Business partnerships rarely fail overnight.
More often, they unravel one disagreement at a time.
The following fictional story illustrates how quickly a successful business can descend into a legal dispute when there is no shareholders’ agreement.
The Deadlock.
Five years ago, Sarah and Ben started a business together.
They each owned 50% of the company. Sarah focused on sales and business development while Ben managed operations. The business grew steadily, and they built a loyal client base.
Today, the business is thriving.
The problem is they no longer agree on what the future of the business looks like.
Sarah wants to invest in expansion. Ben wants to reduce debt and increase profits.
Sarah and Ben are in a deadlock. Neither of them is wrong, they simply want different things.
If Sarah and Ben cannot reach agreement, the company may simply remain paralysed while the dispute continues.
Unfortunately, the Corporations Act 2001 (Cth) provides no simple mechanism for resolving a commercial deadlock between equal shareholders. In limited circumstances the Court may intervene under the oppression provisions (ss 232–233) or, in extreme cases, order the company be wound up on the “just and equitable” ground (s 461(1)(k)). None of those outcomes is quick or inexpensive.
A well-drafted shareholders’ agreement should include a deadlock mechanism. It may require negotiation, mediation or another agreed process before more drastic steps are taken.
The important point is not which process the parties choose. It is that they choose a process before a disagreement arises.
The Exit
Months pass. The relationship between Sarah and Ben continues to deteriorate.
Sarah decides that without the opportunity to grow the business, and with increasing tension between the shareholders, she no longer wishes to continue working in the business.
She finds a buyer, John, and initiates a sale of her shares. John has never worked in the industry. He does not have the skills or qualifications to do Sarah’s job effectively.
Ben has never met John and does not want John as his new business partner.
Whether Sarah can freely sell her shares depends on the company’s constitution and any applicable restrictions under the Corporations Act 2001 (Cth). Without a shareholders’ agreement, Ben may have little control over who becomes his new business partner.
If the sale or the conduct surrounding it is oppressive or unfairly prejudicial, the Court may grant relief under ss 232 and 233 of the Corporations Act. However, those remedies are designed to resolve disputes after they arise, not to provide a commercial exit mechanism.
If they had a shareholder agreement it would have well drafted clauses addressing:
What began as a disagreement has now created uncertainty about the future ownership of the business.
The Wrong Business Partner
John comes on board as the new sales and business development manager.
Ben’s concerns quickly become a reality. John is out of his depth. He struggles to understand the business and contributes very little to the day-to-day operation of the company.
Sales decline and Ben is working 80 hour weeks trying to keep the company afloat
These situations are surprisingly common in privately owned companies, but Ben cannot simply remove John because he is disappointed with his performance.
Whether John can be removed as a director depends on the company’s constitution, the Corporations Act and the voting rights attached to the shares. Likewise, there is generally no automatic right to force John to sell his shares simply because he is no longer contributing to the business.
If John’s conduct, or the way the company is being managed, becomes oppressive, unfairly prejudicial or unfairly discriminatory, Ben may seek relief under ss 232 and 233 of the Corporations Act. The Court has broad powers, including ordering one shareholder to buy out another.
A well-drafted shareholders’ agreement should deal with what happens if a shareholder stops contributing to the business, resigns from employment or otherwise fails to perform their agreed role.
The Unexpected Hier
A year later. Tragedy strikes. Ben suffers a fatal heart attack.
Ben dies intestate. Ben’s only living relative is his Great Aunt Edna who is 80 years old. Under the applicable intestacy laws, Great Aunt Edna is entitled to inherit his estate.
John is now in business with Great Aunt Edna.
Aunt Edna has no interest in the business, but she is very excited about the extra dividend income.
The Corporations Act 2001 (Cth) provides rules dealing with the transmission and registration of shares following a shareholder’s death.
It does not require the deceased shareholder’s estate to sell those shares to the surviving shareholder.
Without a shareholders’ agreement, John may have no ability to purchase Ben’s shares or regain control of the business.
A well-drafted shareholders’ agreement often works alongside estate planning by providing a clear buy-sell mechanism, a valuation process and, in some cases, insurance arrangements to fund the purchase.
The bottom line
Sarah and Ben’s story is fictional.
Unfortunately, the disputes it illustrates are not.
Every year, Australian courts hear disputes between business owners who started with optimism but never agreed on what would happen when circumstances changed.
The Corporations Act 2001 (Cth) provides remedies when relationships break down. Those remedies, however, usually involve litigation after the damage has already been done.
A well-drafted shareholders’ agreement however plans for the difficult conversations before they become expensive disputes.
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