Avoid Shareholder disputes with your Business Partners

Avoid Shareholder disputes with your Business Partners by planning ahead for their potential departure

Most standard shareholders’ agreements do not include provisions for what happens if a business partner stops working for the company.  This is because the working relationship is expected to be governed by an employment contract or service agreement and the ownership of the company is separately governed by the shareholders’ agreement.  In our experience, a dispute between shareholders is far more difficult to manage if the shareholders’ agreement does not properly deal with what happens when a business partner’s employment terminates or changes.

Partnerships and LLPs

If two people go into business together, then they would normally either form a partnership, limited liability partnership (LLP) or a limited company. The choice of vehicle is likely to be driven by tax.  However, the legal agreements covering the different structures normally create a different relationship for shareholders than they do for partners or members of an LLP. 

If two or more people go into partnership or set up an LLP, then they would normally agree to devote their whole time and attention to the business.  If a partner stopped pulling their weight or ceased to work full time, then the other partners could expel them or perhaps agree to reduce their share of the profits each year to reflect their reduced contribution.

When a partner leaves via retirement or expulsion, they would normally get paid out their share of profit earned, plus any capital which they have contributed.  It would be less common, but also possible, that the leaving partner would get some payment for goodwill.  For partnerships where the goodwill is seen to attach more to the individual than the business, such as professional partnerships, normal practice tends to be that the partners will get a share in profits earned to date, but no payment for goodwill.

Limited Companies

If business partners set up a limited company instead, their working relationship is governed by their employment contract or service agreement, which is distinct from their shareholding.  If a business partner stops pulling their weight, then it may be possible to take disciplinary proceedings against them under their employment contract, but that may be difficult if there is only one other director who may not be able to make business decisions on their own.  Even if a business partner is dismissed or resigns, he will still retain his shares in the company unless there is an agreement to the contrary. 

Where a company receives outside investment, the investor would normally require “good leaver” and “bad leaver” provisions to be included in the arrangements.  Under good leaver and bad leaver provisions, if a shareholder ceased to be an employee or director of the company, then they are forced to offer their shares for sale.  If they are a good leaver, they would normally receive fair value for their shares.  If they are bad leaver (for example, because they have been dismissed for gross misconduct), then they would receive only what they had paid for their shares. 

In our experience, leaver provisions are often not properly addressed in shareholders agreements where there is no outside investment.  We would recommend that business partners should consider carefully what they expect from each other and what should happen if one business partner stops delivering their part of the bargain.

In a similar way to a partner in a partnership who is subject to expulsion or retirement from the partnership, a leaving or defaulting shareholder should have to offer their shares for sale to the company and/or the ongoing shareholders.  Depending on the nature of the default or the circumstances of their departure, you should consider how the shares will be valued. 

As set out above for a partnership, you would normally get your share of profits to date and any capital contributed to the company.  This is the equivalent of a net asset valuation for a company.  As an alternative, you could consider valuing the company based on a multiple of profit, which would in effect include an element of goodwill.  You should also consider what impact the defaulting shareholder’s departure would have on the business, as the continuing shareholders would not want to be paying full value for a business which is then going to struggle without a key member of the team. 

Everyone’s circumstances and requirements are different and there is no one size fits all approach.  The important thing is to ensure that business partners consider these issues up front and address them in a shareholders’ agreement.  This helps reduce the legal costs and stress at the time of a shareholder’s departure, which might otherwise be incurred if no agreement is in place, or if the agreement does not properly provide for what happens in these circumstances.  The ongoing shareholder will not want the defaulting or leaving shareholder to retain any shares and the defaulting or leaving shareholder will want to know that it will at least get something back for their investment of time and money into the business.

We therefore recommend that you include good and bad leaver provisions in any shareholders’ agreement between business partners.  You may also want to consider putting in place life insurance policies to fund the purchase of the business partner’s share if he dies.   

If you would like any further advice in relation to shareholders’ agreements or company structures, then please contact Jon Rathbone in our Corporate and Commercial Team.