At the start of most businesses those involved normally have a rosy outlook on the future – they get on, they’ve got a great business plan and the bank has agreed to fund their vision, but a few years later things may be very different. With the passage of time, much can go wrong so let’s take a bikebiz.co.uk look at what the legal effect of management war is and what can be done to protect everyone’s interests from day one.
An example of what may go wrong is shown in the fictional case study of Bob and Jim. Bob and Jim first met whilst working for a bikes and P&A supplier (although this could be any business) in the North West 13 years ago. After enjoying a close working relationship for a couple of years they decided to go into business. Bob and Jim got some advice from their accountant and formed a company, BoJim Bikes Ltd, which set up as a top-end cycle dealer. BoJim Bikes started trading in 1990 with Bob and Jim holding 50 percent of the shares each.
Things went well for the first 10 years, BoJim Bikes acquired another two dealerships and made a reasonable profit. However, 6 months ago Bob and Jim’s relationship started to show cracks. Jim at 43 was looking for a new challenge and considered expansion was the key to protecting the business. Bob at 51 was looking to retire from an active role in the business but wanted to keep his shareholding. What started as a disagreement into strategy gradually developed into management warfare – Jim accused Bob of stifling the business and Bob felt Jim was undermining their previously good relationship and the financial stability of the company.
Bob and Jim hit deadlock. Neither wanted to sell their stake in BoJim Bikes but neither could they agree on how the business should be run or the future of the company. Their legal position is centred around 3 key areas:
* Bob and Jim’s position as shareholders
* Bob and Jim’s position as employees
* Bob and Jim’s position as directors
We look at each aspect in more detail below.
Bob and Jim’s position as shareholders
Jim wants to carry on with the business but Bob doesn’t want any active involvement and wants to retain his shareholding. Given they both own 50 percent of the business this means that Jim will effectively be working for Bob for free. The questions that owner managers commonly ask in this situation are whether Jim could divert the business out of the company, or pay himself a large bonus. We look at these issues below.
* As Bob has an equal shareholding in the business it is unlikely that Jim will be able to carry on running the business without his involvement. If however that were the case Bob might be able to bring a claim for “unfair prejudice”. This would involve Bob bringing proceedings before a Court on the basis that his interest as a shareholder were being prejudiced because of Jim’s conduct.
* Typical examples of “unfair prejudice” include excluding a party from the management of the business, from the profits of the business or one party extracting a disproportionately greater share of the benefits of the business – for example by paying a substantial salary to himself or excessive bonuses.
* Such litigation is complex, costly and time consuming – it normally take a minimum of 12 months. Another downside is that the Court has very wide discretion in relation to the judgement it can make. Typically it will order that one shareholder (or a group of shareholders) will buy out the shares of another shareholder. In this case, where clearly Jim wants to continue to run the business and Bob does not, the Court would be likely to order that Jim buys Bob’s shares. If the parties cannot agree on a valuation the Court will decide on an appropriate valuation for the shares and will normally appoint an independent accountant to value the company.
* However in this case it is more likely that there is simply a deadlock with neither party being able to run the business without the other’s assistance. Bob could therefore apply to the Court for a “just and equitable winding up”. This is available in cases where, although the business has been incorporated, it is in essence a partnership. In this case the Court would be likely to order that any proceeds resulting from the winding up would be shared equally by Bob and Jim.
* Winding up it is an exceptional remedy because of its potential effect on third parties – the result of the Order is that the company will be liquidated and will therefore no longer exist. This is likely to have ramifications for creditors and employees as well as the business itself.
* An application to Court is likely to take as long as an unfair prejudice application if it is contested. Thereafter a person would be appointed by the Court to arrange the winding up of the company. That person (typically an accountant) would need to ensure that debts were recovered, creditors paid and the assets of the company were realised in the way most beneficial to the interest of its members as a whole in all the circumstances.
* The costs of winding up a company can be substantial. The winding up will become public knowledge and this may have an effect on the amount realised for assets. It removes from the control of the owners of the business the ability to decide when to market an asset (whether it is the stock of the company or property from which it trades). Jim and Bob are therefore likely to realise significantly less than they would otherwise have done in an orderly sale. Prolonged litigation leading up to the sale is also likely to have a significant effect on the business – even if the court can intervene to a certain extent to maintain the business and break the deadlock, it cannot hope to run a business in the same way that its owners can.
* Often there are very few potential buyers for a business and a liquidator is bound to look at the company’s own management for potential purchasers. While in many respects Jim’s position is equally prejudiced by a winding up, if he then goes on to purchase assets from the business he may in fact be able to cherry pick assets, probably at less than true market value.
In short it is certainly in Bob’s interests (and probably also in Jim’s) to try and resolve the matter without litigation.
Bob and Jim’s positions as employees and directors
As well as deadlock at shareholder level this is also deadlock both from an employment and directorship perspective. Neither Bob nor Jim can have their employment terminated by the Company lawfully unless it has a fair reason. Even if a fair reason is established the Company must ensure that it follows a fair procedure prior to a dismissal. On the above facts there is unlikely to be a fair reason for dismissing either Bob or Jim therefore any dismissal is likely to be unfair. If either Bob or Jim are unfairly dismissed they may be able to sue the Company for unfair dismissal.
Neither Bob nor Jim can remove the other as director as a resolution of the company would be needed to make such removal effective. As Bob and Jim own 50 percent of the shares in the company a resolution cannot be passed as this would require a majority vote.
Protecting your position as an owner manager
When setting up companies, the individuals concerned need to consider not only what happens when things go right but also what happens when things don’t go to plan. From an individual perspective a director will want to know what his rights are both as an employee and director and also as an owner. In terms of owner managers it is also necessary for the management team as a whole to consider what should happen if one or more of them were to under perform or do something worse such as defraud the business.
The questions which should be asked are when should a director be removed and what should happen to his shareholding when he goes – can he retain it or should he be forced to sell his shares to the remaining owner managers? Management will also want to consider if departing directors should be restricted in their ability to compete with the company.
The best way of protecting the individual director, the management team as a whole and the company is to agree at the start what should happen if things go wrong. A relatively simple set of contractual documentation can remove the uncertainty when things don’t go to plan.
As a basic starting point each director should have an employment contract – this should include not only details of their salary and their notice period but also restrict their ability to compete with the company once they leave its employment. Termination of a director’s employment by a company does not automatically terminate his appointment as director. Therefore it is very useful for an employment contract to contain is a clause appointing authorising somebody to execute all necessary director resignations on behalf of the leaving employee.
The next stage in the protection process is looking at documenting share ownership and what happens when an owner manager leaves. The most common way of doing this is to put in place a shareholders agreement and articles of association which are tailored to the specific concerns of the management team. These will deal with if and how a leaving or under performing director will be required to sell his shares to the remaining directors and for what value. This documentation can also include restrictions on controlling shareholders selling out without taking minority shareholders with them and provide a mechanism for resolving disputes.
A breakdown of the relationship between the owner managers of a company need not be a messy and protracted affair. It is never likely to be pleasant but if planning and forethought is given to the relationship at the beginning, and documents put in place to reflect such agreements, it will ensure that if a relationship does breakdown, parties on both sides will know where they stand.
Your company may not be facing problems now but are you certain of the future?
Helen Caudwell is a senior solicitor and Patrick Rawnsley is a corporate partner in the Leeds office of the national law firm Eversheds.