Why a shareholders’ agreement is like a pre-nup
Often the last thing on anyone’s mind when they start a business is how the business will operate down the track. During a business start-up phase owners are focused on business development, marketing and product development. Legal and accounting issues are put on the back burner to be revisited when things aren’t quite so busy. In reality that day never comes but after all, what could possibly go wrong?
Quite a lot really. Without an agreement, there are no rules about running the company or getting your money out if you want to exit. A shareholders’ agreement is really the commercial equivalent of a pre-nuptial agreement.
Forming a company in New Zealand is very easy compared with the rules in other countries. Most people chose to have their company governed by the Companies Act rather than their own tailored constitution. Even if they do invest in a constitution, this is a publicly accessible document and there are a lot of things that companies quite legitimately do not want in the public domain. Those issues are almost always dealt with in a shareholders’ agreement.
Nearly all issues arise around governance, control and exit. A good shareholders’ agreement will cover all three areas.
The first is governance. Who will serve as a Director and how will that be determined? What are the Directors’ duties? What does the composition of the Board look like? What say do other shareholders have? How are decisions made?
Secondly, how will the company be managed? Who is in charge and how are operational decisions made? What role do other shareholders have?
The third area is around exit. It is not uncommon for shareholders to want to exit the company for any number of reasons. In any start-up, you need to consider whether or not there should be a penalty if a shareholder exits early. Cashflow will almost certainly be tight in the first couple of years of trading. You need to think about whether you could pay out a shareholder early on. Aligned with that decision, it’s important to have a good, hard think about just how much value they would have contributed at that stage. A formula should be employed to help with any valuation and included in the agreement.
One thing that is crucial is to own as much of the value in the company as you possibly can early on. Rather than floating an idea with your friends, prepare a business plan in detail before approaching anyone. It is a lot easier to propose a smaller shareholding once the hard work of the business plan is done – after all, it’s your intellectual property. It’s even easier if you have already some foundation customers on board. In short, the more advanced the business, the more you will own.
One idea that has grown in popularity over the years is sweat equity. This is the idea of giving your employees shares in exchange for length of service or a reduced salary. Think very carefully before committing to this. Sweat equity is quite a compelling idea but incredibly difficult to implement objectively and fraught with difficulty. Our advice is always to consider a profit share system instead.
Many shareholdings are allocated amongst friends. When problems arise, the absence of a shareholders’ agreement will almost always destroy those friendships. By investing time up front with a shareholders’ agreement, you’ll often be alerted to any potential issues down the track and work out early whether or not you can really work with these people.
Feel free to contact us if you would like advice on a shareholders agreement. It is always easiest to implement one at the inception of the business but it’s never too late and will help you avoid some of the pitfalls down the track.