When friends go into business together, they usually do so with a high degree of optimism. The focus tends to be on the product or service and marketing – to the detriment of formalities.
If a company is formed, it is usually “off-the-shelf” with a standard memorandum and articles of association. Very little thought is given to negative situations which may arise at a later date. However, as Benjamin Franklin once stated: “By failing to prepare, you are preparing to fail”. Shareholders and partnership agreements are the pre-nuptials of the business world. They deal with situations which are hard to contemplate when business partners are full of enthusiasm but which commonly occur and should be catered for while everyone is still lovey-dovey.
When a company is formed between friends starting a business, each will usually take an equal number of shares. The articles of association will normally deal with the holding of board meetings and shareholders meetings and the appointment and removal of directors. Shareholder decisions are made by a simple majority. Extraordinary decisions which alter the articles or fundamentally affect the company normally require 75% approval.
A shareholders agreement can be very useful to deal with situations which are not covered by the articles. It can include pre-emption rights which require that new shares be offered to existing shareholders first to protect shareholders from a dilution of their stake. Rights of first refusal prevent a shareholder from selling his or her shares to an undesirable third party without offering them to the other shareholders first.
Drag along rights would allow a majority of shareholders to compel a minority to participate in a sale of the entire share capital. Tag along rights would allow a minority to tag along if the majority were selling their shares.
Compulsory buy-back provisions can deal with situations where shares fall out of a partners hands – for example, on death, bankruptcy, mental illness or divorce. Dispute provisions can provide for each side to bid for the other’s shares resulting in the highest bidder buying the other out.
Where two people go into business together with a view to making a profit, a partnership exists. If no partnership agreement is put in place, the business is governed by the Partnership Act 1890. This is an important point because there are provisions of the Partnership Act which the partners may not want to apply.
For example, under the Act, all partners take an equal share in profits and must contribute equally to losses – but the partners may not want this. Similarly, unless an agreement states otherwise, a partner cannot be expelled by a majority decision.
Also, if one of the partners dies or becomes bankrupt, the partnership comes to an end and the business is wound up. Some partners may contribute cash, others property and others still “sweat” equity. The partners may wish to recognise these different contributions by different proportionate shares in the capital of the partnership. To address these issues, partners should come to an agreement at the outset – trying to formalise what was initially agreed some time later can prove difficult.
By having these agreements in place, businesses have predetermined structures to deal with situations which may otherwise end up in Court. In that way, the cost of producing an agreement is justified. If you do not have a formal agreement in place, the best advice is to get advice.
To save costs, some business owners will download a template from the web and populate it but that practice is not recommended. As with any legal document, the devil is in the detail and minor mistakes can have major implications. Also, there are tax and company law considerations which you will need advice on.