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Shareholder Disputes

You and your partners are starting up a new company. It’s incredibly hard work. But the team is functioning seamlessly, filled with energy and ambition, and everything is going great. So, when should you bring in counsel to start lawyering the financial and authority agreements among the partners? At Sajen Legal, our advice is, right from the start.

At this early stage, calling on legal advice to formalize sensitive issues such as voting rights and percentage ownership splits can seem premature, even counterproductive. Maybe you haven’t secured your major start-up investor so it appears too soon. You may have questions in the back of your mind over which partner is really going to deliver, so some key issues remain outstanding. Alternatively, you may be so optimistic about your new business – and so certain of future financial success – that you believe dividing the spoils will be easy. A large pie is easy to share.

Anyway, involving lawyers will raise delicate relationship questions and force a discussion about negative scenarios that could spoil the positive, collaborative spirit at a delicate moment. Above all, there is the cost: why rush to spend on expensive legal fees?

These questions and concerns are common. But the failure to clarify relations, establish a legal framework for new partnerships and agree on processes for dealing with future eventualities is one of the most common entrepreneurial errors. It happens all the time, and down the line can lead to significant strain and disruption – and much higher legal bills – when things to do not go entirely to plan.

In a recent example, Sajen Legal was engaged to represent the trustee of a partnership being wound up precisely because issues of legal authority and control among the partners had not been clarified at the beginning. It was a particularly unfortunate case because the business – a residential property management concern – had been in operation for nearly 25 years. Even if the company had not grown as they had originally hoped, clearly the principals had worked together with a degree of success over the years and had achieved a long track record as a viable concern.

But life doesn’t stand still, and relationships evolve. In this instance, the interests of the investors on the one hand and the chief executive on the other had diverged. While the original start-up funds had been essential to getting the business going, over such a long period of operation the CEO had come to feel that his investment of time, effort and decision-making was more important to the company and gave him a higher level of authority and ownership than the investors. It was a classic case of who is in charge? Who really owns the business?

As a result, when came time after many years to make changes, conflict was inevitable. It should have been possible to extract one or both of the investors amicably. Or the business could have been sold or wound up in a planned and orderly manner to maximize the benefits for all. Such exit strategies are normal, indeed inevitable, in any business and can and should be prepared for right from the get-go.

Yet as would become all too apparent through subsequent legal proceedings, none of this groundwork was in place. All those years ago, when relations were sunny and prospects positive, there had been no discussion about the end game. There was little clarity over authority in the business, and underlying ownership issues were murky at best. Above all, there was no defined process for working out potential changes in relationships that could readily have been foreseen.

Because of the age of the business, Sajen Legal and other counsel found ourselves digging into historic files from decades ago. We were looking for a detailed memorandum of understanding, contracts clearly defining relationships or a track record of explicit internal communications among the principals in which their understanding of their respective authority over the business could be gleaned.

What we found was unsatisfactory: through all the documents, memos and messages we reviewed, no real legal clarity emerged. The understandings among the partners had not been made clear – or at least not been clearly written down. It was as if you have been playing a board game for hours and hours (in this case years and years), and then when you come to a disagreement, you can’t find the rule book: all you can do then is fight over it.

A notable aspect of this dispute was control of financial information. This is an especially common problem. Here, the CEO held all the financials on the current business and its underlying assets, while the right of the investors to have access to this material was not enshrined and they had been effectively operating in the dark. It means parties to the matter fighting over assets that may actually not even be there.

Law firms get criticized for taking big fees, but this dispute was not inevitable. In the end the attorneys, liquidators, court administrators and other professionals indeed all had their fill. Whatever the respective percentages fought out among the principals, the dispute thus significantly depleted the money left over for them to divide. They all lost.

How much money, effort and emotional strain would have been saved had the principals made the modest but prudent early investment, a quarter century earlier, to write that rulebook in the first place.

“It’s so much harder to negotiate a resolution or even a process for resolution when things start to break down,” says Sajen Legal Managing Director Kyle Kimball.

“When the sky is blue and everyone loves each other, you can negotiate much better arrangements. It’s not about deciding who will take the table and chairs, but rather agreeing a process in advance that means you won’t have to go to court. That’s were calm and experienced legal advice from the start can be so critical.”

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