Weighing the need for legal certainty against the cost of advice in a business context is a delicate balance. In this article we explore legal agreements for small businesses and how pragmatism at the start-up and scale-up phases of a business can you help to navigate waters that may later prove turbulent.
Do early-stage businesses really need to bother with legal agreements?
Imagine you are going into business with your best friend. You currently trust each other implicitly and work well together. But what happens when one person’s life takes a different route, perhaps due to a new spouse or child? Expectations can differ, tensions increase and cracks can emerge.
If you have in place an agreement (sometimes known as a ‘Founders Agreement’ or a ‘Business Pre-Nup’) that regulates how you will work together, your respective roles and responsibilities, how you will make decisions and resolve disputes then you can hopefully avoid cracks growing into craters.
At the outset it is important to work issues through on your own before discussing them fully with your future business partner. Issues to consider include:
- What’s your ‘end game’ for the business?
- What’s each person’s job description/sphere of responsibility?
- How will decisions be made – do any need unanimity?
- What happens if someone leaves the business either temporarily or permanently? Will they relinquish their ownership interest? If so, on what terms?
- Will you protect the business through service agreements and restrictive covenants? Will intellectual property rights be vested in the business? Inadequate protection risks one person walking away, competing and potentially undermining years of hard work.
Once decisions are made, we recommend documenting them to avoid disputes over what was agreed. Taking legal (and business) advice can pay dividends in the longer term. Exercise caution though as too restrictive an agreement could have the unintended effect of creating a layer of bureaucracy that may impede efficient day-to-day management of the company.
Even if you’ve already established your business without any agreements, you can still put consensual agreements in place.
Start-up to scale-up
To grow any business you will likely need investment. The type of investment will likely dictate the legal agreements that will be put in place. In scaling-up you can expect the legal framework to evolve alongside greater external funding and the likely more complicated structure that follows.
For example, investors taking equity in the company will generally expect board representation, investor protections and requirements on the company to provide certain financial information on a regular basis. Upon taking in equity investment your original legal agreements will be reviewed and/or rewritten – but careful thought needs to be given to the same kinds of issues as before.
On scaling up, the level of investor protections and extent of limits accepted by existing shareholders must be considered against what an investor can bring to the table, including the funding but also any valuable expertise, experience and contacts the investor can make available to the company.
Heading for an exit
Having a suitable agreement in place can instil a culture of corporate governance within the company, which helps demonstrate to potential acquirers or investors that the company is well run.
Further, it is typical for an agreement to include rights such as ‘drag-along’ and ‘tag-along’ rights that provide the shareholders certainty as to delivering and participating in a sale. What’s more, a situation where shareholders have fallen out can only be detrimental to a company’s performance and a buyer’s appetite for a deal – a suitable agreement can reduce the risk of a dispute among the shareholders.
What happens if we have no agreements?
This is an undesirable position. There are many potential points of tension that could arise – founders may fail to grow with the business, become bored or disillusioned with progress. If you don’t have agreements in place a co-founder might walk away and start another venture leaving their existing investment in the business. While this might seem good at the start this can cause further tension as the business grows. As lawyers we are then asked, ‘Why should X [the silent partner] reap the benefits of my work?’ or ‘Can I force X to sell their stake?’. Negotiation is often key – but what are your bargaining chips?
Without an agreement the parties must rely on the Companies Act and/or the company’s articles (which themselves might not be tailored to the circumstances). There is no concept of a ‘no fault’ divorce in English law. The percentage shareholder interest held by X can be a game-changer: X can force or prevent actions or cause a deadlock to arise. In addition, if X is a director (even a non-executive one) X has the right to access to a wealth of company information not available to mere shareholders. Dealing with claims brought by shareholders and/or directors can cause significant disruption to a business. A director can bring claims against the company whereas shareholders can (i) bring claims against the company and/or individuals; and/or (ii) can commence a petition to wind-up a company or seek a buy out of their shares by the other shareholders.
Tailoring your agreements to the stage of the business is important and involves a delicate balance between obtaining necessary protection, reducing the scope for disputes to arise, legal costs and effective management of a growing company.