I am often asked why it is important to document / record shareholder arrangements—particularly by SME owners. Let me give you three practical examples which I often use; each is true. I appreciate there can be an upfront payment for fees. But as you will see, I think it is worth it; the alternative is usually worse.
Mr Smith owns all of the shares in a private company.The company is doing well but Mr Smith is not getting any younger and wants to slow down. He brings into his company, where he is currently sole shareholder and sole director, Mr Jones. He sells Mr Jones 25% of his shareholding for £25,000 and it is agreed that should Mr Jones leave he will resell the shares to Mr Smith. Five years later the company has expanded dramatically and is making very large amounts of money. It has trebled its workforce and can barely keep up with its orders. However, Mr Smith and Mr Jones are unable to carry on working together and Mr Jones wants out. Mr Smith says that’s fine and he will buy his shares back for the same price at which Mr Jones acquired them, i.e. £25,000. Mr Jones is not a happy man! He suggests that the price for the shares should reflect the massive rise in the company’s profitability over the last few years and requests a figure some twenty times the amount offered. There is no documentation to assist. A simple agreement (even if covering little else) might have suggested words to the effect that “should Mr Jones leave, his shares will be valued by an independent third party (which may include the company’s auditors), and such valuation will be the price at which Mr Smith will purchase those shares”. Of course the clause could have been slightly (or much) longer but even basic wording such as that ought to have done the trick. In the end – and this is based on a set of facts almost identical to the example given – the parties agreed a very expensive deal for Mr Smith on the steps of the court. As I recall the total bill, including the cost to re-buy the shares and legal fees for both parties, was pushing £1 million. The initial price that Mr Jones paid for the shares was about £4,000.
Mr Blue and Mr Grey each own 50% of the shares in a private limited company. They are the only directors. There is no shareholders’ agreement or any other written arrangements between them. After some time working together they disagree fundamentally about the future direction of the company and there is a complete breakdown in trust and confidence between the two of them. The company is profitable and has plenty of cash in the bank. Neither of them is prepared to sell his shares to the other and neither of them is prepared to sell his shares to a third party. Each wants total control of the business. There are legal mechanisms by which they could deal with this but that would involve an application to the High Court. Neither is prepared to pay to initiate such proceedings. Because of the mistrust between the parties the bank accounts are frozen. The company, therefore, cannot pay its debts even though there is plenty of cash “available”. In the end after several weeks of fruitless negotiations between them, they get some sensible and commercial advice from their respective lawyers and they come to a settlement – although not necessarily the best one. It does not really matter what that settlement is. During the interim period the customer base of the company has suffered badly. The Company has lost the confidence of its employees and its suppliers. There is a sense of mistrust between the two parties on an ongoing basis and six months later the company is sold for a significant discount to its true value. Both of the shareholders end up with a lot less than they would have wanted.
Mr James and Mr Johns each own 50% of a PR company. They disagree on the future direction of the company. It is all very amicable but they don’t want to continue working together. The company is extremely successful and has a very large pot of money in the bank. They are both equally relaxed as to whether they go or stay but one of them will have to go – the other person will continue to operate and, indeed, own the company. The fact that there is a significant cash sum in the bank again, there is no shareholders” agreement or any other document which plots a route to determine how they divide up the company. In this instance a truly “commercial” solution was suggested. The fact that they were media related companies inspired their legal adviser [WHO ME?] to suggest they invited their friends and contacts, together with as many media sources as they could find to a party . They would toss a coin. The person who chose correctly would then decide whether he took the cash or the company – in this case, remarkably, both were sufficient to satisfy each party. Unfortunately although one of the two shareholders thought this was a great idea – the other didn’t. The final outcome is not known but rumour is, again, they ended up in court.
The fact there was no shareholders’ agreement added significantly to this drama. A good lawyer advising clients setting up a business together would always suggest some sort of written document between them. It could be as long or as short as they wish. None of this is particularly difficult or particularly expensive. The cost of litigation is significantly greater in time, cost and management terms, than the cost of having a short, clear shareholders’ agreement drawn up at the outset.