Business Succession Planning – Shareholder Agreements What have you and your co-investors agreed?

A successful exit from a business can be, and often is, affected by the steps you take when setting up the business.

Although there are various business structures that can be used in New Zealand, by far the most commonly used by SME business owners is the limited liability company.  Companies can be set up quickly, provide limited liability to shareholders, are a flexible and known structure for investors and provide a platform for growth (for example, raising capital by the issue of shares).

Capital requirements to start a business mean that it is common for SME companies in New Zealand to have multiple shareholders.  Typically, the major focus of the business partners at the start up stage is the business opportunity, rather than the structure of the company and the relationship between the shareholders who want to do business together.  This can be the case even where significant sums are invested.  Only later, usually when things don’t work out as hoped, do the parties give serious thought to structural issues and how best to extricate themselves from the mess.  By that stage it is often too late to achieve a clean exit.

The Companies Act 1993 (the Act) and the company constitution adopted by the company (if it adopts one – it is not mandatory but is desirable) provide a broad framework for the incorporation and ongoing operation of a company.  Even if a constitution is adopted, typically they are generic “off the shelf” documents and while they deal with the relationships and the operation of the company at a high level, they do not deal with business specific shareholder issues with any precision.

Where multiple parties own shares in a company, we strongly recommend a shareholder agreement.  A shareholder agreement governs the specific relationships between shareholders, the company and its directors, and can be tailored to the particular circumstances of the parties and the business.

One of the other tangible benefits of a shareholder agreement (in addition to providing a tailored framework for the operation of the business) is that its preparation and execution forces the parties to identify, consider and agree key business issues and desired outcomes right at the outset.  Things like:

• The roles shareholders will be responsible for
• Who will actively work in the business
• How the business will be funded – by whom and how much
• How directors are appointed
• What happens if there is a dispute or serious shareholder default

We accept that in most circumstances, it is the responsibility of the directors to control the day-to-day operations of the company.  However, while the directors have duties under the Act, in the absence of a shareholder agreement or a comprehensive constitution, there are only very limited circumstances where the directors are required to defer to shareholders.  We set out some comments on the matters we would likely include in a shareholder agreement below.

Some fundamental points include:

• Shareholdings – Who will hold the shares? If a shareholder wishes to sell their shares, who has the right to buy them?

• Roles – Agreement on the roles that each shareholder will play in the business.

• The business – What is the agreed business and what are the requirements for any change? For example, will a material change require the approval of shareholders – if so, is it to be a specified percentage or unanimous?

• Financing the venture – What are the initial funding requirements of the company and how will any new funding be provided? Is bank funding needed and how will it be secured?

• Directors – How will directors be appointed and removed? Does each shareholder (or shareholding group) have right to appoint and remove their own director?  If so, this will “entrench” the appointment and removal of the relevant shareholder’s interests on the board of the company and offer additional protection.

• Agreement relating to fundamental issues – Some issues are so fundamental that any change should require the unanimous consent of shareholders. For example,  extending or changing the scope of the business, buying another business, selling all or any part of the business, issuing further shares and acquiring capital items over certain specified amounts.  While the Act includes restrictions on “major transactions”, does this adequately protect shareholder interests?

• How profits are distributed – An agreed dividend and reinvestment policy.

• Death or Disability – What happens if a shareholder dies or becomes disabled? Buy out rights for the other shareholders may be desirable.  Buy/sell insurance to enable the remaining shareholders to buy out shares in the event of the death or disability of a shareholder may also be appropriate.  If you do not address these issues, you may end up in business with your co-shareholder’s relatives.

• Drag Along/Tag Along – How is an exit (sometimes called a “liquidity event”) managed? Consider whether a specified percentage of shareholders should have the ability to drag other shareholders into an exit (sale of business or shares).  For example, if there are shareholders who hold a significant majority shareholding, they may wish to control the exit arrangements.  Usually these are accompanied by tag along arrangements, enabling minority shareholders to require acquisition by the purchaser.

• Disputes – Include mediation and arbitration provisions to facilitate the resolution of disputes between the parties.

• Termination – Specify circumstances that lead to termination and the obligations of the shareholders upon termination. For example, a material default by a shareholder may trigger buy-out rights for other shareholders.

• Valuation of Shares – Include a clear mechanism to value the shares in the event of a shareholder exit.

Options to Acquire Shares

Finally, in the context of business succession, there may be arrangements where key employees or the next generation are given incentives to take ownership of shares in the company over time.  These incentive arrangements may include options to purchase shares contingent on key performance indicators included in the shareholder agreement.  In these circumstances, the shareholder agreement and its governance provisions (including any thresholds for reserved matters) should be updated to reflect the changes in ownership percentages for shares acquired by incoming shareholders.

The best time to document a shareholder agreement is right at the beginning of the venture. In the context of business succession involving multi-party ownership, the best time to document a shareholder agreement is prior to the new investor entering the fray.  However, all is not lost if this has been overlooked.  Now is your opportunity to address this issue before disputes arise!

Hesketh Henry regularly assists family business owners with legal aspects of business succession planning and execution.  If you would like to discuss, please get in touch with Ben Hickson or John Kirkwood at Hesketh Henry.

Disclaimer:  The information contained in this article is current at the date of publishing and is of a general nature.  It should be used as a guide only and not as a substitute for obtaining legal advice.  Specific legal advice should be sought where required.