Short notes on: SHAREHOLDER EXIT STRATEGIES

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1 Short notes on: SHAREHOLDER EXIT STRATEGIES Introduction Often when the personal circumstances of the owners or shareholders of a company change drastically, the arrangement(s) in relation to the ownership running of the business/company need to change as well. This in the best interests of the company s continuity. In the case of shareholders, these changes are regulated by the shareholders agreement (generally speaking) by way of the exit or buy out provisions (therein contained). In the case of directors, regulation is based on the MOI (memorandum of incorporation) and Companies Act and generally involve considerations for managerial succession. The two converge to a certain extent in the case of shareholder directors. Exit In well drafted shareholders agreements (in instances of 2 shareholders or more) a provision always regulates exit from the company by way of voluntary offer. This may be invoked or triggered by any circumstance facing the shareholder generally, including a changed desire to continue holding shares. Conversely, the mere fact circumstances have changed may result in a deemed offer of sale, such as long term illness or permanent disability. In either case, the remaining shareholders or the company buys the affected shareholder out by purchasing his/ her shares from him/her. There are a number of tax implications resulting from these transactions, which must be considered by companies and shareholders alike to ensure their ability (in terms of having the cash) to buy out. In many instances depending on the reasons for the sale of the shares (illness or disability or death are common reasons), these provisions are also supported by an appropriate buy and sell agreement.

2 Generally speaking, buy and sell agreements regulate together with the shareholders agreement the purchase of shares that are being offered on the basis of illness, permanent disability or death of a shareholder. In addition these are usually linked to life insurance or other insurance policies. These policies essentially fund the buy out transaction. Buy out by a sole shareholder In companies owned and managed by a sole shareholder, when something happens to this person or he/she is unable to continue with the business, often no succession planning has been put in place. Practically this means that the business is sold off on death of the shareholder or is so seriously diminished immediately before this actually occurs (because all the goodwill of the business was actually enshrined in the person themselves) that the business to be sold has little or no value other than the assets it holds. This has a devastating effect not only on the business but on the personal estate of the owner, which may preclude him or her from looking after their dependants. The essential consideration, based on which, the business was in many ways first started. One of the key ways to avoid the value being diminished is to ensure that the relevant business overhead expenditure cover, contingent liability insurance to cover bank overdrafts or sureties are in place. Of course in addition to ensuring healthy cash flow, cash reserves, systems and processes are in place. In addition grooming existing staff to take over or to buy in over time may be valuable continuity measures to consider and implement sooner rather than later. Buy out by a fellow shareholder Similar to the case of the single shareholder and the recommended provisions for facilitating a healthy buy out (in that context) and future in that instance, regardless of the manner in which buy out is funded (by way of cash or insurance policy), a buy out transaction by a fellow shareholder will have certain tax consequences. In all instances a capital gains consequence for the seller. In addition where any dividends are declared just prior to or with the sale, dividends tax (paid by the company).

3 Where the sale is funded by way of insurance policy, there may be additional estate duty consequences depending on the presence of certain factors or the way on which the policy was structured. The problem arises however where remaining shareholders do not have the funds to buy out the other and where selling to an outside third party is not a viable alternative. In this instance any companies consider that the company reacquire its own shares. Buy out by way of share buy back In this instance the company acquires its own shares. There are additional requirements to be met, in terms of the Companies Act of In addition here too there will be similar tax consequences, particularly for the seller of the shares. In respect of the capital gains consequences, there will be a deduction in respect of a calculation considering the seller s contribution to the company s tax capital and the balance taxed in the shareholders and as a dividend. This is illustrated by the below calculation: Say for example a company buys back a shareholder s shares is for an amount of R 600,000. The contributed tax capital was R 100,000. The shareholder owns 40% of the total shareholding and bought the shares for R 200,000 in Therefore R 40,000 is a return of capital and R 560,000 is a dividend. The dividend is therefore included in the taxpayer s gross income as a dividend. Dividends tax of 15% on R 560,000 is also payable and as such R 84,000 be paid in terms hereof. From a capital gains tax perspective: Proceeds R 600,000 Less the amount included in gross income R 560,000 Less base cost R 200,000 Capital loss = (R )

4 Before the buy back occurs the directors of the company must ensure the compliance with sections 46 (and 48) of the Companies Act, which determine that the solvency and liquidity test is to be applied. The sections provide as follows: According to section 4(1): a company satisfies the solvency and liquidity test at a particular time if, considering all reasonably foreseeable financial circumstances of the company at that time a)the assets of the company, as fairly valued, equal or exceed the liabilities of the company, as fairly valued; and b)it appears that the company will be able to pay its debts as they become due in the ordinary course of business for a period of i)12 months after the date on which the test is considered; or ii)in the case of a distribution contemplated in paragraph (a) of the definition of distribution in section 1, 12 months following that distribution. Section 46 provides that: A company must not make any proposed distribution unless a)the distribution i)is pursuant to an existing legal obligation of the company, or a court order; or ii)the board of the company, by resolution, has authorised the distribution; b)it reasonably appears that the company will satisfy the solvency and liquidity test immediately after completing the proposed distribution; and c)the board of the company, by resolution, has acknowledged that it has applied the solvency and liquidity test, as set out in section 4, and reasonably concluded that the company will satisfy the solvency and liquidity test immediately after completing the proposed distribution. Conclusion It is of paramount importance that shareholders of all companies during their business continuity planning consider their own and the company s financial ability to buy out a shareholder waning to exit. Insurance appropriately structured are very useful for this purpose, considering all the

5 appropriate tax implications. In addition it is important that shareholders align their own affairs and wills most appropriately with this. Consult with one of the attorneys at Schoeman Tshaka for expert guidance in business continuity strategies and to have those implemented even if your business is still relatively small or only has one or two shareholders.