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Managing Expectations in Shareholder Agreements

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Managing Expectations in Shareholder Agreements

If you’re buying shares in a listed public company, you pay the market price for the share which is correlated to the underlying assets of the business and the expectation of earnings in the future.

It’s no different when you’re buying shares in a private company. The waters get muddied, though, when you’re forming a ‘partnership’ in a company from the inception of the business.

We’ve all heard stories of Silicon Valley start-ups who have sold their businesses for mega millions of dollars even though they’ve had little more than an idea and no profits. The purchasers of these start-ups are paying high prices due to the value that the start-up provides as an additional piece of their business model.

So, what happens when you get two people who want to start a business together?

There are a number of steps that are prudent to determine early on in the process.

This list is a starting point but by no means an exclusive list of items to consider:

1. Does the business have an inherent value from the get-go?

For example, is there business already agreed to be provided or potential business with a high likelihood of success that is already in place before the entity is formally created?

2. What value does each person bring to the business?

For example, this could include expertise, list of contacts, sales leads, access to networks, team and of course, money!

3. What time commitment will each party commit to working on, in and for the business?

For example, are there existing employment contracts in place such that the person can only work evenings and weekends, or if one person is a mum with school-aged children who can only commit to working school hours and school terms.

4. What role will each party play in the business?

It’s good to agree early on who will be responsible for each of the major areas of the business, e.g., sales and marketing, operations, finance, legal and human resources.

5. Identify the communication channels for keeping both parties informed of all aspects of the business.

For example, using online tools to track leads and potential sales, time recording systems to track team performance and so on.

6. Determine reporting mechanisms.

Both for regular monthly updates on all aspects of the business but also for when there are issues that need to be addressed and discussed by both parties.

7. Whilst there is excitement about the new venture, it’s also important to determine the exit strategy.

In the event that either one person wants to move on or there’s an irretrievable breakdown between the parties. This is the equivalent of a pre-nuptial agreement for the business and is an important item that is often overlooked.

8. Identify who will have the casting vote in the event of a disagreement.

9. Create a mechanism on how to handle disagreements between the parties.

10. Talk to a lawyer to create a properly documented shareholders’ agreement.

That will encompass what is covered above and other areas that will assist in the event of unforeseen eventualities in the future, e.g. what happens if one party is unable to work due to illness or injury

11. Consider when to implement key man insurance.

Which pays the business money to ensure that the business can employ someone to temporarily fill the key person’s role in the event they are unable to do so for a period of time, usually due to illness or injury.

12. Agree at what point in time the parties will take out life insurance on each other.

This is to ensure that in the event one party dies (or if you have the Total Permanent Disability or Trauma insurance, then when an event occurs), the value of the business is paid to the Estate from the insurance policy.

The shares are transferred to the ongoing person without them having to finance the buying out of the shares. These arrangements are called share buy-back agreements with insurance policies to support them.

The aim of this is, if you’re entering into an agreement as 50/50 shareholders, there needs to be a 50/50 contribution of value from the beginning.

Otherwise, it will soon become apparent that one person is doing a lot more than the other and then cracks will appear in the relationship as a lack of fairness and equality will be felt by the person doing the extra work, unless, of course, it is part of the initial agreement.

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