Startups II: Breaking Deadlock

Every startup has to develop its business efficiently, nimbly and appropriately in line with the needs of each industry and business sector. Thus, the operating procedures of the corporate bodies must be regulated and set up with this aim uppermost in mind.

In practice, there are various scenarios that can lead to a standstill in the decision-making process at both shareholders’ meetings and on the board of directors. Such circumstances, known as “deadlock situations”, entail a risk for any start-up.

There is therefore a need to set in place contractual solutions in bid to keep such scenarios at bay. This blog takes a look at some potential solutions to deadlock.

• Solutions without altering the structure of the business

Among the various alternatives often touted, without impacting on the corporate structure, are the following:

1. Casting vote by the Board Chairman. The Board Chairman is given a casting vote in order to tip the scales one way or another in the event of a tie.
2. Submitting the issue to a third party. A third party (usually a first-rate consultancy or accounting firm) is named in order to resolve the dispute. Quite aside from the hefty price tag, this poses the risk of leaving a decision of great importance in the hands of a third party unrelated to the startup.
3. Consultation with the parent company. This option is only open to companies reporting to a parent company, which is tasked with breaking the deadlock.

• Solutions that alter the structure of the business

Unlike the scenarios referred to above, the following alternatives involve a variation to the corporate structure (these are, needless to say, more drastic, although by no means less common options):

1. “Russian roulette”. Whereby shareholder A offers to sell its shares to shareholder B at a certain price. Shareholder B has two options: accept Shareholder A’s offer, paying the price and remaining as the sole shareholder, or reject shareholder A’s offer, with no choice but to sell its shares to shareholder A for the price proposed by the latter, which remains as sole shareholder.
2. Mexican shoot-out. Whereby both shareholders make an offer for the shares in the start-up, indicating the price in a sealed envelope. The highest bid wins the auction and the victorious shareholder must pay the price to the other shareholder.
3. Call option/put option. Whereby a sale or purchase option is arranged in the case of a situation of deadlock, to one or more shareholders in order to take up the stake of the other company shareholders.
4. Drag along and tag along. Under a drag along right, in the event of the sale of its shares, the majority shareholder is generally granted a drag-along right to require the minority shareholder to join the sale on the same terms and conditions. Alternatively, a tag along right is the right, generally granted to minority shareholders, to take part in a sale by the majority shareholder, selling its shares on the same terms and conditions as those offered to the majority shareholder.

Which arrangement best suits my startup?

Having looked at the various systems for breaking deadlock, it is only natural for a company to wonder which option is best suited to its particular circumstances.

There are no one-size-fits-all criteria to suit all projects across the board. The process must start with a rigorous, objective analysis of the idiosyncrasies of each startup. In our experience, prevention and the use of a range of mechanisms can help to solve this type of situation.

Either way, we recommend avoiding the use of highly sophisticated mechanisms that, far from offering a solution, tend only to muddy the waters.

In short, taking action to prevent situations of deadlock can help companies sidestep potential difficulties that harm the business or project in question. Much as Machiavelli once said: “it is better to act and regret it than not to act and to regret it “.

Garrigues Corporate/Commercial Department