’t need these clauses to resolve disagreement. There are other, simpler ways of avoiding deadlock that are probably more beneficial for the owners and the business.