In the realm of startups and visionary founders, success stories are often intertwined with the challenges faced by their families when they pass away. This reality surfaces when conflicts arise between a founder’s business partners, stakeholders or investors, and their personal estate beneficiaries or family members.
A particularly complex situation arises when a deceased founder has agreed (generally under a shareholders agreement) for their shares in the company to be subjected to a ‘deemed offer’ or ‘deemed sale’ in the unfortunate event of their death. This clause leads to an automatic ‘forced sale’ of the deceased’s shares. In cases such as these, surviving family members who have aspirations to inherit the founder’s business interests will be disappointed. Even if a founder stipulates in their will that their family members inherit their shareholding, the binding nature of a deemed offer or sale provision takes priority.
How can founders safeguard the interests of their businesses and investors while protecting their family legacy? The answer relies on mastering the detail and being diligent in execution.
A deemed offer provision is a clause stipulating that under specific predefined circumstances — generally described as ‘trigger events’ — a shareholder is ‘deemed’ to have offered their shares to the company and/or the remaining shareholders for purchase. In agreements where a deemed offer focuses on a sale to the company and the company fully or partially turns down the offer, the remaining shares are then offered to the other shareholders proportionate to their existing shareholding.
Some provisions are structured such that on the occurrence of a trigger event, shares held by the affected shareholder are, at first instance, offered to the venture’s other shareholders pro rata in relation to their existing shareholding. In the absence of an agreed-upon price for the shares, the shares would generally be offered at their fair market value. The offer will then need to be accepted for it to be binding on the other shareholders. If the offer is not accepted, the deemed offer would fall away, meaning that the affected shareholder (or their legacies) would have full title to the shares.
Most shareholder agreements would generally contain a list of events concerning shareholders that would trigger a deemed offer under a shareholders agreement. These events generally include, but are not limited to:
For the purpose of this discussion, we shall focus on death as an event triggering a deemed offer or sale under a shareholders agreement.
From the perspective of co-founders, shareholders, and external investors, deemed offer provisions play a vital role in maintaining an efficient capital structure. This framework ensures that, among other things, significant ownership stakes are held by active contributors who play a pivotal role in the company’s ongoing growth, as opposed to passive stakeholders. By doing so, these provisions prevent the dilution of ownership concentration and safeguard the overall ownership stake of existing shareholders.
In the case of a shareholder’s death, the estate’s executor, often unfamiliar with the business, can disrupt operations and risk business continuity, especially when the deceased held a significant stake in this business. Generally, executors would generally prioritise the liquidation of a deceased estate, potentially leading to the sale of the deceased shareholder’s shares (typically to the highest bidder) to external buyers. A more favourable outcome for surviving shareholders and/or the company is having the first option on whether they wish to purchase the deceased’s shareholding or not.
While a forced sale of a deceased founder’s shares may intend to secure business interests through a seamless transfer of ownership to surviving key stakeholders, the business’s interests do not necessarily align with those of the deceased founder’s personal legacy. Commonly, founders build their ventures with the hope of creating a valuable business asset and establishing lasting personal wealth.
However, although well-intentioned, a forced sale triggered by a founder’s passing can harm the value of the founder’s personal estate. As such, it becomes crucial for founders to equip themselves with robust financial planning knowledge, striking a balance between business pursuits and the preservation of their personal estates.
Maintaining family interests during business succession requires skillfully balancing ongoing business operations and protecting the founder’s estate. It is, therefore of paramount importance that the terms of shareholder agreements are crafted in a manner that protects both the founder’s interests and the company’s path forward.
To achieve this balance, active and intentional discussions between founders, other stakeholders, and investors must be had.
Below are some of the practical points of negotiation that a founder, depending on its bargaining power, may leverage in negotiation deemed offer provisions in a shareholders agreement:
As opposed to a deemed offer triggering a forced sale of all shares held by a deceased founder, founders can negotiate for only a portion of their shares to be available for sale when a deemed offer occurs following their death. This measured approach ensures that the founder’s estate retains a stake in the business, allowing it to share in the venture’s future prosperity.
The portion of shares subject to a forced sale can then be negotiated with the remaining stakeholders. From an investor or existing shareholder’s perspective, the real risk in agreeing to such a compromise could be if, post-sale, the deceased estate continues to hold a significant portion of the venture’s shares, complicating voting etc. If a deceased estate holds just a passive or non-controlling interest in the business, it shouldn’t be that much of a concern.
There is no one-size-fits-all approach in these types of negotiations. A lot of factors can come into play in negotiations, including the size of the business at the time of the founder’s death, the sophistication of all parties on the cap table, the company’s prospects to raise a future funding round and so forth.
It is quite common for shareholders to agree that, upon the death of a shareholder, the remaining shareholders and the company have the first option to purchase the deceased’s shares first at at a certain discount. While some may view this as being cannibalistic of the surviving shareholders, it can be a necessary incentive for them to take advantage of the offer, simultaneously increasing their ownership and offering liquidity to the departing deceased shareholder’s estate. This approach streamlines the sale process and mitigates the need to involve new third-party buyers.
The discount generally varies from one transaction to another, depending on the influence held by the requesting shareholder (usually an investor and/or majority shareholder) and the bargaining power of other shareholders. Therefore, although there may be no guarantee that an investor would agree to a zero discount on a forced sale, a founding shareholder may attempt to negotiate for one or in the worst case, a reduced discount.
Needless to say, the above considerations require a sound understanding of the law and/or corporate transactions in general. As such, it is always recommended that founders seek the help of legal counsel to offer guidance tailored to individual circumstances.
From a personal estate planning perspective, there could be other ways in which a founder can plan their affairs such that in the event of their death, there is business continuity and that the surviving shareholders are not prejudiced.
While the below does not constitute legal nor financial advice, here are some possible thoughts that could be unpacked with the help of a qualified finance or legal professional:
In this type of agreement, co-shareholders can take a life insurance policy to cover the lives of each other. In the unfortunate event of a co-shareholder’s passing, the life insurance pay-out can then facilitate the purchase of the deceased shareholder’s interest by the surviving co-shareholder.
An important feature of this agreement is that it places an obligation on the other shareholders to purchase the shares of a deceased shareholder on the terms stipulated in the buy-sell agreement. This is a significant contrast with a deemed offer provision under a shareholders agreement, which only becomes effective once the deemed offer has been accepted by the shareholders.
Therefore, under a buy-sell agreement, there is an absolute guarantee that the shares of a deceased shareholder would be bought at a predetermined price, which in most cases would be the higher of a specified insured sum and the fair market value of the relevant shares.
Companies can opt for life insurance policies on key shareholders’ lives. In the event of an insured shareholder’s death, the insurance proceeds (generally payable to the company) can then fund the company’s repurchase of the shares held by the deceased shareholder.
These insurance products can somewhat help ensure that the shares of a deceased shareholder are at least bought at fair market values, and thus offer equitable compensation to a deceased shareholder’s beneficiaries and stop a forced sale event if triggered by the relevant deeming offer provisions.
However, for early-stage startups, especially those in the pre-seed to seed stage, obtaining insurance products like buy-sell agreements and key man insurance can present challenges. These products are generally not cheap and thus may potentially burden startups and founders still striving for financial stability.
Furthermore, in these early phases, allocating resources to these types of products could divert funds from the business’s core operations and growth initiatives, which are mostly necessary for a startup in that phase. Nevertheless, as startups progress and evolve toward more mature stages, such as securing a Series A funding round, the practicality of implementing such insurance solutions becomes more realistic.
The protective shield these products offer, by ensuring seamless transitions and business continuity, aligns well with the heightened responsibilities and higher stakes of more advanced startup phases. Therefore, while the cost factor might be a challenge initially, as startups grow and their financial capacity strengthens, these insurance products become strategic tools that warrant some consideration.
In the world of startups and visionary founders, balancing business success with family legacies requires careful planning. Deemed offer provisions in shareholder agreements play a vital role in this process. By negotiating thoughtfully and seeking expert advice, founders can chart a path that preserves both their business and personal legacies.
Thando Sibanda is Deputy Head of Legal at Founders Factory Africa.
Disclaimer: The views and insights provided in this article are intended for informational purposes only. They do not constitute legal and/or financial advice or recommendations. Every individual situation is unique, and decisions related to insurance products and legal structures should be made based on personalised consultations with qualified professionals.