My Word Is My Bond

"Dictum Meum Pactum – My Word is My Bond".  

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Oh how much easier business life would be, arguably, if we all lived by that motto. Or would it?

Here, I want to highlight a case study involving a former client who failed to commit their agreement to writing—a cautionary tale about the pitfalls of informal arrangements and the importance of properly documenting key business agreements.

The case centres on a “lost” shareholders’ agreement and explores what might have happened if the parties had put in writing certain key elements of the agreement and had it to hand at the required moment.

We'll cover some technical points, including:

• Unfair Prejudice – a legal claim minority shareholders can bring against majority shareholders if they believe their interests are being compromised.
• Minority Shareholder Protections – rights in shareholders’ agreements to protect minority shareholders.
• Pre-emption Provisions – a mechanism to force an offer of shares for sale to other shareholders under certain conditions.
• Articles of Association – the company’s constitution.
• Good Leaver/Bad Leaver Clauses – terms which provide the ability to strip a shareholder-employee of their shares if they leave or are underperforming or their behaviour becomes unacceptable.

Above all, this case study is an affirmation that all business relationships come to an end. Ideally the end is planned and expected, for example a retirement or leaving for a new role. Sometimes the end of the relationship is unplanned or unexpected, for example in the case of ill-health. Whatever the situation, having guiding principles helps minimise the pain and expense of bringing the business relationship to a close.

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Case Study – Company C

There is a company let’s call it Company C which has a number of shareholders. Company C, a specialist service provider, was founded over seven years ago by Shareholder Group A (the group of “good” shareholders) and Shareholder B (the “bad” shareholder).

Company C began with high hopes. The founders, experienced individuals, wanted to create a new boutique business that offered high quality services for their target market. The founders had been in the market for a number of years, and they felt, if they broke out on their own, that they had an edge and could persuade a number of their old clients to follow them. Initially they were very successful and the business grew at a healthy rate.

When they set up Company C they divided the shares in accordance with the relative size of each shareholder's service line. So some shareholders had larger amounts of shares and some smaller depending on the size of the “department” they were responsible for. Each founder was both an employee and shareholder and paid themselves a salary.

Initially, Company C thrived. As time rolled on the intra business relations between shareholders began to change. Shareholder Group A began to feel that Shareholder B’s performance was slipping. Shareholder B was no longer as busy as they had been. The fee income they were generating was falling and the amount they took out of the business by way of remuneration didn’t really reflect their contribution in the opinion of Shareholder Group A. While they were spending a lot of time marketing there wasn’t as much delivery from them or their team. Shareholder Group A felt they were “carrying” their business partner - Shareholder B.

Seeking to end their business relationship with Shareholder B, Shareholder Group A sought my advice. How could they terminate the relationship? What became clear very quickly was that while they thought they had prepared a shareholder agreement they couldn’t actually find it! To make matters worse their employment agreements hadn’t been updated since the business was set up, so there was no clear road map on how to exit Shareholder B.  

Meanwhile, Shareholder B seemed to anticipate the move and could see the writing on the wall. Before Shareholder Group A could get properly organised, they received a letter from Shareholder B to say that Shareholder Group A were making decisions without due consideration of Shareholder B’s interest and the majority (Shareholder Group A) were taking the business in a direction Shareholder B was not comfortable with. Shareholder B felt their investment in the business was being prejudiced and therefore they were taking steps to launch a claim for Unfair Prejudice of a Minority and were filing that claim against Shareholder Group A.

As you can imagine, receiving the threat of this claim was a lot to take on board for Shareholder Group A. They were suddenly on the wrong end of a serious high court action.

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What Could Have Helped?

Planning and well documented intentions and obligations of all parties always helps. My colleague and partner here at Healys has also written on the topic, exploring Proactive Planning to Prevent Disputes which you may find interesting.

In our case study, the shareholders in Company C would have certainly benefitted from the following:

1. Minority Protections:  A shareholders’ agreement with a carefully drafted set of “minority protections” could have helped. This would have set out a clear statement as to what issues were reserved to the board of directors to manage on a day to day basis and what matters had to be passed to the shareholders for their approval. Very often items like these include a requirement for shareholder consent to approve a business plan, make expenditure outside of the agreed plan and/or hiring people (senior executives) above an agreed salary threshold. This may have helped give Shareholder B a better feeling that they had a say in the direction of the business.
2. Pre-emption Provisions: Given that relations looked to be rapidly breaking down, the next question was what would happen if Shareholder B resigned (or was sacked) but still owned shares in Company C? Pre-emption provisions could have made it clear that a termination of employment would lead to an automatic offer of sale of their shares. It’s not uncommon for former employees to hold shares in a business. Perhaps where they have retired from the day to day operations and are waiting to have their capital bought out.  But in many cases founders will want to make sure that once a person resigns, it triggers an offer of sale of shares. These provisions are usually cross referred to in the shareholders agreement with the detail being covered in the articles of association. These provisions need to be proactively added to a company’s articles of association as the standard Model Articles don’t include them.  In this case unfortunately the articles of association of Company C were untouched so there was no mechanism that would mean the shares were automatically offered for sale.
3. Good Leaver/Bad Leaver Clauses: Performance was also raised as an issue by Shareholder Group A.  Another set of provisions which could have been inserted into articles of association and referred to in the Shareholders Agreement are “good leaver/bad leaver” provisions. As the name suggests, these provisions relate to the status of an employee when their employment terminates. The usual position where a shareholder leaves on good terms and has contributed to the value of the business is that they should get their “fair” share of the business on exit (usually the open market value of their shares determined by an independent third party). However, if they are effectively being thrown out (for example for poor performance or worse) then the exiting shareholder may only get the face value for their shares. There are some variations to this, but essentially that would be the structure. As you can imagine having these provisions in place focuses the mind of a shareholder-employee to make sure they continue to hit performance targets and focus on the growth of the business. If these provisions had been included in a shareholder agreement or in the articles of association, then it may have helped to exert some pressure on Shareholder B to keep the relationship on track.  While the provisions are potentially draconian, this can act as a clear incentive for a shareholder knowing that if they underperform they will lose the value of their stake in the business.

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The Outcome

So how did this all end up for Company C?  Somewhat surprisingly, late in the day during legal proceedings, the original shareholders agreement was unearthed! And while it didn’t contain all of the above provisions, it did contain enough guidance to offer a way out for the parties.  As is often the case, when parties are faced with associated costs and the embarrassing prospect of fighting things out in court everyone becomes motivated to explore options to settle. For the shareholders in this case study, a valuation was made of Shareholder B’s interest and after much back and forth a deal was agreed. Shareholder B left the company bruised by the experience and Shareholder Group A were left to pick up the pieces and had to try to restore their reputation and move the business forward.

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Lessons Learned

Track Your Documentation: First of all keep track of paperwork! It will be pivotal should it be needed to defend a claim or deal with a general breakdown of relations.

Draft Comprehensive Agreements: There are key terms in a shareholders agreement which can help ether to reduce the risk of a dispute arising in the first place or allow parties to navigate their way through things once parties agree to go their separate ways.

Plan for the Endgame: As Benjamin Franklin once said “nothing is certain except death and taxes”. The same could be said in a way for any business relationship, in that they can all be said to come to an end eventually; whether amicably or otherwise. With that in mind, it's worth considering at the outset of the relationship how this endgame might work out and ideally have a proper plan in place from the beginning, minimising the pain and anguish that a turbulent exit can sometimes generate.

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If you’ve made it this far, well done! The topic is heavy and not one founders always want to think of at the beginning of a business relationship; but seeing as you did make it this far, why not also explore what our dispute resolution team say about navigating disputes when thing go wrong.

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