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Entrepreneurship Series Part 3: Shareholder Relationships

David Montegriffo
Senior Associate

In the third of David Montegriffo’s Entrepreneurship series, where he looks at the ins and outs of setting up a business in Gibraltar, today he discusses Shareholder Relationships and how to safeguard the success of your business at a time when tensions can run high.

There will often be a large degree of trust between individuals going into business together, especially where this involves close friends or family. Many founders will start a new business with a wave of enthusiasm, optimism and hunger for success. However, breakdowns in relationships can take place for any number of reasons and this is especially true when the stakes are high and there is money involved. It is not uncommon for relationships to become strained and for tensions and resentment to creep in. When issues arise among founders, it can hamper the running of a business.

With this in mind, it is important to correctly map out the relationships between founders and agree any significant points at the outset. Unfortunately, this level of pre-planning is often an afterthought for many owners. There is no requirement in law for co-founders to sign up to a Shareholders’ Agreement. However, having one in place is likely to be helpful in avoiding uncertainty and providing a clear path towards resolution of disagreements and disputes. Below is an exploration of various important matters which should be explored prior to parties entering into business together.

Management and decision-making

The ongoing management of the business is a key matter which is often addressed at the outset. It is common for a shareholders’ agreement to make provision for each founder to appoint a director to the board of the company. This means that each founder will have a direct representative on the board who will be well placed to direct the day-to-day operations of the business in line with the intention and spirit of the founder.

In terms of key decision-making, it is common for founding shareholders to retain a veto right over certain major decisions to protect against the company deviating too far from their initial vision (this may include retaining control over matters such as any changes to the nature/name of its business, paying any dividends, etc).

Ongoing financing requirements

A common source of disagreement in business relates to its ongoing funding requirements. Founders may have a different opinion of the short, medium and long-term funding picture and differing levels of financial power. It is therefore helpful to agree on the likely funding requirements for different stages of the business and to agree on the implications of failing to meet the agreed commitments (such as an ownership dilution or forfeiting certain rights). This is particularly relevant for start-ups which need to allocate significant funds to marketing and product development in order to get an idea off the ground and eventually turn a profit.

Dividend policies

Shareholders may have different expectations as to the financial returns due from the business. A formal dividend policy which specifies how profits will be allocated as the business grows or which sets a minimum or maximum percentage of the profits to be distributed to shareholders in each financial year will be helpful in reducing the risk of disagreement.

Control over transfers of ownership

Founders are usually keen on restricting the free transfer of shares by shareholders. Without any controls in place, a shareholder could theoretically sell their share of the business to any third-party purchaser. Remaining shareholders who initially went into business with their close co-founder may suddenly find themselves in business with unpalatable and objectional characters with whom they would never have started a business.

It is therefore logical that shareholders agree on the rights and procedures which will kick in where a transfer of shares is proposed – these include provisions such as pre-emption rights (which allow the existing shareholders a right of first refusal to purchase shares), drag along and tag along rights (which force other shareholders to sell their shares or to join in a sale on equal terms), mandatory transfers (where shareholders can be forced to automatically sell their shares where they have done something to damage the business) and lock-ins (where no shares can be sold until a minimum agreed period of time has expired).

Deadlock resolution

Throughout the existence of a company, shareholders with equal voting power or veto rights can find themselves in deadlock situations where they are unable to reach a consensus on a particular matter. This can result in a stalemate situation that hinders the smooth functioning of the company. Incorporating deadlock provisions into a shareholders’ agreement will expedite a solution – these may include sealed auctions, the appointment of a neutral third party, a ‘Russian Roulette’ mechanism involving a forced buyout at a fair price, or, as a last resort, a liquidation.

Degree of sophistication and stability

Proactively addressing potential points of contention in advance will display a degree of stability for your business (especially for banks and potential investors who seek reassurance before investing in a company).

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