Business people are continuing to enter commercial arrangements with enthusiasm and high hopes, and failing to put in place sensible documentation to cover the all-too-regular fall-outs that occur.
Two recent real-life examples, in NSW, highlight the risks of this “normal” casual approach…
Case Study 1: Plumbing business down the drain ...
Two brothers and their wives were partners in a medium sized plumbing business turning over about $900,000 a year. The business was set up as a company, with two family trusts as equal shareholders, and the four individuals as the directors. The company had a very simple off the shelf Constitution. All of this is very common.
The sisters-in-law had a falling out which then caused tension between the brothers. At the time the business had been offered a long-term high margin contract with a local hospital, but it needed to acquire a $60,000 piece of equipment to perform that work.
One of the wives did not believe that the capital expenditure was worthwhile in the prevailing economic client and pressured her husband to vote against the decision to purchase it. Consequently the business missed out on the contract and revenue began to slide south.
Several months later the brother and wife who opposed the equipment purchase wanted out of the business. Whilst the other brother was keen to buy their 50% interest, the parties could not agree on a fair value for the shares, given the downturn in sales, and allegations that had surfaced about the respective contributions of the parties to the business. All the while business performance continued to suffer.
The parties had mistakenly assumed that the Constitution was sufficient to govern their relationship. It wasn’t. It didn’t address any of the issues faced. This is a classic example of where a Shareholders’ Agreement could have provided a mechanism for decision-making involving major capital purchases, a process for resolving deadlocks and disputes, and an agreed valuation formula (and process) for buy-outs by one party of another party’s shares.
Furthermore, after the business crumbled, both brothers set about re-establishing their own plumbing businesses, and were now fighting over clients! This could also have been dealt with by the Shareholders’ Agreement.
Case Study 2: The investor with no control ...
A small start up property development business had three shareholders, two holding a 20% shareholding each, and the third a 60% shareholding. The major shareholder was essentially the financial backer, and contributed close to $1 million to assist in the purchase of land for the company’s first project, as well as mortgaging his own home (which is always a big call).
The two minority shareholders ran the day-to-day business operations and were both directors. The major shareholder believed it was not necessary that he be a director as he was not involved in the daily operational side of the business. The company had a Constitution, but there was no Shareholders Agreement between the three men.
The two directors decided to alter the nature of the project from a residential development to a commercial one. By the time the major shareholder found out about the shift in focus, council approval had been obtained and excavation works had begun on the site. The major shareholder disapproved, having lost a substantial amount of money in a previous commercial development.
He came to us confident that there must be several breaches of contract, or fiduciary duty, and that he could stop the project and recover his investment.
We immediately advised him that his chances were slim. The Constitution allowed the directors to make all decisions concerning the business without referring to shareholders at any stage. There was no investment agreement in place governing the terms of the major shareholder’s investment. There was no clear breach of director’s duties or any provision of the Corporations Act.
The project has since collapsed and the bank has returned about $500,000 to our client, but he is still chasing the balance without any guarantee of success and at substantial expense.
These problems could have been avoided by having a Shareholders’ Agreement that required unanimous shareholder approval of all major company decisions (such as changing the nature of a project), and that attached a number of robust conditions to our client’s investment.
- Partners/associates in small businesses should enter into a formal written agreement as a priority because it benefits all parties (and their estates) by providing clarity as to how key events in the life of the business will be dealt with.
- Disagreements between partners almost always happen. If serious enough they can escalate into disputes. Continuing unresolved disputes will inevitably damage the performance and reputation of the business, and consequently the return to all principals.
- In most cases a partnership agreement, shareholders agreement or joint venture agreement (as the case may be) can be a concise document that is good value to have drawn up.
- Seek professional advice at the start of your business venture, not after you encounter a problem. It will be cheaper to have a robust commercial agreement prepared than to engage a lawyer to settle a dispute.