Domination Games – Not Necessarily What You Had in Mind

Doron Afik, Esq.
April 29, 2015

In a conversation with a person who held 50% of a company he complaint that he cannot sell shares in the company because if he does so he will "lose his control". This means that the actual value of the shares is significantly lower than it should be because of lack of alienability of the shares. Similarly high-tech entrepreneurs often insist "not to lose control" and block investments in the company. So who really has control over a company and does one really need hold over half of the shares in order to have "control".

The Israeli law defines "control" over a corporation as the ability to direct the activities of the corporation except where such ability derives solely from the position of a director or other officer of the corporation. The law creates a presumption that the holder of half of the "control means" of the corporation is the controlling shareholder, but this presumption may be contradicted.  The definition of the term "Control Means" varies from one body of law to the other but would generally the right to vote at the general meeting of the corporation and the right to appoint directors or the chief executive officers are considered control means.  Note that a corporation may have more than one "Control Holder".

A common legal accident occurs when a person who holds all the shares of a corporation seeks an investor to receive half the shares and agrees with a broker brokerage fee in the form of shares. Although the broker's holdings are, for example, one percent stake in the company, the broker has now become the factor that tips the scales (e.g., each major shareholder holding 49.5% and the broker holds the remaining percentage). Thus, the broker has now become the only control holder in the company – i.e., the controlling shareholder is the only shareholder with no significant holdings and with no genuine interest in the benefit of the Company, other than the desire to maximize its personal gain from receiving payment for its vote from the higher bidder.

In addition, a person may be a controlling shareholder even if such person holds only a small percentage of the shares if a special class of shares exists. Sometimes a lower class of shares may become the controlling shares if a transaction may be vetoed by such class.  A change of rights of a class of shares require a class vote and if a merger transaction requires change of the rights, the class of shares receives effective veto rights (for example, if one created a special lower employee share class and for the merger it is necessary to cancel such class and convert such shares to ordinary shares).  Theoretically a person may be a holder of control over a company even without shares if control rights are granted by agreement which gives the power to direct the activities of the Company or (and this is preferable, because a company can breach a contract but cannot legally circumvent provisions of its articles of association) if the Company's articles state personal rights of a certain person regardless of such person's holdings.

A mergers and acquisitions lawyer will know how to formulate the company's articles, shareholders' agreement or investment agreement to grant each party the means of control such party really needs and overcome obstacles in the negotiations. Only well drafted legal documents will be able to avoid future conflicts. Furthermore, it is important that as early as at the stage of incorporation proper constitutive documents will be drafted to anticipate future investments.  Thus, at such stage the company should already consult lawyer specializing in mergers and acquisitions and present such lawyer with the interests of the founders of the company to allow the lawyer to build the optimal company legal architecture in a manner tailored to the parties' needs.