Save yourself a world of pain with a shareholders agreement

7 July 2016

With ventures involving more than one person, lawyers, accountants and financial advisors will usually recommend some form of shareholders agreement.

Even if you’re going into business with your best mate.

Even if you’ve known that person for decades and would trust them with your first-born.

Depending on your structure, that governing agreement could take the form of a shareholders partnership or unitholder agreement.

But why bother?  

There are 5 important reasons:

1. It provides a reliable starting position

“There are three sides to every story: your side, my side and the truth. And no one is lying. Memories shared serve each differently”.[1]

Titled ‘the unreliable narrator’, this is one of my favourite sayings. It was American film producer Robert Evans who expressed this sentiment so eloquently. 

This quote comes in handy when explaining to clients that once a dispute arises, there is rarely an immediate agreement on what happens next – and there is even less chance of agreeing on what actually occurred in the lead-up to the dispute. It is human nature that each person has a clouded view, tainted by their own self-interest.

That tainted view does not necessarily make the person a liar or morally corrupt.

It just makes them human.

Given this fact of life, a governing agreement established from the get-go – before a dispute arises – creates a reliable starting position both parties have agreed on. Naturally lawyers will raise issues about the terms of the agreement that do not support their client’s side of the story – things like misrepresentation; misleading and deceptive conduct; unconscionable conduct or even the agreement not recording legitimate expectations of a party[2] – BUT at least when a governing agreement exists, there is a starting point.

Compare this scenario to what happens when a dispute arises without a governing agreement: the dispute becomes even harder to resolve because the parties first have to agree on a starting point. As the nature of human kind dictates, each party will argue their side of the story – the one that best serves their desired outcome.

That situation becomes even more convoluted when you take into account the relevant legislation (be it the Corporations Act 2001 (Cth) or relevant State partnership or trust legislation) and the establishment documents (ie constitution or trust deed).[3]

So the first important reason to have a governing agreement is that it provides a reliable starting position should a dispute arise in the future. 

2. It establishes rules of engagement

For the same reason each professional sport has official rules, so should people going into business together. 

Imagine watching a game of sport where play is suspended until the players decide how to deal with a particular aspect of the game. Imagine if that pause lasted 12-18 months pending a court decision. Think of the disruption that would cause. It would be impossible to play. 

Now apply that same logic to a business. 

The fact is that when people understand the rules of engagement and where the goal posts are, they generally conform. When something goes awry, they are usually given the opportunity to rectify that behaviour before consequences apply.  

A well-worded governing agreement means everyone has some understanding of the rules, processes and consequences. That could mean a dispute resolution procedure[4] or the ability to buy out the non-conforming persons. Simply by existing, these provisions can prevent a dispute arising in the first place. 

3. It identifies accountability

Often neglected, one of the rules of engagement is accountability of the people involved. People forget that when they are involved in a venture, they generally wear two hats. Their first guise is ‘owner’; the second is ‘worker’ in the business (unless they are a silent investor). 

It is common for disputes to arise because the parties have not set out the responsibilities and expectations of eachparty when it comes to their role in the business. Understandably, this often leads to feelings of disgruntlement where one party believes they are adding more value to than another party, who they believe is ‘free-loading’ off their hard work.

A governing agreement should distinguish between a person’s ownership in the venture and that person’s responsibilities in the business. This may be documented in more detail in a separate employment/contractor agreement, but is best addressed at the same time as the governing agreement.

That way, the parties can specifically cast their mind to the responsibilities each have undertaken and how they will be made accountable to the other. Some responsibilities will go right to the heart of that person’s ownership and justify consequences such as losing a proportion of their ownership in the venture[5], and the failure to comply with other responsibilities that would merely result in a request for corrective action.

In my experience, longer-lasting ventures have had this discussion at the outset, rather than reacting to a disgruntled or non-conforming owner down the track. Yet another solid reason to establish guidelines of accountability.

4. It nuts out divorce clauses

Once the governing agreement is signed, I frequently joke with clients that it will now be filed away in the top drawer, never to be seen again. That’s what we all want of course – and is true until a dispute arises or it’s time for a party to exit (voluntarily or involuntarily). 

So when the governing agreement sees the light of day, it’s the exit (or divorce) clauses that are the most important.

 
Divorce clauses usually deal with:

  • A dispute resolution procedure;
  • What amounts to a default and the consequences;
  • What happens in case of death or incapacitation and whether life insurance or Total and Permanent Disability (TPD) insurance is taken out to cover those events;
  • Whether there are drag and tag rights;
  • What happens if someone just wants to leave. 

While it’s true that no governing agreement can ever deal with every single event that may arise, experience shows us that the vast majority can be addressed in a well-drafted governing agreement.

Covering off common divorce events and establishing a procedure everyone can follow with minimal disruption is a very compelling reason to bother with an agreement. 

5. The process itself is an acid test

Perhaps the most important reason of all is this: the process of agreeing on the terms of a governing agreement is, in itself, revealing as to whether you should be in business with that person.

I watched an Optus ad on TV recently starring Mark Wahlberg, where he says: “You never go into business to be small”.Well, more importantly, you never go into business to fail. 

In the early days of a venture, the parties involved have a very blue-sky perspective. They are full of energy and their focus is on the venture’s success – not its failure. The process of preparing a governing agreement makes everyone stop, take stock and think ‘What if?’

‘What if it does not go as well as we expect?’

‘What if the other person does not perform?’

‘What if…’

The process requires everyone involved to see things from a different vantage point – one where the sky is more overcast than blue.

The point is that a venture with another person is only truly tested once things go wrong. So considering the venture and the other parties’ views on what will happen if things don’t go as planned gives you an insight into whether these are people you want to be in business with. Better to find out now than after you’ve invested your time and money.

So why bother …….

So to the question – Why bother having a governing agreement? – my answer is simple: it’s wise to have a document that reflects all three sides of your business’ story: your side, my side and the truth.

[1] The Kids Stays in the Picture(1994): An autobiography by Robert Evans

[2] Re Media World Communications Ltd v Naidoo (2005)216

[3]Cody v Live Board Holdings Limited [2014]

[4] Although care needs to be had that the dispute resolution clause does not ‘obviate the statutory regime’ (in this case the winding up procedure): A Best Flor Sanding Pty Ltd v Skyer Australia Pty Ltd [1999] VSC 170

[5] See Pioneer Energy Holdings Pty Ltd (in liquidation) [2013] NSWSC 1134 where a clause requiring the sale of the shares for a $1.00 in the event of a breach was held to be unenforceable as a penalty.

 Please contact Antony Harrison for any further information.


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