Exit in Private Companies – An Overview

Abstract

For a considerable number of years, I, together with my colleagues in Aarhus and in particular Mette Neville, have argued that exit rules in private companies, especially in SME’s, are necessary. Exit rules may be defined as rules which under certain conditions provide a shareholder with a right to have his or her shares redeemed by the company or, as the case might be, be purchased by other (majority) shareholders in the company; in other words the company or other (majority) shareholders have an obligation to - under certain conditions - redeem the shares or purchase them.

The reason why exit rules are necessary in private companies is that there is typically one significant and fundamental difference between private companies and publicly traded companies. This significant and fundamental difference is that shares in publicly traded companies have a standardized market which shares in private companies do not have. Since there is no standardized market for the shares there is regularly a lock-in effect in the sense that (minority-) shareholders in the absence of contractual rules or corporate rules in law or the articles of association cannot sell their shares because of lack of normal market conditions or at least not sell them on “fair conditions”, i.e. to a price which reflects the information of the company had the information been available.

In a family business and quasi-partnership, the parties are typically less aware of the risks of doing business together or of the legal consequences of their failure to cooperate in doing business jointly. They also can be assumed to be less rational in a way micro-economic theory would describe as homo economicus but with a legal awareness attached to it, to not have full information and to be restricted by transaction costs of preparing the family business or quasi-partnership in a legal format by way of articles of association and/or shareholders’ agreement ex ante entering into it.

In this article, I will try to illustrate why a exit right is recognized in some countries while in others it is difficult, if not near-impossible, to even have an academic discussion on the subject as a whole, the different de jure and de facto strategies which exist to accomplish an exit right, and what the consequences of the different strategies are – for shareholders, the lawmaker and, in economic terms, for economic growth.

A statutory explicit exit right, which specify under which circumstances a shareholder may exit the company as well as specifying the exit procedure, including who – the company or the other shareholders – is under an obligation to redeem the shares or purchase them and the valuation of those shares, is the preferable legislative alternative (like Norway and UK illustrates). From my analysis, I believe it is quite clear that the alternative, i.e. an implicit exit right, easily may be misunderstood in practice (like the situation in Sweden illustrates) or at least be hampered by being subject to a slow evolution in the courts combined with being a principle of uncertain nature and scope (like previously Norway and currently possibly Germany illustrates).

From a supply perspective, a well drafted explicit exit rule with a few typical specific exit situations, but drafted in such a way as to allow future evolution, presumably promotes economic growth in ensuring that individuals can walk away to new entrepreneurial activities without being locked into a present, dysfunctional entrepreneurial activity. From a demand perspective, an explicit exit right provides a shareholder in a family businesses or quasi-partnerships at least with some kind of relief ex post a particular oppression, deadlock or freeze-out, even if such a statutory right might not be exactly what the shareholder had contracted for ex ante.

Keywords: Exit rules

JEL Classification: K22