What You Need to Know About Shrinking Your Shareholder Base

By Kresimir Peharda, Partner

Private companies sometimes find themselves with more shareholders than they intended and had planned for.  That can come about as a result of crowdfunding, acquisition, reorganization, bankruptcy, etc.  Management can get overwhelmed when dealing with shareholder relations and many small shareholders.

How can companies shrink their shareholder base?

There are several ways to decrease the number of shareholders.  They include, in order of easiest to most difficult:

  1. Stock buy-back
  2. Conversion
  3. Reverse stock split

 

Stock buy-back

A stock buy-back is the most straightforward option.  Companies must verify that they:

  1. Meet the solvency tests under the laws of their state of formation
  2. Are allowed to buy-back securities under their charter documents
  3. Are allowed to purchase their securities under any contractual agreements (stock purchase agreements, loan covenants, etc.)

 

Other issues to consider:

  1. What price is fair to shareholders (409A valuation, recent 3rd party purchase, financial statements)
  2. Does the company have the resources to carry out the buy-back without an outside transfer agent?

 

Conversion

The main issues in a conversion of securities are:

  1. Blue sky for all states affected. For example, an exchange of preferred for common is considered a sale of securities under federal securities laws.
  2. Shareholder approval from both common and senior classes of securities may be required
  3. Reviewing charter documents for authority
  4. If any cash is issued, meeting the solvency test under state law

 

Other issues to consider:

  1. Conversion formula. If the charter documents do not specify a formula, what will be the formula?
  2. Does the company have the resources to carry out the conversion without an outside transfer agent? Reverse stock split

 

Reverse stock split

Reverse stock splits are the most complicated of the three options.  The reason for this is that in some states payment of cash in lieu of fractional shares requires approval from the state.  This involves filing an application detailing the proposed action which is reviewed for fairness and against the minority freeze out statute of that state.  This creates a risk that the stock split will not be approved even if all of the shareholders approve.

 

Other items to consider:

  1. Shareholder approval for the stock split
  2. Authority for a reverse stock split in the charter documents
  3. Reviewing contractual provisions for anything that restricts a stock split
  4. Where cash is issued in lieu of fractional shares, meeting the solvency test under state law

 

Lastly, companies may want to consider engaging a transfer agent to handle the share re-issuances and capitalization table administration if the number of shareholders is large enough or internal resources are limited.