In Part 1, we looked at how broad pre-completion covenants in a share sale agreement can trip change of control clauses in a target’s existing commercial contracts before a deal even completes. The same risk survives the deal. After completion it just hides somewhere less obvious: the shareholders’ agreement.

Sophisticated investors, whether private equity sponsors or venture capital funds, taking a minority interest will usually insist on protections in the shareholders’ agreement: rights over key decisions, and controls over what happens when a shareholder wants to exit or is forced out on a default. What is easy to miss is that these protections can themselves amount to a change of control. A minority shareholder may sign the shareholders’ agreement assuming that, holding well under half the shares, change of control is someone else’s problem. It is not.

This article examines the following three ways in which change of control risk can arise in connection with a company’s shareholders’ agreement:

1. a deemed change of control arising out of the rights provided to a minority shareholder under a shareholders’ agreement;
2. a change of control that arises on the exercise of pre-emptive rights; and
3. a change of control on a forced sale following an event of default.

The first is a standing risk: it arises the moment the shareholders’ agreement is signed, does not require the transfer of any shares, and lasts as long as the rights do. The second and third are event-driven risks: they arise only later, when shares actually change hands. That difference is discussed below and shapes how each risk is best managed.

Deemed change of control arising from minority shareholder rights under a shareholders’ agreement

The bundle of rights, not the percentage stake

A private equity or venture capital investor may take a minority shareholding in a company but, under the shareholders’ agreement, have the right to appoint directors and senior management, veto budgets and business plans, approve acquisitions and disposals, consent to borrowings and capital expenditure, and sign off on changes to the constitution.

Each of these looks reasonable on its own. However, read together as a bundle, these rights can start to more like control. If a company cannot approve a budget or business plan, borrow, buy a business, sell an asset or hire its most senior people without a minority shareholder’s consent or approval, a contract counterparty with a broadly drafted change of control clause may have an argument that the minority shareholder has obtained deemed control of the company. This may give rise to change of control risk for the company, by providing one or more of the company’s contract counterparties with a right to terminate, renegotiate or withhold consent under their contracts with the company.

Here lies the irony. The protections that a sophisticated minority investor negotiates hard for in order to protect its investment can end up putting that investment at risk by handing the investor deemed control of the company.

Why this risk needs to be addressed early

This risk is created when the shareholders’ agreement is signed and these special rights are granted to the minority shareholder. No shares need to be transferred in order for this risk to become live. So it has to be considered early, both when negotiating special shareholder rights under a shareholders’ agreement and when entering into key third-party contracts.

If a change of control clause under any of the company’s contracts is going to be triggered by granting a bundle of rights to a minority investor, the parties should consider whether to obtain the relevant third party change of control consents prior to signing the shareholders’ agreement. Without that alignment, parties may discover too late that rights intended to protect a minority investor’s position have unintentionally shifted control to the minority investor and inadvertently created issues for the company and its shareholders.

Change of control in the context of pre-emptive rights

A transfer of shares under a pre-emptive rights clause in a shareholders’ agreement carries two features that make it easy to overlook in a change of control context:

• The first is timing and bypass. Pre-emptive rights are often exercised between shareholders. Ownership can shift, and a contract clause can trip, without the board orchestrating anything or having a natural moment to pause and seek third party change of control consents.
• The second is concentration. Pre-emption channels a departing holder’s shares into the remaining holders rather than dispersing them to the market. That can quietly push an existing minority holder over a threshold, precisely because of how the pre-emptive rights mechanic works.

This means third party change of control consents may be needed prior to the pre-emptive right being exercised and the transfer occurring, often with little warning.

Change of control on a forced sale following an event of default

How a forced sale becomes a change of control

The inclusion of an event of default clause is customary in a shareholders’ agreement. An event of default under a shareholders’ agreement will be taken to occur in a range of circumstances, including on the insolvency of a shareholder, a breach of a restraint, a material breach of the shareholders’ agreement, and often a change of control of the shareholder itself.

The usual consequence of an event of default is a forced or compulsory transfer of the defaulting shareholder’s shares. The defaulting party is deemed to offer its shares to the other shareholders, often at a discount, so the remaining shareholders can buy up the defaulting shareholder’s interest, exit them from the company, and move on.

The trap is that a forced sale of a defaulting shareholder’s shares can:

• result in a change of control in circumstances where the company has not obtained third party consents prior to the forced sale occurring or where consent cannot be obtained; or
• render the event of default clause ineffective if third party consent to the change of control cannot be obtained.

The remedy the non-defaulting parties designed to protect themselves can quietly set off a separate problem in the company’s contracts, whether a termination right, a consent requirement or a renegotiation, at the very moment they thought they were tidying things up by exiting the defaulting shareholder.

Why a forced sale is worse than an ordinary transfer

Two features make a forced sale on default worse than an ordinary transfer.

First, the timing is poor: forced sales are often required on short notice when a shareholder has breached the shareholders’ agreement and the other shareholders want to exit them as quickly as possible.

Second, cooperation is low: the defaulting party may be unwilling to help obtain third party consents, and the transfer mechanic is often automatic. The good-faith consent obligations that work for a friendly transfer may be worth very little here. The result is that the transfer rarely goes as smoothly as the non-defaulting parties hope. That needs to be contemplated when the regime is drafted, not discovered when it is invoked.

Managing the risks

These three risks are different, but they share a common root. Managing these risks does not need to be over-engineered, but it is worth doing properly. Here are a few practical steps:

• Diligence the material contracts. Review the company’s material contracts (e.g. financing, key customer and supplier agreements, licences, leases and joint ventures) to identify change of control clauses. Note which would be triggered by granting investor protection mechanisms to minority shareholders and which would be triggered by a future transfer under pre-emptive rights or in the context of a forced sale on a default.
• Know which definition of ‘control’ you are dealing with. Some clauses only catch a change above 50%; others catch deemed control, or any change in the holder of a set percentage. The wording determines your exposure, so read it rather than assuming.
• Get consents at the right time. Make sure you know when consent is required and obtain it before the change of control has been triggered.
• Wire consents into the transfer machinery. Make the transfer provisions (pre-emption, any drag or tag, and the forced-sale regime) each expressly subject to, or sequenced with, obtaining necessary consents, supported by a good-faith cooperation obligation. Recognise that this obligation is weakest in a default scenario, so consider whether the company or the board can pursue consents independently of an uncooperative shareholder.
• Calibrate the rights bundle. Narrow the reserved matters, add materiality thresholds, and favour information or consultation rights over hard vetoes where the commercial logic allows, so the package collectively looks less like control. The trade-off is less protection, which should be a deliberate choice rather than an accident of precedent.
• Allocate the cost. Decide in advance who bears the loss if a contract is lost for want of consent, whether through warranties or indemnities in the sale agreement or as between shareholders in the shareholders’ agreement, rather than leaving it unsaid.

The bottom line

Change of control risk hides in plain sight. In the rush of a deal it is natural to focus on the transaction documents and the share transfer, and to overlook the implications of these mechanics in a shareholders’ agreement. But if a key contract defines control broadly, those routine investor protections can become the trigger for a termination right, a consent requirement or a renegotiation, at the worst possible moment.

The answer is not weaker protections. It is to treat the shareholders’ agreement and the company’s key contracts as one connected set of documents, not two. The rights a minority investor bargains for, the pre-emption regime and the default machinery are all meant to protect the investment. Drafted without an eye to how others define control, each can do the opposite, and hand a counterparty the very leverage the deal was meant to remove.

This article was written by Tom Morgan, Partner and Jacca Chang, Solicitor.