Shareholder disputes can be highly emotional for the parties involved.  It can be extremely frustrating for an investor in a brand to discover that they are not on a level playing field with the other investors, particularly when the business is doing well.

It is also not unusual for small business owners to take investment at face value without considering the risks to which they could be exposed further down the line.  They may sign up to contracts without taking legal advice or rely simply on oral arrangements. 

We find that often no thought is given to the contractual relationship between the parties until it breaks down and they discover the full extent of their rights (or lack of them), obligations and liabilities.

Take the scenario:

  • A UK small business owner (“Shareholder A”) discovers an exciting new fashion brand whilst travelling.  He thinks it can be exploited in the UK to the benefit of both parties.  The brand is owned by a sole trader who is keen to take up his offer (“Shareholder B”).  Shareholder A begins marketing and distributing the brand across the UK. 
  • Within a few years, the brand is developing well but needs further finance.  Shareholder B informs Shareholder A that he has agreed to take on a new investor for this purpose (“New Investor”) and has entered into a shareholders’ agreement. Shareholder A is keen to participate in any investment in the company and so Shareholder A agrees to enter into the shareholders’ agreement with Shareholder B and the New Investor, taking a small equity stake.  Shareholder A does not take legal advice.
  • Within a short space of time, the New Investor positions himself as a large majority shareholder (holding over 50% of the issued share capital of the company) and sole director of the company.  Shareholder A is spending a significant amount of time running the business and Shareholder B is no longer involved.  

Where does this leave Shareholder A?

Prevention is better than cure

The cost of good legal advice can be expensive.  The cost of bad legal advice will be more expensive.  The cost of no legal advice could be the most expensive.  Ultimately, having a properly documented contract from the beginning can often avoid many disagreements that arise by setting out clear responsibilities between the parties and remedies in the event of dispute.

If Shareholder A had taken legal advice prior to signing the shareholders’ agreement, he would have discovered what his rights and obligations were (in this case, few rights and many obligations).  More importantly, he could have negotiated certain consent matters which are key to protecting the rights of minority shareholders; for example, that the board could not grant any security over the company’s assets, make or take loans, pay any dividends or allot and issue shares without Shareholder A’s consent.  A shareholder with a large minority stake (up to 49% of issued share capital) is in a good bargaining position when negotiating such consent matters.

Having a director on the board is also helpful in these circumstances.  Shareholder A could have negotiated the right to nominate a director to the board (most likely himself) so that he could be kept appraised of what the company was doing on a day to day basis.  Without this (and in the absence of specific shareholder consent matters) Shareholder A has no input on the strategy, finances or commercial operations of the company.

Funding

The future funding of the business is often a big issue.  Minority shareholders should ensure that funding arrangements are recorded in writing to ensure that they are not obligated to advance funds to the company and that there are no default provisions which may lead to a further dilution of their shareholdings (either by permitting a transfer or issue of shares).  All discussions regarding funding should also be documented. 

Access to information

Shareholder A lives in a different jurisdiction from the company and has no board seat so visibility is very poor.  If appointing a director to the board is not possible, minority shareholders should famliarise themselves with the accounts and get to know the company’s advisers where possible.  We also recommend that a provision regarding reasonable access to information is included in any shareholders’ agreement.

Amendment to Shareholders’ Agreement

Shareholder A could take steps to negotiate a new shareholders’ agreement with the New Investor to put them on a more equal footing.  This obviously requires an element of cooperation.  We often find that sitting around the table in face to face discussions can be more effective than lengthy email exchanges.

Summary

To ensure that a balance is met between protecting the minority shareholders and the majority not being held to hostage by them, taking preventative steps early on is highly recommended.

 

 

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