How long is a piece of string?
I am often asked ‘can you do shareholders agreements, and what do they cost?’ The short and correct answer might be something like ‘yes, between £200 and £20,000. Plus VAT.’ I find this doesn’t go down too well. So instead I might reply ‘why do you want a shareholders agreement?’, or ‘what do you want the shareholders agreement to cover?’ The answer is often: ‘I don’t know; but I’ve been told that I need one’!
What people really need is advice on why they might want a shareholders agreement and what they might want it to say. The drafting can only be started once they have considered this advice and can give clear instructions. But it is very hard to give an estimate for the advice itself. Every situation is different and it can take some time for a client to digest the advice and decide exactly what they want. They often find they need to think through some fundamental issues which they have not yet properly addressed.
It is even harder to estimate legal fees when the process needs to involve getting all the other shareholders to agree everything.
The only certainty I can give on pricing is that OnHand Counsel is almost certainly going to provide considerably better value for money than any other law firm! (For a reminder why, click here).
So, in an effort to make the process easier for everyone, this issue of The Business is dedicated to giving you free of charge, gratis, no obligation whatsoever, a pretty comprehensive checklist of issues to think about if you are thinking of getting involved with anyone else in a company.
I recommend you keep this checklist safe to refer to as and when you might need it. Then if you ever have need to ask a solicitor for help you will hopefully already have a pretty clear idea of why you might want a shareholders agreement and what you might want it to cover. So one day this might save you money!
Quite a lot of the issues in this checklist are also relevant if you are thinking of using other business structures, for example partnerships or LLPs. Your thoughts on these issues might even influence your final decision on what business model or combination of business models you want to use. If you haven’t already done so you might want to check out my article ‘Business models for a downturn – Business Models for Joint Ventures’ which I set out in Issue #1 of The Business. You can find all issues of The Business at the back end of the OnHand Counsel website.
Joint venture companies can take all sorts of shapes and sizes. They can involve all sorts of shareholders, all of whom might have different interests. They can be complete start-ups or can involve one established business taking shares in another established business.
Your decisions on the various issues set out on this checklist will help you to decide what you want to put into any shareholders agreement.
Start with the bigger questions first
• Why are you going into business together?
• What are each of your aspirations and objectives?
• What are you each expected to put into it and what are you each expecting out of it?
• What might happen in the future? How might things change?
Even if you end up never having a shareholders agreement, it is important to address these questions. Only then can you meaningfully drill down into more detailed issues. And the more you all understand each other on these bigger questions, the better you will be able to deal with change. It is impossible to cater in advance for all possible eventualities. People change. Businesses change. Economies change! Things happen.
And for this reason I also strongly advise people going into business together to diarise regular breakaway sessions, perhaps every three months, where everyone can take a step back and look at the big picture and address the same questions again.
Do you also want to have tailor-made Articles of association?
There are a lot of ways to structure a company or to entrench particular rights for different shareholders. Some of these can be dealt with by shareholders agreeing things between themselves. But some things are more conveniently done by having tailor-made Articles of Association. These can become as complicated as simple as you want them. In particular, you can create different classes of shares, each of which has different (or no) voting rights, different rights to dividends and returns of capital (for example rights to fixed dividends in priority over other shareholders), and different rules relating to how shares can (or must) be transferred.
My approach is to advise that the parties to a joint venture company should consider and agree how they want to deal with all the potential issues; but should then try to keep the company structure, the Articles and any shareholders agreement as clean and simple as they can be comfortable with.
What is each party contributing?
What is each party putting into the business?
• Time, effort?
• Ideas, contacts, IPR?
• Equipment, technical resources, production facilities, premises, distribution channels, management, other assets or facilities?
On what terms should cash or other assets be put in to the business?
• As loan capital or as share capital? Loans are a safer ‘investment’ in that they can be repaid more quickly, and in priority to shareholders’ share capital, and can be secured over the company’s assets.
• Or should they be leased or licensed to the business?
Should ownership of IPR be retained by the contributing shareholder, or transferred to a separate joint venture company, which can then licence it out to the trading joint venture company? This can provide an efficient (and tax-efficient) revenue stream. And if the trading company fails, the IPR can still be safe. And it can be a useful way of setting up a franchise structure or other more localised joint ventures relating to different trading companies in different areas.
Should any employees be seconded to the joint venture company?
Do you need to agree now as to when any future funding will be needed, and if so as to how it should be dealt with? Should some or all shareholders be required to contribute? Who? And how much? Is there agreement as to how much third party finance such as bank loans might be needed? Should shareholders be required to give guarantees of third party loans in some circumstances? What if they don’t? Should there be an adjustment to their shareholdings or share rights? Should they be required to sell out?
What is each party expecting to get out of the venture?
A secure job? A good salary? A degree of control over their own destiny?
Business opportunities for their main business? For example by way of licensing or distribution agreements?
A return on their investment? Dividend stream? Return on capital? Are any of the shareholders to have priority rights to dividends? To returns on capital? Fixed dividend coupons? There’s a lot you can do by setting up different classes of shares with different rights to dividends and returns of capital.
To sell out for millions in a few years time or to float? Can the shareholders agree an exit strategy in advance? For example that they will look to sell the shares in the company in 5 years time?
Default position for a private company:
If you have over 50% of the voting shares you can decide when to make dividends. Otherwise shareholders have no automatic right to receive dividends. So, do the shareholders need to agree dividend policies in advance?
• Return on capital:
If you have over 75% of the voting shares you can decide when to wind up the company, which can occasionally be a sensible way to realise and sell its assets and distribute the proceeds to the shareholders by way of a ‘return on capital’.
• Exit by selling out:
Unless you have at least a 90% shareholding, you cannot force a sale of all the shares in the company. It is up to each shareholder to decide if he wants to sell. And unless you can sell the entire company (ie all the shares in it) you are generally unlikely to be able to find a buyer.
If you have a controlling shareholding you may be able to arrange for the business and assets of the company to be sold as a going concern leaving the sale proceeds to be distributed between the shareholders by way of dividends or by way of a return of capital on a subsequent winding up.
Who should be entitled to shares, and how should they be allocated? Should there be different classes of shares, and what rights should attach to each of them? The decisions might depend on what each stakeholder is contributing, or is expected to contribute, towards the success of the joint venture; and on what they are expecting to get out of the joint venture.
The founder shareholder
With a new business, there is often one main founder/driving force behind it (perhaps working with other ‘founders’ of significant importance to the new business) who has to make these decisions. Starting from owning 100% of ‘nothing’, he needs to strike a balance between seeking to retain control and as much of a stake as possible, and seeking to ensure that the business is given the best chance of building value. It is better to own a small share of something valuable than a large share of something worthless. Shares are traditionally provided to people or businesses that provide money or other ‘valuable’ assets, such as IPR or goodwill (eg ‘owning’ the target customer base). But how should other contributions such as helping to develop ideas and putting in time and effort be rewarded?
The working shareholder
One of the most common problems when people decide to set up a company to go into business together arises from the simple fact that a shareholding in a company is a capitalist thing. Once a shareholder has shares, then the default position is that:
• He can’t be removed as a shareholder
• He is automatically entitled to voting rights, dividends and returns on capital
• He can ride the back of the successful growth of the company and participate in any subsequent exit, whether by way of a share sale or a flotation
• In order to get all this there is no requirement whatsoever for him to lift a finger to make any further contribution to the business of time, effort or money.
The other side of the coin is that if he has a minority shareholding then unless he has extra protections under a shareholders agreement:
• His voting rights are pretty much worthless
• He only gets dividends if the controlling shareholders choose to pay them
• Having shares gives him no job security – he can get kicked out as an employee or director at any time
• His shares are pretty much worthless unless he can sell them. Which he generally can’t unless the majority shareholders agree.
Questions to ask
Trying to set up a company for people who want to go into business together can therefore often be like trying to fit a square peg into a round hole. It begs some very important questions:
• How hard is each person involved expected to work on the business?
• What exactly are they expected to do?
• How long do they have to work this hard?
• How is this effort to be valued?
• Are they taking a risk that their effort might never be rewarded, and if so how should they be rewarded for taking this risk?
• How much can be rewarded on a straightforward employment/remuneration basis?
• Should they be given an immediate share in the long-term future of the business by being given shares in the company?
• Broadly speaking, at what stage should anyone be entitled to move from being a worker to being a capitalist who does not need to work but who simply owns a share of the business?
• Could they be given options to acquire shares at different times in the future depending on whether they are still working as expected?
• If they give up or get a bit slack, what can the others do about it?-
o Should they have to leave?
o What should their pay-off be?
o Should they have to transfer any shares to other shareholders?
How should these shares be valued? Should there be a discount to reflect the fact they have left early or haven’t done as much as expected?
• Have they contributed anything else fundamental to the birth of the business or its chances of success? For example any involvement in developing the original ideas? Any money? To the extent their contribution is not just time, effort and skill, how should it be rewarded? Should it be looked at separately from their contribution of time, effort and skill?
Management and control, and minority protection
Who is responsible for what at executive level? How are decisions to be made?
Default position for a private company:
• Holding over 50% of the voting shares gives you the ability:
o To appoint and dismiss directors, and therefore to load the board of directors and have full control
o To sanction new issues of shares
o To declare dividends
• Holding over 75% of the voting shares gives you the ability:
o To change the Articles
o To disapply pre-emption rights
o To wind the company up.
So, does one person or close group of people control the company by owning more than 50% of the voting shares? Is there a driving force behind the business? More than one? Are there others who are playing more of a ‘bit’ part or have a smaller investment but who still need some entrenched rights to protect their interests somehow?
Should all shareholders have voting shares? Do you want different classes of shares with different voting rights?
Should certain shareholders or groups of shareholders have the right to appoint and remove a certain number of their own nominated directors?
Should the chairman of a shareholders meeting or a board meeting have a casting vote? Who should be the chairman?
What quorum does there need to be to hold a meeting? Do particular directors need to be present? But what then should happen if someone keeps refusing to turn up?
Most investors and other shareholders in private companies are happy for the company to be run by its management, as appointed by the founder shareholders or majority shareholders; but they want to build in the ability to protect their interests if they think things are going awry. This could be to prevent the ‘controlling’ shareholders running the company too much with their own interests in mind, or simply to give the minority shareholders comfort that they can step in if they think the company is being badly managed.
Should certain minority shareholders or groups of shareholders (or their appointed directors, if any) have veto rights over certain material decisions? Or should a specified majority vote of shareholders be required to approve certain decisions? (eg 75%? Much depends on how the shareholdings are actually made up between different shareholding interests).
The following are some examples of issues on which veto rights might be given:
• Share issues
• Grants of options
• Capital expenditure or contractual commitments over pre-agreed limits
• Borrowing limits
• Major acquisitions/disposals
• Significant changes in the nature of a business
• Dividend distribution policy
• Appointment and dismissal of directors
• Material dealings with IPR
• Dealings between the joint venture company and its shareholders or anyone connected with them.
Where shareholders’ interests are represented by their appointed directors on the board, most issues can be resolved by the board. But beware the position where a shareholder’s interests are actually different from those of the company itself – an appointed director could be in breach of his duties as a director if he simply votes as directed by his appointing shareholder. So it can be sensible to provide for certain issues to be decided or ratified by the shareholders themselves.
If the shares are owned 50:50 between two shareholders or two different groups of shareholders there is a risk that you could get into a deadlock where no decisions can be made and the company could grind to a halt.
If a deadlock arises, how should it be resolved? Not easy. The following are some ways:
• Agree in advance on an independent expert who will have the authority to resolve some issues. Easier said than done…
• Shotgun-type provisions, such as ‘Russian roulette’: where a shareholder can give notice to the others giving them the option either to sell their shares to him at a price per share which he nominates, or to buy his shares at the same price – this helps a sensible price to be aired!
• Provide that if the deadlock isn’t resolved any shareholder can insist on the company being wound up. This rather damoclean option can often help focus the mind.
Leaving the company: transfers
Is the joint venture company capable of surviving as a stand-alone body or is it dependent on any of its shareholders continuing to have an interest or involvement in it as a shareholder?
Who are you going into business with? Should there be restrictions on whom shareholders can sell their shares to?
Default position for a private company:
• A shareholder can’t sell shares unless the board agrees.
• There is no ready market anyway for minority shares in a private company. Who would want to take the risk of buying shares in a company controlled by someone else who they have no control over and where they have no certainty of ever receiving any dividends or of ever being able to sell their shares?!
• Before a shareholder can transfer shares to anyone else, should he have to offer them to other shareholders first? This is known as ‘pre-emption rights’.
• If so, to whom? Eg to one connected group of shareholders first, then to others?
• Should a shareholder be permitted to transfer shares to some family members or family trusts?
• Should a shareholder be permitted to transfer shares to particular business associates, or to other companies he has a stake in (or group companies in the case of corporate shareholders)?
• Should a shareholder be permitted to transfer his shares to anyone else? What about competitors of the joint venture company or of any of its other shareholders?
• Should there be a period of time when some or all shareholders should not be entitled to sell their shares at all? – a lock-in period? How long?
• Should a shareholder be forced to offer his shares to other shareholders (a mandatory transfer notice) in certain circumstances? Eg:
o On leaving employment?
o On death or critical illness? This is one circumstance which can often be insured against, and there are a number of arrangements which can be entered into enabling the remaining shareholders or the company itself to acquire the shares of a deceased shareholder for a pre-agreed amount using the proceeds of an insurance policy.
o Insolvency of a shareholder?
o Material breach of the shareholders agreement?
o A change in how a particular shareholder is itself owned or controlled?
o Any other prescribed events?
• How should the shares be valued on a mandatory transfer notice?
o On a going concern basis?
o On a net asset basis?
o Any other accounting criteria to factor in?
o Who should make the decision – the company’s auditors? By reference to last audited accounts? Should new accounts be drawn up?
o What discount if any should be applied to reflect the minority shareholding?
o Should the value be reduced to penalise the shareholder?
o Should a shareholder who is an employee be paid a reduced value depending on the timing or circumstances behind his employment ending, eg if he has resigned before a certain date, or if he is dismissed for misconduct?
• If the other shareholders cannot or will not buy, what should happen? Should the company be wound up?
Drag and tag:
If a particular shareholder, or a holder or holders of a significant percentage of the shares (51%? 65%? Other?) want to sell out, can they force the other shareholders to sell as well on similar terms, even if they don’t want to? This is known as a tag along. For a client who is setting up a company in which he will be the majority shareholder, this is one provision I will always recommend. Apart from this, he may not really need a shareholders agreement, as he already holds all the cards. But unless you own over 90% of shares in a company, you can’t force another shareholder to sell his shares.
Conversely, if you are a minority shareholder, do you want a provision saying that if the majority shareholders want to sell their shares they should also make sure that the prospective buyer also offers to buy your shares as well, and on no worse terms?
Relationship of each shareholder with the business
Should there be restrictive covenants as to what each shareholder can do and what the joint venture company can do?
Should there be agreed terms on which the joint venture company will contract with any of the contributing shareholders or their associates?
Future investment/venture capital
Business start-ups often get started on a little money (friends, family and fools, as the saying goes) and a lot of effort. More serious money is often likely to be needed at a later stage. People with serious money want a serious stake in the business, and want to be able to protect their stake in various ways. When setting out with a new business you need to be aware in advance of the kinds of issues which are likely to arise at this stage, so you can prepare yourself as far as possible in advance.
End of the road: termination of the joint venture
• Should the joint venture be set up with a defined lifespan, after which it should be sold or wound up in an orderly pre-agreed way?
• Are there any circumstances in which one or other party can require that the joint venture is brought to an end? eg:
o Material breaches of obligations?
o Insolvency of a party?
• What are the mechanics and implications of termination? How should the venture best be unravelled?
• How can its value be realised, and by whom? Should the parties agree to try to sell the joint venture company to a third party?
• What should happen to assets which have been contributed by shareholders to the joint venture business?
• What should happen to assets (eg IPR) which have been generated by the joint venture business?
Accountancy and tax issues
Whilst as a rule you should never try to let the accounting or tax tail wag the commercial dog, it is always wise to get accountancy and tax advice at an early stage. One example of a danger area is how people can be taxed on shares they receive as earned income. OnHand Counsel can help point you in the right direction for any professional advice you may need of any kind.