By Paul Mandel, Collins Barrow
Minority Shareholders – Moving OnBusiness & Professional Tax advice
When you are a minority shareholder at a private firm and decide to leave and sell your shares, the situation can become complicated and lead to disputes.
From the May 2016 print edition, page 39
Are you a minority shareholder in a consulting engineering firm? Owning and selling shares can be slightly more complex than you realize. From buying or selling shares and handling disputes with majority shareholders, to understanding the true financial value of your shares (hint: it may not be what you think), as well as the tax implications, here is what you need to know.
Shareholder agreements —
a “must have”
Minority shareholders at most private companies, including engineering firms, have two kinds of legal protection: securities legislation and shareholder agreements. The latter includes additional rights that extend beyond what’s included in legislation.
It is important to remember that a shareholder agreement doesn’t simply fall into your lap. It must be proactively and independently created. In these agreements, the majority shareholder usually gives up rights to the minority. The agreement also provides guidance as to how shareholders are expected to conduct themselves.
If you’ve joined an established firm, they likely already have an agreement in place, so you should familiarize yourself with the advantages and limitations of being a minority shareholder. Then if a dispute arises, you know the options available to you.
Breaking up is hard
Shareholder disputes do not necessarily evolve because people don’t get along. Most disputes occur when one party wants to retire or get their money out of the private firm. Unlike public companies, where you can sell your shares with the click of a button, the option to sell private firm shares is much more limited. Your motivation may be a timing issue, not necessarily a disagreement with the direction the firm is taking. It doesn’t have to be a clash of egos, but when disagreements arise a dispute resolution forum is necessary.
Public courts typically aren’t the best way to resolve shareholder disputes. The proceedings are public and the process slow. For privately owned firms, there are better alternatives: mediation or arbitration.
Mediation brings all parties in a dispute together. Usually the mediator hears the evidence and makes a recommendation to resolve the issue, but it’s not binding.
Arbitration provides a less open-ended solution. This process takes place in a private court where the parties have signed a legally binding contract agreeing that the decision of the arbitrator will be enforced. This option is faster and allows for more privacy. However, in my experience, mediation is preferable because you still have some control over the outcome.
Before you move on
Generally there are up to three options available if you want to sell your shares (likely outlined in your shareholder agreement):
(1) Sell your shares back to the company;
(2) Sell your shares to another stakeholder in the firm;
(3) Sell your shares to an outside buyer.
Option 3 is often not available to you because many shareholder agreements don’t allow the sale of shares outside the firm. They want to keep the wealth and ownership within the company.
Option 2 is usually only available if the firm’s board of directors has set up a marketplace and an established price for the sale/purchase of minority shareholdings.
With all of the options, you may be at the mercy of a concept called “minority discount.” Also referred to as “discount for the absence of control,” it’s exactly what it sounds like.
You may not receive full-value payment because you have a “non-controlling interest.”
While there is no objective tool or formula to quantify this minority discount, in my experience shareholders could receive as much as 30% less than the allocated-share value (when selling shares as a stand-alone transaction as opposed to being part of the sale of the whole business).
But there’s one more thing to consider — do you and your firm actually know the true value of the shares?
What’s in a share?
When your board of directors sets the value of company shares, it’s often based on their estimation of how well (or not) the firm has done in the past year. Sometimes, they may consult with the company accountants or experts, but even then it may not be a thorough valuation exercise. So the current price of your shares may be under or over-valued in the open marketplace (i.e. if the company were to sell the business as a whole), especially considering the minority discount concept.
In order to learn the true value of your company assets, it’s usually necessary to use business valuation techniques or (preferably) hire an expert business valuator. The process considers both the firm’s income and cash flow streams, the assets and liabilities of the company, and transactions in the greater marketplace.
This knowledge is not only invaluable when selling shares or handling a dispute, it is also important for personal financial planning — from individual estate and tax planning (for instance, passing on shares in the case of death), to asset measurement in cases of a matrimonial dispute.
The taxman’s share
So you’ve dealt with any disputes and found a buyer for your shares. How much are you going to have to pay in tax?
If you’re selling to another shareholder or outside buyer, the proceeds will be taxed as a capital gain. Even if you pay the top marginal tax rate for capital gains (26.76% as of 2016), that’s better than if you redeem the shares (sell them back to your firm). In this case the proceeds will be taxed as a dividend income with top rates between 39% and 45%.
To add to the reasons why you may prefer to sell to other shareholders or an outside buyer, there’s also a lifetime capital gains exemption that allows you to sell up to $824,176 (2016) worth of qualified shares, tax-free. (Remember this exemption is not available if you own shares in a publically traded engineering firm.) There are tests that determine whether your shares are eligible for this exemption, but the major requirements are:
• your company must be a Canadian Controlled Private Corporation (CCPC);
• the firm must carry on active business;
• a specified portion of the company’s assets must be used for active business purposes.
Keep in mind
In the end, whether you’re holding your shares, selling them, or addressing a dispute, arm yourself with knowledge. Learn the true value of your company’s shares and understand the implications of your shareholder agreement.cce
Paul Mandel, MBA, CPA, CA. CBV, CFF is a partner at Collins Barrow, Toronto. Valuations, with 20 years of business valuation and litigation support experience. He acts as an expert witness and lectures extensively. Email email@example.com