The hazards of being shareholders in private firms

[WORLD] When investing in a private company, it is crucial to understand the terms that will allow you to exit and recover your investment.

Unlike publicly traded companies, exiting a private firm can be far more challenging, particularly if the owners are unwilling to buy back your shares.

The lack of liquidity in private markets poses a significant challenge for investors, as shares cannot easily be sold on a stock exchange. This often forces minority shareholders to rely on negotiated exit strategies, such as buyback clauses or drag-along rights, which should ideally be outlined in the shareholder agreement. Without such provisions, investors may find themselves trapped in a company with no clear exit strategy, even if the company is performing well.

Seeking a court order to liquidate the company is also a difficult and costly process. Courts tend to be extremely cautious about intervening in an ongoing business, and they typically do so only when it is “just and equitable” to do so.

Recent legal trends highlight the importance of documented evidence when addressing shareholder disputes. For example, in a 2023 ruling, the High Court rejected a minority shareholder’s request for liquidation, citing a lack of proof of financial mismanagement. The judge emphasized that mere disagreements over business strategy are not sufficient grounds for winding up a company, underscoring the high threshold for judicial intervention.

In short, it is not enough for minority shareholders to simply express dissatisfaction if they wish to exit. They must provide evidence of "unfairness," such as bad faith or misconduct by the majority owners.

Experts advise potential investors to conduct thorough due diligence not only on the company’s financial health but also on the track record of its majority stakeholders. Past disputes or legal issues involving the company’s founders could serve as warning signs. Additionally, it is prudent to seek legal counsel to draft or review shareholder agreements, ensuring that exit mechanisms and dispute resolution procedures are clearly defined from the outset.

Below are three cases that demonstrate how courts handle shareholder attempts to exit private companies.