In many privately owned businesses, key people often hold shares, sit on the board of directors and are employees. While this structure can align incentives and promote long-term commitment, it can create significant difficulties if relationships break down.
A dispute involving a shareholder, who is also an employee and director, is often more complex than an ordinary shareholder disagreement or employment dispute. The individual’s departure can trigger issues across multiple legal and commercial relationships simultaneously. Businesses that plan ahead are generally better placed to manage these situations efficiently, preserve value and minimise disruption.
A shareholder who is also an employee-director, occupies three distinct roles: shareholder, employee and director. Each role carries different rights and obligations. For example:
- shareholder rights arise under the shareholders’ agreement, constitution and the Companies Act 1993;
- directors owe statutory and fiduciary duties to the company; and
- employment rights and obligations arise under the employment agreement and employment legislation.
When a dispute occurs, in the absence of appropriate contractual provisions, the company may find itself in the uncomfortable position of having:
- a former employee who remains a shareholder and still has voting rights and a seat on the board;
- disagreements about the value of shares; and/or
- disputes regarding access to company information.
These issues can delay business decisions and create significant costs and potential losses for the company.
Common areas of dispute
Ability to require sale of shares: Without a shareholders’ agreement or provision in the company’s constitution which expressly requires an individual to offer their shares for sale, a person’s employment ceasing will not automatically require them to offer their shares for sale. It is therefore key that such a contractual provision is in place. We would generally recommend this is recorded in a private shareholders’ agreement (not a public constitution) given the sensitive nature of the subject matter.
Share valuation: Even with a shareholders’ agreement in place which triggers a sale, a frequent source of disagreement is the value of the departing shareholder’s shares. Often shares are to be purchased at “fair value”, but the shareholders’ agreement does not clearly define how the valuation will occur. The result can be lengthy arguments about both valuation methodology and price.
Even where an independent expert is appointed, uncertainty around the process can significantly delay the exit. The valuation provisions should address:
- the valuation methodology;
- the effective valuation date;
- appointment of the expert valuer;
- timeframes for providing information and issuing the valuation; and
- whether the determination is final and binding.
Certainty is often more important than pursuing a theoretically perfect valuation outcome.
Another issue to consider at the outset is whether a “fair value” purchase price is appropriate in all cases, or whether a different value should apply depending on if they are “good leaver” or “bad leaver“. For example, an individual may be regarded as a bad leaver if they leave employment within a certain period of time after they acquire shares (say two years) and, in this case, they will only receive the lesser of the price they paid for the shares and fair value at the time their employment ends. Conversely, a good leaver would receive greater of the fair value of the shares and the price they paid.
Funding the buyout: Even where the parties agree on value, the practical issue remains: how will the purchase be funded? For growing businesses, the amount payable to a departing founder or senior executive can be substantial. A shareholders’ agreement can provide for staged payments over time which can significantly reduce financial pressure on the company and remaining shareholders, while still ensuring the departing shareholder receives fair value.
Directorship issues: Where a departing employee is also a director, questions commonly arise regarding:
- when an entrenched right to appoint a director (if applicable) will come to an end;
- what information the former director should continue to receive; and
- continuing confidentiality obligation.
It is generally preferable from a company perspective for a departing shareholder to immediately lose their right to appoint a director on their employment ceasing, but this is a matter for negotiation and the parties may consider that this right should remain at all times they remain a shareholder. Ultimately, this is a point for negotiation and agreement, which should be recorded in a shareholders’ agreement.
Employment disputes: The employment relationship frequently drives the wider dispute.
Performance concerns, strategic disagreements, health issues, leadership conflicts or remuneration disputes can quickly escalate into broader shareholder issues. Businesses that focus exclusively on settlement discussions about the commercial relationship (for example, focusing negotiations primarily on the value of the shares) without maintaining appropriate formal employment processes may find themselves in a weaker position if negotiations fail.
Very long notice periods in the employment agreement can also become problematic during disputes. Although businesses often seek long notice periods to protect continuity, excessive periods can substantially increase the cost and complexity of termination. A balanced notice period is often more practical than one designed for the most extreme scenario.
Other common mistakes include relying solely on settlement negotiations (with no formal employment process), or failing to ensure that the settlement discussions are held on a without prejudice basis. Either can leave an employer struggling to (lawfully) terminate employment. Even where parties are attempting to negotiate an exit, businesses should continue to:
- document concerns;
- respond appropriately to complaints;
- follow any contractual requirements or procedures; and
- maintain a proper decision-making record.
If negotiations fail, and the employer needs to unilaterally bring the employment to an end, a contemporaneous paper trail can be extremely important.
The importance of forward planning
A well-drafted shareholders’ agreement, constitution and employment agreement should work together to provide a clear pathway for an orderly exit.
Businesses that address valuation, transfer mechanics, governance rights and employment issues in advance are far more likely to achieve a swift resolution if a key employee-shareholder-director leaves the business.
Planning for the departure of a key individual can feel uncomfortable. However, experience shows that clear documentation established during good times is often the most effective way to preserve relationships, protect value and minimise disputes when circumstances change.
If you have any questions, please get in touch with our Corporate & Commercial team or your usual contact 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.
