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26/10/2016 | Stephen Harvey shareholder, agreements, new business, investment

Burying Your Head in the Sand Doesn’t Avoid Conflict

Why shareholders’ agreements are vital
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Most of us would heartily agree that we’d prefer to walk through life assuming the bad stuff happens to someone else. This is no truer than for people who are starting a new business venture.

When you’re having a conversation about risk with a client in this position, we all know that one of two things can happen:

  1. They bury their head in the sand and avoid discussing potentially negative outcomes; or
  2. They avoid spending any additional money to protect their investment, thinking it really won’t be necessary.

In both instances, this is the wrong outcome! The cost of establishing a shareholders’ agreement at the outset will invariably seem minimal if people can manage, or avoid entirely, a host of unforeseen circumstances down the track.

Following are some tips to support this all-important conversation you’re having with your clients.

Relationships are irrelevant – shareholders’ agreements are not!

A shareholders’ agreement enables business owners to deal with important issues like:

  • Internal structure of the company;
  • Obligations of the shareholders and management to each other;
  • Financial controls;
  • Determination of policy and management issues;
  • Options to buy any shares being sold by another shareholder;
  • Sale, transfer and allotment of shares;
  • Management of the business; and
  • Dispute resolution.

Case Study: What if there is no agreement?

Hindsight Pty Ltd has three shareholders, each with expertise necessary for the operation of the company’s business. Each shareholder contributes $100,000 and verbally agrees to remain with the company for a minimum of five years, with an option to stop working at that point. They have a business plan but no shareholders’ agreement.

Now, imagine the following scenarios:

  1. After one year, the business is doing well, but not as well as expected. Two of the shareholders agree to persevere, believing that the business will succeed. The third wants to get out. The remaining two do not have the resources to buy him out or cannot afford to let him go.
  2. After five years, one shareholder wants to stop working in the business and play golf. The other two want to keep working but don’t want the third to profit from their effort.
  3. The three shareholders are siblings. They have not discussed any governance issues, thinking they don’t need to because they understand each other and are all totally committed. One sibling marries, has children and is frequently absent. The other two, while sympathetic, cannot manage without the third or don’t want the third to profit from their hard work.
  4. The company buys real estate. Two shareholders provide all of the funds to acquire and develop the property, while the third has no money to contribute at the outset. After several years, the value of the property has increased substantially. The shareholders who contributed the original funds are now faced with the other being entitled to one-third of the property’s net value.

Shareholders' agreements force shareholders to focus

The great benefit of a shareholders’ agreement is that it focuses attention on the issues that each person considers important, and how they will deal with any problems that may arise. In doing so, one or more of them may decide they do not want to be a part of the venture at all, or that the relationship must change to accommodate commercial reality.

Preparing a shareholders’ agreement has many benefits including:

  • Generating discussion around what should happen when expectations are not met;
  • Committing to paper the parties’ real intentions rather than relying on subjective recollections after the event;
  • Highlighting individual intentions rather than assuming everyone else knows exactly what was meant;
  • Eliminating ambiguity; and
  • Raising possibilities which have not been considered.

An agreement provides certainty and predictability in situations which might otherwise result in time, money and effort wasting disputes or "management paralysis".

Feel free to contact us any time to discuss shareholder agreement options for your clients at the start of their new business ventures.