Due diligence checklist when buying a company: share ownership and transfer restrictions

What are the actual things to look for when you conduct corporate due diligence on a company you want to buy? In my experience there are three checks that matter most on a share purchase: that the sellers own the shares they are selling, whether pre-emption rights exist, and whether there are any other restrictions on transferring the shares. Each one is a hoop you need to jump through, and each is usually found in the company's own documents rather than anywhere public. Miss one and the transaction can be challenged.

Make sure the sellers own the shares

This sounds obvious, but you would be surprised how often there are discrepancies. You need to verify that each seller is recorded as the legal owner of the shares they are selling to you.

To do that:

• Check the company's register of members. This is one of the statutory registers the company is required to keep, and it is the legal record of who owns the shares.
• Compare it with what the sellers have told you. The sellers will have given you their own account of who holds what. It should match the register.
• Compare both against Companies House. The public record should tell the same story as the internal registers.

If there are any mismatches between those three sources, investigate them before you proceed. Find out why they differ and get the position corrected before completion rather than after it. A seller who is not recorded as the owner of the shares cannot validly sell them to you, however genuine their belief that the shares are theirs.

Check for pre-emption rights

Pre-emption rights give the existing shareholders a right of first refusal when another shareholder transfers or sells their shares. This is especially relevant if the company you are looking to buy has more than one shareholder. If not everyone is on board with you becoming the owner of the company, pre-emption rights can create real problems.

You will typically find them in one of two places:

• The articles of association. These are publicly available on the company's Companies House profile.
• A shareholders' agreement. This is a private contract between the shareholders and is not publicly available, so you will need to request a copy from the shareholders.

How to waive or disapply pre-emption rights

If there are pre-emption rights, the other shareholders will need to waive them. In practice that means two things:

• Waivers in the SPA. The share purchase agreement should record that the other shareholders waive their pre-emption rights in respect of the transfer to you.
• Following the pre-emption process where necessary. The pre-emption provisions typically detail a procedure, for example offering the shares to the existing shareholders first, and you may need to follow it.

If the pre-emption rights are in the articles of association, it may simply be a case of passing a special resolution at the same time as the board approves the sale of the shares to you. That special resolution would state that the pre-emption rights in the articles are disapplied for the purposes of the transfer.

Other restrictions on share transfers

Beyond pre-emption rights, the articles may contain other restrictions on how shares can be transferred. Two come up regularly.

Board approval of the transfer

Some articles of association require board approval before shares can be transferred. In fact, the vast majority of articles require a board meeting at which the directors approve the transfer. So you need the directors of the company to be on board with you becoming the new owner of the shares, not just the shareholders. On a small company the directors and the shareholders are often the same people, but not always, and where there are directors who are not selling you need their approval too.

Conflicted directors and quorum

Other articles state that a director who is also a shareholder cannot approve the sale of their own shares, because of the conflict of interest. If that is the case, you need to make sure that one of two things happens:

• The conflict of interest provisions are disapplied by special resolution, so the conflicted director can take part in the decision; or
• There are enough other directors present to form a quorum. A quorum means enough directors are present for decisions to be validly made even when the conflicted director is not counted.

In summary, you need to understand what hoops you have to jump through and then make sure you jump through them properly, exactly as the relevant documents describe.

Why following the procedure matters

The risk of not identifying these hoops, or not jumping through them properly, is that the transaction may be found not to be valid. This is typically what happens when the correct procedure has not been followed and someone later decides to challenge the transaction. Having paid for the shares, the last thing you want is to discover that the transfer to you was never validly approved.

Next steps

Ask the seller for the register of members, the articles of association and any shareholders' agreement at the start of due diligence, and compare them with the Companies House record. If you find pre-emption rights, board approval requirements or conflict provisions, have your corporate solicitor build the waivers, special resolutions and board minutes into the completion documents. For the fuller version of this review, see my guide to corporate records due diligence.