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Why shareholder agreements are vital when going into business

How often do friends or colleagues go into business together, never stopping to think about a legally binding shareholder agreement until something changes and things get nasty?

When a group of colleagues, friends or family members start a business together it can be a highly rewarding experience;  a group of people coming together to work towards a shared passion or goal.

However, as businesses change, and as the lives of people in a business change, the relationships between shareholders can become strained or even dysfunctional. Unlike a highly diluted ownership structure such as a publicly listed company, private businesses owned by a small group can be vulnerable to individual changes in circumstance. These conflicts can destroy entire enterprises if left unchecked.

Too often, thought is given to the vulnerabilities of a business only when the cracks have already started to appear. While there are ways through these situations, they are clumsy, expensive and usually result in painful personal rifts between owners.

Planning ahead at the beginning of the business relationship is a much more effective way to prevent business-ending conflict. With that in mind, Shareholder Agreements are an ideal way to enshrine measures to prevent problems before they arise, or to offer avenues to resolve any issues that appear in the future.

When a group of potential business owners come together, it is vitally important that they don’t let their passion to ‘get on with it’ distract them from asking some fundamental questions about how the business is to be run. They should take a moment’s pause, and seriously consider implementing a Shareholder Agreement.

Every business is different, and individual advice should be sought, but there are key issues that are almost universal.

Issues of key personnel

Is there a ‘key individual’ whose presence is fundamental to the business? Has one of the shareholders brought with them a skillset or asset that is irreplaceable – and, if so, what happens if they leave? Perhaps this could be remedied through a clause that forces the individual to sell back or transfer their share should they leave the business.

Beyond individual shareholders, the group decision-making model needs to be thought about. There are many ways to set up a board and directorship. These options need to be considered carefully in light of a given business. Just some of the issues that should be set out in a Shareholder Agreement include:

–       Who are to be the directors?

–       Are employee shareholders entitled to be on the board?

–       Is board representation meant to reflect the volume and spread of shareholding?

–       Who is going to be the managing director or chairperson?

–       Will the chairperson have a casting vote?

–       Should certain decisions require a higher level of approval than the typical ’50 percent plus one’?

It is self-evident that a business is more likely to stand the test of time when these critical issues are agreed in writing and not through some sort of ill-defined informal agreement.

Issues of shareholding and financial reward

A business, and the people in it, should never lose sight of the fact that circumstances change. One of the great challenges of a young business can be when key shareholders, for personal or professional reasons, make the decision to ‘break away’ from the rest of the shareholding group.

These changes should be contemplated early on. A Shareholder Agreement can’t predict the future, but it can build in the mechanisms and rules for the evolution of a business or its owners’ circumstances.

What happens if one of the owners can no longer contribute and decides to leave? What if there is no market for their shares, or the business lacks sufficient capital to absorb that owner’s departure? If the business is still in an early stage, it is important that a process is established at the outset which means an owner can leave even if there isn’t capital readily available to redeem that owner’s interest. This can be handled in a number of ways such as prescribed valuation methodology or agreed price, coupled with an agreed payment plan by instalments (with or without interest).

Indeed, the very things that shareholders are allowed to do after they leave should also be considered. For instance, some businesses might want to consider a restraint clause imposed on a departing shareholder to ensure they do not enter into direct competition with the business right away. As with all legal agreements though, these clauses need to be carefully planned and orchestrated for risk of being treated as unenforceable by a court.

Issues of success

It seems contradictory to consider problems that may arise in the wake of a company becoming successful, but it isn’t. As businesses begin to prosper and grow, there are new challenges to contend with. Just some of the possible scenarios and questions that can emerge are:

–       How does the company intend to distribute dividends to the shareholders?

–       How does management decide whether dividends are appropriate?

–       How are new shares to be issued if more capital is required?

The possibilities don’t end there. Often times, competitors or investors may begin to take an interest in a blossoming business and pursue a share of ownership in their own right. What happens if a majority shareholder wishes to sell their stake to someone that is unknown or disliked by the minority shareholders? A Shareholder Agreement can accommodate these situations in a number of ways, such as ‘tag-along’ and ‘drag-along’ rights which give the shareholders the right to force others to sell or buy shares if certain conditions are met.

Equally, many businesses succeed because they create a service or product that meets a unique need in the market somewhere. This may constitute intellectual property – but who owns it? Does it belong to one shareholder whose idea was already in existence and then brought to the business? If an employee shareholder has ownership of the property, a company without adequate safeguards in place may find itself held to ransom if and when that employee decides to move on.

Shareholder Agreements make sense

While many of these scenarios inherently suggest a gloomy experience of partnership and private share ownership, it is often not the case. The important thing for businesses of all sizes to remember is that it is simpler to set out fundamental rules before a conflict arises than while in the middle of one.

The range of issues that might arise in managing a company and the relations between its shareholders are many. That’s why Shareholder Agreements make sense. The key to a successful Shareholders Agreement is to understand the needs of a business and its owners, and to anticipate, as far as possible, the ways to deal with those as they arise.

Shareholder Agreements, in most cases, should address the broad issues of governance, departure, capital raising and decision making. If these fundamentals are properly built into such an agreement, the chances of catastrophic, emotional conflict between fellow shareholders are lessened.

Most of all, shareholders should be proactive about ensuring their business is adequately configured to accommodate changes within the ownership and changes in the business itself. Seek expert advice and save yourself from the pain and cost of a complex legal dispute further down the road.

Gerard Magnerhttp://www.hallandwilcox.com.au
Gerard Magner is Partner, Commercial Dispute Resolution, Hall & Wilcox.