The key events in this case are as follows:
- 1993 – Conran Holdings Limited (“CHL”) formed. Mr Gunewardena acquires 2% of CHL's issued shareholding.
- 12 August 1993 – CHL adopt new Articles (“the 1993 Articles”). Under the 1993 Articles, leaver provisions were adopted that an employee who ceased to be an employee of a member of the Group (other than through death) was compulsorily required to transfer their shares. In the absence of agreement between the departing employee and the prospective buyer, the sale price was to be determined by CHL's auditors on the basis of “fair selling value” (“the fair selling valuation”).
- 4 October 1995 – CHL amended the Articles (“the 1995 Articles”). Under the 1995 Articles, if the auditors were asked to certify a fair price for the shares of the departing employee, the value would be calculated on the basis of profits generated over the last two years. This change was made at the instigation of Mr Gunewardena as at the time CHL was profitable and he wanted greater certainty that his shares in CHL would be valuable – so that if he left he would receive the significant funds required to pay up amounts owing to CHL in respect of his shares (which at the time of adoption of the 1995 Articles was £375,000).
- 2006 - Mr Gunewardena and his private equity backers bought out the restaurant business of CHL and Mr Gunewardena ceased to be the CEO and an employee of CHL - instead becoming an employee of CGL Restaurant Holdings Ltd (“CGL”), but remaining a director of CHL.
- 19 April 2013 – Mr Gunewardena acquired CHL’s remaining 51% shareholding in CGL. This terminated CHL’s interest in CGL and meant that Mr Gunewardena was no longer employed by a member of CGL’s Group [and the compulsory transfer provisions contained in the 1995 Articles were triggered].
- 19 November 2014 – the auditors of CHL concluded that Mr Gunewardena’s shares were worth nothing as CHL had made losses in the two years preceding his departure in April 2013.
The High Court made the following findings:
- that despite CRL being treated as a subsidiary of CHL for accounting purposes, on a strict interpretation of the articles of CHL, CRL was not to be treated as a subsidiary for the purposes of the transfer provisions in the 1995 Articles, which meant that Mr Gunewardena’s departure from the business at the time of the buyout to run the hived-off business (although he remained on the CHL Board) when CHL was profitable did not trigger the compulsory transfer provisions. If it had, Mr Gunewardena’s shares would have been worth significantly more than a few thousand pounds.
- that the valuation of the auditors was correct and arguments regarding irregularities in the filing of the articles and purported agreements made between Mr Gunewardena and Terence Conran regarding the price of his shares were dismissed on technical and evidential grounds.
Lessons to be learned
These types of leaver provisions are very common in shareholders’ agreements and small changes to these clauses can have a significant impact on the outcome of a valuation particularly in relation to minority discounts. In this case, when a substantial part of the business was hived off into CRL (this part being the restaurant business that was valued at £50m at the time), from what we can see from the outside, Mr Gunewardena should have revised the metric on which his shares were valued on his departure. This was because, although the residual CHL business was profitable, its profits were much diminished after the disposal of the restaurant business and so the continued use of a profit metric provided him with significantly less certainty of a return on his Shares than before.
Parties should be very cautious about relying on such a specific valuation metric as the level of profits is only one of the ways to value a business, and can be both radically out of kilter with the true value, and open to manipulation. For instance, in times of expansion or where owner managers extract value through operating costs, profits could be low but the underlying business could be healthy and valuable.
It is more common for auditors to be given a freer reign to determine value – and whether that be according to balance sheet valuation, discounted cash flow forecasts on the basis of profit multiple of comparative businesses, or a combination of these metrics. This approach means that changes in a business over time are less likely to produce anomalous results.
The golden rule therefore is that it is important that you consult your solicitor whenever presented with a shareholders' agreement or an amendment is proposed to the articles of the company in which you are a shareholder.
For further information on this matter or advice on Shareholders’ Agreements please contact Jonathan Morris, a partner in our Corporate and Commercial team.