Planning for the times when partners fall out
All business partnerships start out with good intentions. They vary in form but they have one thing in common – the capacity to go horribly wrong. Disputes can arise between shareholders for many reasons; over business strategy, composition of the board, succession planning and workloads, to name but a few. Shareholder agreements are supposed to take account of such eventualities but who can foresee everything?
“More often than not there is more of the human element to these disputes,” says John Reynolds, head of litigation at London law firm McDermott Will & Emery. “Shareholder agreements have basic provisions for areas of possible disputes but often fail to take into account the fact that people change and, as a result, find they have very different ideas about how to move the business on. When you are dealing with disputes between individuals as shareholders, emotions run high.”
Family businesses are no more prone to faulty shareholder agreements than any other business, he says but the effects of a falling out can be devastating. “A family business requires the same elements of a shareholder agreement as any other company. It may be far less palatable to contemplate that you will have a mass fall-out with your father or your brother but it does happen,” says Mr Reynolds.
One classic problem with shareholder agreements that everyone should tackle is the issue of share value when a shareholder wishes to exit, says Tong Bogod, a partner at BDO Stoy Hayward, the accountancy firm. He also cites the issue of minority discount and the fact that many people do not realise that owing 20 per cent of a private company worth £1m does not mean their share is worth £200,000 if they wish to leave.
David Gallagher launched Prime Time Recruitment in 1992. Initially it comprised himself and a non-executive chairman, followed by several more investors and, to date, a total of 16 shareholders.
“We lost a couple of shareholders early on because they felt they were doing more than some of the other shareholders. They were wrong; they simply weren’t seeing the full picture across the board.”
As the business grew, Mr Gallagher needed to bring in senior executives, who wanted to have equity or a salary package plus share options.
“This was something we had planned for when we drew up the shareholder agreement and we had put some equity to one side: 2.5 per cent of the 3I’s [the venture capitalist involved in the business] equity and 2.5 per cent of management equity. Even so, some of the board members saw this as a diluting of shareholder value.” He argues that the value that new executives bring to a company can increase its value to shareholders.
Further problems loomed when the buy-out valuation clause of the shareholder agreement was enacted. It set out that shareholders a level down from the main board would receive an amount decreed by a set formula, involving multiples of share value, while for members of the main board the calculation was done by an external assessor. As a result the departing board member gained little value. With hindsight, says Mr Gallagher, the shareholder agreement should have been drawn up differently.
“It was justified at the time because we felt it was a very good incentive and we wanted to safeguard people’s investment for them. The consensus now is that multiples of share value should be offered to everybody or nobody.”
Bringing new people into a company can be a source of shareholder dissent and should be acknowledged in an agreement. “As organisations grow they need to know who they are going to need,” says Alan Waring, head of risk management consultancy Alan Waring & Associates. “Typically, you might have three or four people start a company on the basis of their knowledge. When they reach a certain stage of growth it becomes apparent that they don’t have enough knowledge of marketing and finance – they are not very good as business managers – but they don’t know how to give way…they can have a stranglehold on the business.
Some of the most acrimonious disputes occur in businesses run by two friends with equal stakes, an inadequate shareholder agreement and a share structure that leaves the business in deadlock. Common themes in such a case are lack of communication and a perceived imbalance of input, says Susan Clark, head of law at Yorkshire law firm Last Cawthra Feather.
“People forget they needed someone else’s money at the start. One partner may have put money in at some personal risk, while the creative person doesn’t put in any risk money at all. A few years later, when profit starts to increase and the risk seems to have gone, the investment partner is no longer flavour of the month.”
Ms Clark says shareholder agreements are like wills: they should be reviewed regularly and change with circumstances, even if at first sight they do not appear to affect shareholder value. “There may be a formula for valuing shares but if the nature of the business changes it could be inappropriate. For example, the value might be based on property assets but as the business grows the majority of the assets might be goodwill and trading and the formula might not reflect that.”
Business partnerships with irreconcilable differences resort to litigation. For the founder of one consultancy and software developer, failure to pay attention to the details of a shareholder agreement had legal repercussions and almost cost him his business.
He says: “The company had three shareholders, myself and two others – people I had known for years – one of who was entrusted with the task of organising our shareholder agreement. It soon transpired that he wasn’t up to his job but when tried to let him go he referred to the shareholders agreement and brought in his lawyers.”
The clauses of note included a 12 month period of notice and the rights of existing shareholders to buy people out at a nominal valuation. “He felt his 10 per cent stake was worth far more than it actually was…we were weeks away from insolvency. Had he pressed his claim I would have had no choice but to close the business,” says the owner.
The solution was to draw up a compromise, costing the company about £50,000, which set out a nominal buy-out share price and revenue from previously assigned contracts.
“Disputes are by no means always resolvable,” says Ms Clark. “Horrendous arguments can result, where one partner leaves, to be bought out by the other, or an application can be made to have the company wound up on equitable grounds.”
The key to rescuing a dire situation is to keep the lines of communication open. Renegotiation of an agreement, says Mr Reynolds, is possible only while all parties are willing to work towards a resolution.
“People enter into business ventures feeling very optimistic about the future… they can’t foresee potential problems or disagreements and that is often reflected in shareholder agreements. If it was left to litigation experts to draft shareholder agreements, they would be drafted very differently. You can’t predict every eventuality and a balance has to be struck between protecting interests and seeing things go wrong”.
Issues for shareholder agreements
Definition of the business carried out by the company
Intended capitalisation and financing of the company
How much to be provided by proposed shareholders now and in the future: timing of funding injections; possible need for external finance; are shareholders prepared to provide guarantees?; potential types of future funding
What and how assets will be contributed by the shareholders
Composition of board: ensure adequate representation but also that the company can be managed effectively; clarify who has the right to appoint the chairman and chief executive; explore need for different classes of shares to reflect different voting rights
Intended policy on distribution of profits (growth or cash)
Means for swift resolution of deadlock if shareholding split 50:50
Resolution of disputes: for instance, clarify means of selecting an arbitrator
Undertakings relating to confidentiality, non-competition and non-solicitation of employees and customers
Transferability of shareholdings and suitable exit routes: method of, basis for and timing of the valuation of shares being transferred
“Financial Times” 11 October 2001