Knowledge Hub | Articles

06 May 2013

Share the legal paperwork not the disputes

Going into business will always be a stressful time and even more so if friends or family are providing funding, expertise or sheer hard work. It can be tempting to bypass the legal paperwork in favour of goodwill and to save costs, so all available money goes into the business but, explains David Smellie, partner in the corporate and commercial group, that can prove an expensive mistake.

A, B and C are longstanding friends. C has been very successful and is very wealthy.  When A and B approach C with a new business idea in the retail sector, he agrees to provide the start-up capital by way of loans, and they decide to operate the new business through a company in which they will hold one share each.

They agree that all of them will be involved in the decision-making process (and in particular that C should consent to the granting of any security by the company) and that as much money as possible should be paid to the shareholders as a dividend each year. A and B will work full time in the business, C will provide strategic advice.

None of this is recorded in writing, but they go ahead and set up the company, issue the shares and each becomes a director.

Through the combination of A and B’s hard work and C’s direction and money, the company is reasonably successful, enabling small dividends to be paid to all the shareholders and C’s loans to be repaid.

In time, C becomes distracted with other business interests and fails to notice he has stopped receiving invitations to board meetings and he has not been paid dividends.

C then discovers A and B have increased substantially their salaries, agreed to the company taking on bank loans (giving the bank security) and changed the nature of the business.

As a result of security being given to the bank, the company has very little unencumbered assets and, although the business should be successful this will only be some time in the future.

A and B then offer to buy C's shares for £1,000, stating they believe this to be a fair current value.  

C is very unhappy, especially as he understands A and B hope to sell the company in the future at a large profit. He has heard from another friend that if a minority shareholder has been ignored or excluded by, and is not getting the same "take" as other shareholders, he can take action which could see the other shareholders being forced to acquire his shares.

While there are provisions which could result in C getting an order from a court that A and B have to buy his shares, any valuation could be affected by the bank security and the value would not take into account possible future trading. 

In addition there is a risk that in arriving at any valuation, a discount could be applied to the value of the shares held by C, such that the 1/3 of the shares that he actually holds could be worth substantially less than 1/3 of the value of the company.  

There is also the question of whether A and B could afford to buy C’s shares.

David said: “It may be better for C to remain as a shareholder and bring a personal action to ensure the company does not exclude him from the decision-making process, rather than an action that may force a sale of shares. If he remains as a shareholder and there is a successful trade sale in future, then he may get much more than if he sold now.”

He warns however that the whole dispute could have been avoided if all three had taken legal advice in the first place.

Shareholder disputes can be expensive actions to bring and/or defend (but often may be the only way forward, particularly where there is no documentation and the parties have fallen out and have entrenched positions), and the costs may exceed the value of the shares at the centre of the dispute,” said David.

He concludes, “If an agreement had been signed at the outset, setting out agreed mechanisms for dealing with various scenarios, then a dispute of this type could have been avoided – and at a cost likely to be less expensive overall than any action relating to shareholder disputes.”

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