Business implosion and how to avoid it! Shareholders Agreements

03 / Mar / 2008

Imagine setting up a business and within just two years the company being ahead of targets and headed for greatness.

You have three very smart professional partners and a staff of 55 people. Everything is on track, growth is continuing and the company is regarded as a mover and shaker.

Just over two years into the business one of the partners decides that he wants to go and contemplate his naval on a beach in Bali indefinitely! This in the middle of a major merger that would take the company into the European markets.

The bad news keeps coming. This partner then convinces the CFO to join him in Bali. These two people are absolutely essential for the success of the merger.
So two key people go off to Bali (still with their shareholding) and the merger fails. The company goes backwards for nearly eight months while the fallout is being managed. Partners are distracted and not focusing on the business.

What’s the point of this story?

The partners (all major shareholders) did not have a shareholders agreement in place. They had not sat down and talked through what they personally wanted out of life and out of the business, and they had not written down what their roles and responsibilities were. As a result, expectations varied and the partners did not really know each other.

I’m surprised how many entrepreneurs don’t have a shareholders agreement in place. In my experience, partnership disagreements are a major cause of business failures.

I understand why this happens. The excitement of the start up, the camaraderie between partners, working closely together and the sense of achievement when targets are hit and everything looks rosy.

If ever there is a road paved with good intentions then this is it. Everybody intends to be fair, and they talk about fairness, but it’s just impossible to make it work until you get down to the actual details. It only gains ultimate clarity when it’s in writing – a shareholders agreement.

It gets very awkward. There you are in the excitement of a start up and it just feels bad to be the one to say “let’s get it in writing”. It’s deflating. However, it’s also very important. Swallow hard, breathe deeply and get it in writing.

People and circumstances change.

How would your company be affected if a shareholding founder ended up in the divorce court. Do you know how that would affect your business? What if a founder were hit by a truck? Does his/her shareholding then belong to the spouse? Now there is a spouse with shares and perhaps decision-making power but with no understanding of the business. You can’t assume that the person will be passive. These are real issues and needs to be addressed.

When bringing in a partner, spend a few days nutting out the shareholders agreement. Maybe you won’t agree, maybe the partnership won’t go ahead. If this is the case, it will be a good thing as you obviously have different ideas about how to develop the business. The benefit will be that you all realise this before you go into business together.

Developing a shareholders agreement can be difficult and the outcomes may be unexpected, but these are the very reasons why you should go through the process.

Do your own research. Talk to entrepreneurs and colleagues about the pros and cons of shareholders agreements. Talk to investors.

More good stuff about shareholders agreements

You’ll definitely need to talk to a solicitor to finalise your agreement. It is very risky to do this for yourselves. Just spend the money and get a good solicitor.

Now let’s look at some of the detail that needs to be covered…

The terms of the shareholders agreement should:

• State the opportunity that is the reason for the company’s being. This determines the commercial areas in which the company will operate. All commercial activity in relation to that opportunity is to be operated through the company. By stating the scope of the company’s operations, it also allows shareholders to operate as individuals in areas not defined as part of the business.
• State the future directions and development of the business in terms of its operation and performance. This part of the agreement minimises disputes when individual’s expectations of the direction and performance of the company are not met.
• State the rights of the shareholders so that there is a clear definition between ownership, management and control. You do not want minor shareholders telling you how to operate the business, or taking the business to court if their expectations are not met. The operation of the business is a task for the management team.
• State how the company will be administered and how decisions will be made. It will include such matters as initial investment, further investment, dividend policy, decision policy, voting policy, management and organisation, appointment and removal of directors, meetings and chairmanship.
• Define the tasks and obligations of the individuals involved. If an individual is not contributing in accordance with the agreement then he/she is obliged to sell his/her shares to the remaining shareholders at an agreed value. Each team member has been selected on the basis of what he/she has to offer to the project. If they are not contributing enough in this area, company profits will suffer. Investors may want an increased shareholding if the company does not meet projected performance measures.
• State the method of valuation and transfer of shares if a shareholder wants to leave or is obliged to go, or if an investor wants to join or leave.
• Allow the business to own the intellectual property including further developments, along with all commercial opportunities associated with it. This situation helps to prevent disenchanted shareholders from leaving the company and using the intellectual property and its associated commercial opportunities to set up in competition with your business.

An advantage of a shareholders agreement is that investors will feel comfortable with it since they will identify with the key elements in it such as regular board meetings and job specifications. In other words, a shareholders agreement anticipates the needs of investors and will act to your advantage in negotiations with investors. You have a starting point and some ground rules.

A shareholders agreement that includes the items identified above provides a set of rules for operation of the company. Shareholders will know exactly where they stand. It will reduce uncertainty and aggravation. The agreement will minimise court actions against the business. Disputes and possible future difficulties can be settled out of court since the contractual agreement clearly states these matters.

It is important to consider these matters early in your business. It is too late once there is a dispute. It also is important to receive good legal advice. This advice can be expensive. However, it is worth it when you consider the possible profits you will make in the future.

You do not want legal costs and issues to ruin your opportunity. By virtue of human nature, people are unpredictable, especially where money and power are concerned. Protect yourself. Protect your business.

In summary, a shareholders agreement:

• Lets shareholders know exactly where they stand in relation to all areas of the operation of the business.
• Helps your relationship with your colleagues.
• Helps to ensure the survival of the business through minimising disputes.
• Ensures the company always owns the intellectual property related to the business.