So we’re looking at “what do we mean by business protection?” Many businesses consider and are aware of the concept of disaster recovery when it comes to their IT systems, or their banking arrangements. Businesses also carry insurance which protects them from losses arising from various risks, and we may protect ourselves with life insurance, healthcare insurance etc.
The business protection that I’m going to be discussing today are the provisions that can be put in place at any time to deal with major events that might occur during the life of a business. For example, the death of an owner, falling out between partners or shareholders, or the absence of key personnel for a prolonged or possibly indefinite period of time. These are often seen as circumstances that will never happen to us, but in reality they do happen, and their impact upon successful businesses can be catastrophic.
There are some fundamental misconceptions about business and company legislation, the Companies Act 2006 in particular. This piece of legislation was substantially re-written and was intended to reform company law to simplify it and also to comprehensively deal with all aspects of company law. Arguably it doesn’t, and whilst it is fair to say that incorporates generally accepted principles of company law, these principles have to apply to all types of company, and often the needs of the owner managed limited company are not adequately provided for.
For example it is not uncommon for a limited company to have two directors. Directors are given one vote each and are responsible for the day to day management of the company. In the event that they do not agree, deadlock occurs. The director who doesn’t want change is arguably in a strong position, but the director that does want change is unable to progress because he cannot gain a majority to pass a resolution. The same applies to shareholders where a simple majority or a 75% majority is required allowing in some case important decisions to be passed without the agreement of all shareholders, or important decisions not being able to be passed because of nuisance shareholdings, being lower shareholdings that become important because they are required to tip the balance.
Moreover there is no general right to compel a fellow shareholder to sell their shares. Company owners often assume that they can buy out dissenting shareholders or be bought out enabling them to go off elsewhere and start again. This is not the case. The worst case scenario here is that the company would have to be wound up and its assets distributed to its owners. This is somewhat unsatisfactory for a thriving business with value.
The preferred solution for regulating the relationship between shareholders is the execution of a shareholders agreement. This is a private document between shareholders and can also be binding on the company if there are obligations for the company to adhere to. So long as the shareholder agreement does not seek to change the articles of association, it is a private document not required to be registered at Companies House. It can therefore contain detailed arrangements relating to individuals, and can record information such as capital contributions, division of profits and distribution of assets to certain other specified people for example upon death. Shareholders agreements can also deal with dividend policy, voting rights etc. but for the purposes of today I am going to talk about termination events.
Cats fighting with lightsabers may be a somewhat light-hearted way of describing the relationship between shareholders who have fallen out, but in reality for anyone who has been in that situation, they will know it is not too far away from the truth. A collection of people that started off in business together with dreams of conquering the world suddenly cannot stand the sight of each other, and instead focus their attentions on point scoring. They devote their time to trying to get one over on their business partners and will go to extreme lengths to achieve this. Shareholder disputes can last for years and years because the Companies Act does not generally provide a remedy other than winding up, and whilst directors can be removed with relative ease where a majority exists, the same cannot be said of shareholders. There is no mechanism for mediation, no mechanism for expert determination, and no less extreme remedy other than winding up. Shareholders end up in deadlock positions where neither of them want to leave but neither of them want the other to stay. Further, the limitations of being able to sell shareholdings in private companies’ means the realistic prospect of finding a replacement shareholder is slim. A sale of the entire company may be possible, but this doesn’t satisfactorily deal with a shareholder wanting to continue.
Shareholder agreements can regulate how decisions are made, and can seek to change the required majorities or identify key shareholders who must consent to certain decisions for example founding shareholders. It can also provide for a mediation process, and name a third party, maybe an accountant, and a senior employee etc. who could preside over such mediation. It can also provide a mechanism for buying shares from somebody in the event of a deadlock situation, and can determine how the value of those shares will be calculated to buy a shareholder out. Something Brian will talk about in further detail in a few moments.
Death and illness are two circumstances which nobody expects will happen to them, but frankly is occurring more and more. We live longer, we work longer and we subject ourselves to continuous stress. We get ill, and in some circumstances we can die whilst still working. Without adequate provision for what would happen in these circumstances, as Judi pointed out earlier, shares in a company can end up in the residue of an estate, being left to children, or spouses with no involvement in the business. Sometimes an even worse scenario is incapacity which means the shares remain with the shareholder but they are unable to do anything with them or make any decisions. Both of these scenarios can and do kill companies. Companies become disabled because they cannot act without the person or they lose the expertise of a person. Without a mechanism to try and deal with this, the company gradually disintegrates.
A shareholders agreement can deal with what is to happen in these circumstances. For example upon a long term or critical illness, alternate directors can be named and appointed. Insurance policies can be taken out by the company to pay for the acquisition of the shares of that shareholder something Matthew will talk about later. There can be automatic transfer provisions incorporated into the agreement so that in the event that a shareholder is unable to sign, the company or other individual can be named as being able to sign on their behalf. This ensures that the future of the company is certain and can be quickly dealt with.
In the event of death, the shareholders agreement can direct who shares are going to be left to. Again it can rely upon a policy of insurance to pay a lump sum to the estate of the deceased shareholder enabling the shares to be transferred to the other shareholders or bought back by the company. This keeps the shareholding within the existing share ownership whilst still providing the beneficiaries of the estate with the value of the deceased shareholders shareholding. Again the mechanism of how this is going to be done can be set out so that it happens quickly and outside of the will.
I have already spoken a little bit about the role of directors but I think it is worth considering again. It is essential that when considering business protection the concept of shareholder and the concept of director are kept absolutely separate and the differences between these two roles are acknowledged. A director acts for the benefit of the company as a whole and is responsible for the day to day running of the company. The shareholders are not, and this can be a massive misconception. Therefore, the identities of directors needs to be considered. If there is only one director and they were to die, who would be appointed in their place? Can they be appointed? Who has responsibly for signing bank forms, can anybody else sign them? How will staff be paid? How will suppliers and customers be dealt with, and by whom? If there are a small number of directors or even a sole director, it is always worth considering lifetime appointments of other directors. People within the business who you anticipate would be suitable to carry the business forward either on a permanent basis or at least while a sale occurs. Could somebody start doing this role now, to ensure business continuity? If that is not appropriate, could you identify somebody who could act in the event of your death who could, perhaps by a deed of appointment or through a shareholders agreement be appointed in the event of your death or incapacity? We see all too often single director/shareholder companies which have run for years under the successful stewardship of its owner/manager, suddenly be reduced to a shell in a matter of months because nobody has the power to carry it forward.
Moving on, although we are seeing partnerships to a lesser extent, they are still a useful way of doing business, particularly for businesses dealing with the provision of services. I think the title of this slide perhaps gives away the real problem with partnerships and that is the age of the legislation that governs them. The way that business was done in 1890 is completely different to the way business is done now.
One of the fundamental problems with a Partnership Act partnership is the ease in which that partnership can be terminated. The Partnership Act states that in the absence of a fixed term being agreed, any partner may terminate the partnership at any time on giving notice of its intention to do so to all the other partners. There is no provision as to how this notice will be served, whether a reasonable time ought to be given, and whether it can be revoked. Arguably a partner walking out of a partners meeting saying “that’s it I’m finished” could be enough to bring the partnership to an end. The Partnership Act doesn’t allow for the expulsion or retirement of a partner whilst still allowing the existing partnership to move forward. In reality what then happens is a laboured negotiation whereby the business of the old partnership is transferred to a new partnership made up of the remaining partners. There are financial implications to this through the generation of accounts, service of notice and establishment of the new partnership. There is also problems with business continuity, liability of the old partners, liability of the new partners, and the authority to bind each other. The partnership act also still provides that changes in partnership have to be recorded in the London Gazette or the Edinburgh Gazette or the Belfast Gazette as appropriate. Who in this room subscribes to those publications?
A partnership agreement is therefore crucial for any business where there is potential for partners to come and go, to enable them to move in and out of the partnership without it coming to an end each time. A partnership agreement can also deal with the division of profits, capital contribution, and the ownership of assets. It can also deal with decision making. Again like a shareholders agreement a mechanism can be agreed to deal with how a partner will be able to realise his partnership share upon exit in a way that will not render the other partners having to find huge sums of money to facilitate the exit. A value can be agreed or if not a formula to determine how the value will be agreed can be asserted into the agreement.
To bring things to a close, there is a real risk that relying upon legislation to protect your company or partnership will not provide you with an adequate remedy in the event of one or more of these major events occurring. Whilst the cost of a document which you may never use may seem unjustified, the cost of litigation or extensive protracted negotiations not least through business distraction, far outweighs the cost of any agreement you might want to put in place. An agreement can be a simple set of terms setting out key areas of concern or can be long detailed agreements dealing with a variety of topics. What is absolutely certain is that it is far easier to agree what will happen whilst you are all working together, rather than trying to agree what will happen when one of you is absent or you are in disagreement.
There is no best time, no age of a business in which it is best to get these agreements in place. I would always recommend sooner rather than later and I would also recommend that they are frequently reviewed particularly where there may be a change of ownership or change in business direction. They can be evolving documents and indeed they ought to be evolving documents as all businesses go through periods of change. I strongly recommend taking time to discuss these options with your fellow partners or shareholders, and then seeking to implement this documentation with your legal advisor.
Dawson Radford Solicitors 