Understanding Deadlock in Closely Held Corporations
Deadlock in a closely held corporation stops a business in its tracks. Deadlock happens when a key decision can not be made because there is not enough votes to make the decision. This occurs most often in two situations.
Situations That Cause Deadlock
The first situation is when all the shareholders have the same voting power. Suppose there are four shareholders. Each shareholder owns 2,500 shares. If it takes a majority to take action, this means, three shareholders must vote on favor of a decision. If they do not, then there is deadlock.
The second situation where deadlock arises is when a higher than majority is required to make a decision. Suppose there are 3 shareholders. Shareholder 1 owns 1,000 shares, shareholder 2 owns 2,000 shares and shareholder 3 owns 2,000 shares. Shareholder A vote to merge with another company requires a supermajority vote of 66%. If shareholder 1 and shareholder 2 support the merger, it still can’t happen because the vote would only have 60% approval.
Get Tailored Solutions for Your Closely Held Corporation – Contact Us!
Solutions to Resolve Deadlock
One way to solve deadlock is to have a shareholder agreement that has a solution. There are bunch of different ways to resolve deadlock. One way to flip a coin if there is a decision that has only one or two choices. Since a flip of a coin is random and shareholders typically don’t want to leave their futures up to chance, they will find a way to resolve the deadlock before the coin flip.
Another way to deal with deadlock is to present the situation to a neutral party to make the decision. The neutral party listens to the pros and cons of each side and makes a decision that binds the shareholders. This way works well if the decision is fairly simple. However, if it is a complex decision, the cost of educating a neutral party may exceed the benefit.
One other way to deal with deadlock is to require the parties to meet and negotiate. If the shareholders do not resolve the deadlock in the meeting, then one shareholder can offer to purchase the shares owned by the other shareholders.
The purchase price is negotiated or set by an appraisal. If the other shareholders sell, then the purchasing shareholder can move forward. If the selling shareholders refuse to sell, then they lose their votes on the matter that caused the deadlock. This allows the other shareholder to move forward. If all the shareholders make an offer to buy the other’s shares, then the highest offer wins and he buys the shares.
Sample Deadlock Clause
This is a sample clause that we have used to address deadlock with a put.
Deadlock. If Directors or shareholders arrive at a deadlock in the management of the Company, Shareholders shall enter into a thirty (30) day period of good faith negotiations to resolve the dispute. If, after thirty (30) days, the deadlock remains then a shareholder in dispute shall then have the right to call no less than the entirety of the shares of the other shareholder. Such call shall be subject to the valuation by appraisal. If a shareholder declines to sell his or her shares pursuant to such a call, then such shareholder’s vote shall be disregarded as to the matter causing a deadlock. If there is a mutual call of shares, the shareholder willing to pay the highest price shall either purchase such shares or shall prevail as to the matter causing the deadlock.
This blog is not legal advice and does not create an attorney-client relationship with our firm. The content is intended to promote a general understanding of legal concepts and should not be relied upon as a substitute for obtaining legal advice from a qualified attorney regarding the reader’s specific circumstances. Readers should consult legal counsel for advice concerning their individual situations. All content is provided without any representations or warranties regarding completeness, accuracy, or timeliness.