When two people decide to start a business together, it’s hard for them to see how this promising relationship might one day turn sour. Managing the end-game is something to get right at the beginning with a stakeholders agreement. Russell Wheeler explains why.

BLOG: How Russian Roulette could save your business

No one will ever suggest that a new business owner should rely on luck when starting a venture, but that is exactly what a lot of people do when they fail to make plans to prevent potential problems, problems such as disputes between the ’stakeholders’ (shareholders in a private company, unit holders in a trust or partners in a joint venture) that might arise further down the line.

I’m talking about problems that can be avoided, or at least contained and the damage minimised, if the right steps are taken at the right time. Ideally, this is at the beginning, when stakeholders come together and decide to embark on a business.

But flushed with optimism, most people don’t think about what may go wrong. The ‘it won’t happen to me’ syndrome seems to be a common character trait of the starry-eyed entrepreneur (and, all too often, the people that invest).

As a result, only those who understand how critically important it is to have a stakeholders’ agreement (perhaps because they have had their fingers burnt in a joint business venture before) end up being adequately “insured”. After all, isn’t a stakeholder agreement just a form of insurance against things going wrong?

Better business insurance

Invariably, when people go into business together, they are confident that they can work together harmoniously on an ongoing basis, whether they are working in the business itself or only as directors. Also, most people assume that their best interests are aligned with the best interests of the other shareholders because they have a common objective of making the business successful. Hmmm!

Whatever the situation in the beginning, things change, particularly if the business does not live up to expectations, as often happens. Even if the business is successful, the interests and objectives of the shareholders change for other reasons, such as personal financial issues or family problems, which can mean one of the shareholders needs to sell his/her shares.

If this happens in a ‘Pty Ltd’ company, the shares will almost always need to be sold to the other shareholder(s). There is a practical reason for this – rarely do outsiders want to buy shares in private companies, especially if the shareholding is less than 50 percent and if the company does not have a stakeholders’ agreement to protect minority shareholders

A problem often arises in such situations because the seller usually has an inflated idea of what the shares are worth and the buyer has the opposite view. This is where Russian roulette comes into play. Let’s look at an example.

Russian roulette in business

Sam Sample is a shareholder in Future Widgets Pty Ltd, a 50/50 company (two directors and two equal shareholders). He wants to sell his shares after the business has been selling goods and services for six years. He asks Pam Partner, the other 50 percent shareholder, to buy them. There is no one else interested in buying and, even if there was, Pam could stop the sale to a third party by voting against the registration of a share transfer (in a company with two directors and no casting vote, both directors must vote in favour of a resolution for it to be passed).

To access Lexxon Lawyers Online’s FREE 18-page guide, How to Prevent Problems and Protect Shareholder Value, click here.

Pam makes a very low offer (as is in her best interests) and both parties are not able to reach an agreement on price. Sam comes to me for advice. And I tell him:

‘Why not consider Russian roulette? (The corporate variety, not the corporeal one.)’ It works like this. Shareholder A makes an offer to buy shareholder B’s shares. If B is not prepared to sell at that price, A is obligated to sell his/her own shares to B at the same price. This is designed to ensure that the original offer by A is a fair one.

This will work if both parties want a simple and effective means of getting the situation resolved fairly. Unfortunately, in the real example provided (the names have been changed to protect the innocent), Pam wanted to buy Sam’s shares at a bargain price and did not agree to play Russian roulette.

If such a solution had been agreed to in writing in advance, usually as part of a stakeholders’ agreement, this deadlock could have been avoided. Instead, in the sad case of Sam and Pam, a legal battle ensued. (The rest of the story can tell itself.)

Deadlock-breaking clauses

Not everyone wants a Russian roulette clause. For example, if one of the shareholders cannot afford to buy the other’s shares, Russian roulette will not necessarily produce a fair result. But there are other ways to achieve a fair outcome.

Sam’s problem, and similar problems in multiple-shareholder companies, can be prevented by discussing and agreeing on rights of ‘exit’ at the beginning.

For example, the shareholders might have agreed that they would remain committed for, say, six years after which any shareholder should be able to sell at a fair price. This is important in many companies, particularly ones that want to attract passive investors who need to know how they will be able to exit.

If, after the agreed time, no other shareholder wants to buy the shares at ‘fair market value’ and there is no outside buyer, you may want to consider requiring the company to buy the shares back. If it does not have the money to do so, it can borrow, raise new share capital or sell assets, even the business itself, to finance a buy-back.

Without such a requirement, a shareholder can get ‘locked in’ indefinitely, which can have some draconian consequences for all the shareholders (see below).

The other area where a deadlock-breaking clause is needed is when things can’t get done because there is a voting deadlock. This mainly occurs in 50/50 companies where decisions usually need to be unanimous for a resolution to be passed. I say ‘usually’ because a casting vote can be given to a chairperson but this gives extra power to one of the shareholders so it does not often occur. Therefore a 50/50 company is particularly prone to deadlocks.

A common way to overcome this problem is to agree that an independent person will be used to break the deadlock. For example, if there is no agreement on what is the ‘fair market value’ of the shares, an independent accountant would be appointed to make a binding determination.

The consequences of inaction

What is likely to happen if a problem arises, the directors and shareholders can’t agree on how it should be handled and there is no stakeholders’ agreement to fall back on?

It is not uncommon for a dispute to escalate and end in a court. This takes up valuable time, a lot of negative energy, costs a fortune in legal fees and the court will usually order the company to be liquidated.

But it doesn’t have to end in court for the outcome of a dispute to be bleak. It may arise from something as simple as the shareholders having different expectations – expectations which often are not communicated effectively to the people they are about to go into business with.

As an illustration of this, the minority shareholders of Company Hypothesis Pty Ltd invested on the basis of profit projections that indicated good early profits. One shareholder, a talented marketing man, bought 15 percent and agreed to work for the company as its marketing director for a reduced salary. He expected to receive 15 percent of the profits, which would compensate for his low salary. Another shareholder with 20 percent expected a 20 percent profit share each year. On the other hand, the largest shareholder was interested in capital growth and therefore wanted a large proportion of the profits reinvested. He had the numbers to get his way when it was put to a vote and the expectations of the minority shareholders were dashed – it was decided to distribute only 20 percent of the profits and reinvest the rest in expansion.

There was no suggestion of any misleading conduct, just different expectations. But that didn’t stop the relationship between the directors and shareholders deteriorating. The marketing director left and set up a rival company. Some other employees followed him. The end result was the company’s profits turned to losses.

It would have been so easy to avoid this type of problem by putting the issue on the table for discussion at the beginning. But they didn’t know what issues needed to be discussed. If they had, the disgruntled directors/shareholders would have insisted on a stakeholders’ agreement with a clause requiring the payment of a minimum dividend (as a percentage of profits) and the major shareholder would have required a non-competition clause to stop the marketing director setting up in competition.

This is just one example of many issues that need to be discussed by the stakeholders when they decide to go into business together.

The one problem only you can prevent

There is one significant cause of problems in multiple-owner businesses that is not listed above and that only you can prevent – poor choice of business partners. Despite the importance of a written agreement in preventing problems, the best form of prevention is to go into business only with people of integrity that you can trust. Because, like Russian roulette, unless you know your ‘exit’, the game of business can have serious and not always happy consequences.

The main causes of disputes

There are several common causes for disputes. These need to be discussed and included in the stakeholders’ agreement at the beginning to prevent disputes or, if a dispute can’t be prevented, to provide a means to resolve it

  • Misunderstandings about exactly what each person is required to do.
  • This is compounded by the failure of some to “pull their weight”.
  • Failure to discuss the ‘what ifs’ in the beginning.
  • Different expectations of different shareholders.
  • Excessive remuneration paid to executives who are shareholders.
  • As a result, profits available to the other shareholders are reduced.
  • Limited access to information about the company’s affairs.
  • Minority shareholders end up with their shareholding being diluted.
  • Minority shareholders get ‘locked in’ indefinitely, without an exit opportunity.
  • Minority shareholders have no involvement in important decisions.
  • The majority manage the company poorly.
  • The minority have no power to change the management.
  • Some of the shareholders get involved in a competing business.
  • Deadlocks occur without any deadlock breaking clause.
  • It’s also worth considering what issues might be unique to your circumstances.

What steps need to be taken at the beginning?

The first step is to identify the issues that need to be discussed. But this isn’t easy, even for people who have been involved in other jointly owned businesses, so some guidance is needed. Some examples can be downloaded using your mobile.

The next step is to reach agreement on how to minimise the likelihood of disputes and how to best deal with any disputes that can’t be avoided. It is also advisable to agree on other rules that govern the relationship between the shareholders, the directors and the company, and their rights and obligations. Unfortunately, the constitution of most companies and the Replaceable Rules in the Corporations Act do not go far enough in this area.

The final step is to record the agreement. This used to be expensive, which is why some people would take the risk of things going wrong rather than getting advice from a lawyer who specialises in the area. However, these days it does not need to be expensive, even for a customised agreement.

Russell Wheeler