Affordable • Accessible • Approachable • Able

Call us today on tel 08458 678 978

Skip to navigation
Skip to contact form

Would you be happy for your co-directors to resign from work but still hold shares in your company?

penina-shepherd.JPG

If yes- don’t read on…

In most small and medium businesses, some or all of the directors are also the shareholders of the company. A point that is often missed is that shareholding and directorship are two distinct legal capacities with different rights and obligations attached to each in law (see our previous post).

Think of this scenario:

Two of you set up a company together and you work around the clock. You both own 50% of company and you are both directors of the company receiving an equal salary. Your co-shareholder (Gerard) is married to an American who just had a fantastic offer to be a Hedge Fund advisor in LA. After much deliberation they decided to take the opportunity and make the move. Gerard has therefore resigns from his director’s role in the company, informing you he will be leaving in 60 days.

Clearly Gerard will not be entitled to receive his salary after resignation. Five years later you successfully manage to sell the company for £3m, a great reward for all your hard work.

During these five years, unless stipulated otherwise in the Articles or in the Shareholders Agreement, Gerard remains a 50% shareholder in the company: he is entitled to vote, receive dividends and receive 50% of the £3m sale proceeds!

Directors/shareholders of most small and medium businesses would not be happy to have their business partner resign from their job in the company but still be entitled to be a company shareholder.

How to avoid such a scenario

It is quite astonishing how so many shareholders agreements I see totally ignore this crucial point!

To avoid such position, it is import that your Shareholders Agreement clearly stipulates that termination of directorship triggers provisions dealing with the termination/ sale of the resigning director’s shareholding. The provisions need to stipulate that if the relevant shareholder no longer operates as a director for any reason whatsoever, then the termination of the Shareholders Agreement will apply.

Good / Bad Leavers Provisions

You can also include “Bad Leaver”/”Good Leaver” provisions. In a nutshell, these provisions stipulate that, on departure, the shares of the departing shareholder will be bought by you/the company/ an agreed 3rd party at market value, unless the relevant person is a bad leaver. An extreme example would be, say, your co-shareholder got caught with “her hand in the till”. In such a case she would be a bad leaver only entitled to the nominal value of her shares (e.g. £1 each).
 
It is VERY difficult to get all these provisions in place once the relevant shareholder decides to resign. Like always, there is no time like the present!

For a free consultation on the above or any commercial matter, please contact Penina Shepherd, our Company Commercial Solicitor on (Switchboard) 08458 678 978 or via email to penina.shepherd@acumenbusinesslaw.co.uk

5 Comments

  1. Penina Shepherd - 24/06/2009

    Hi Penina,

    I read your piece on co-directors with some interest (seeing as we are still setting up our shareholders agreement) - but am not sure if I entirely agree with the point made. Essentially, your argument seems to assume that a shareholder director should only be in it for the current income stream, disregarding future income streams, or to maximise the current value of the company - which is not necessarily so. For example a given shareholder director may be busting a gut now in order to set up a long-lasting and profitable business, in the hoped for anticipated future stream of income from future dividends.

    I guess as a point of principle I do not see why it is unreasonable for me if I input into the building up of a profitable business to be able to continue to be a shareholder in the future even if I am no longer a director. But more than that, setting it up the way you suggest is likely to impact on incentives and on the way the business is developed. If I believe that there is some non-negligible probability that I may wish to cease being a Director at some point in the future than it is in my interests (a) to maximise the dividends we pay out while I am still a director; (b) to maximise the currrent as opposed to future value of the company - neither of these two may be optimal from the long run point of view of the company. Of course incentives cut both ways. If I stop being a director, retain my shareholding and hope to live off other people’s hard work than that may also not be sustainable. Hence one then has to think of appropriate incentive packages - which might involve some dilution of shareholding. But I do not really see, that the default position should be that any retiring director should be required to relinquish his / her shareholding.

    best,

    Michael

  2. Penina Shepherd - 24/06/2009

    Hi Michael

    What a strange coincidence. I am just writing an email to you guys about an invitation I received from SU and I was asking if you knew anything about it and whether you would be attending. I just scanned the invite for you (attached) and then I got an email from you! Brilliant!

    Firstly I am delighted that the legal tip triggers conversation & debate- that’s fantastic. More to the point though, this tip is not relevant to “investors shareholders” but to “working company directors” in most if not all of the businesses. An investor shareholder should not (and in most cases does not) get involved in the day to day running of the business and, therefore, it is neither here nor there if they leave as directors.

    The legal tip relates to most companies out there who are set up by the founders. So, for example, say Chris and I are the founders and equal shareholders of ABL. Chris would be extremely unhappy if I left to sunny LA leaving him here to deal with the running of the business (and debating legal tips ?) all on his own, but still owning 50% of this company and thus entitled to half of the dividends and any sales proceeds. My reward for contributing to the business to date will be reflected in the value of my shares when Chris buys me out on my departure. Indeed most shareholders/directors we speak to (I would say weekly- in some weeks daily) do not want to see this happening and we are always amazed how often this point is overlooked even by lawyers.

    I think I should have pointed out the difference in the article between the “investor shareholder”” and the “working director shareholder”. Indeed as I am writing this I received Peter’s email saying he agreed with Michael and then adding “Suppose I am a venture capitalist. I buy a share in a firm”- which is exactly the point. The tip is not about venture capitalists.

    Well there goes my A out of the window… ?

    Hope it makes sense.

    Please let me know if you are going along to that event (and whether you have managed to solve the riddle!)

    Warmest regards
    Penina

  3. Penina Shepherd - 24/06/2009

    Penina

    I was going to keep my head down, but we may be in a unique situation in which 3 economists have the same opinion and i wouldn’t want you to miss out on that.

    I think you leave salary out of the reckoning in your analysis. Lets say your two Directors paid them selves the going rate for managing a business of the type they own then they have been properly rewarded for their effort and at the point of the departure the value of the comapany reflects what they have each brought to the company in terms of their function as an investor say in terms of any initial cash investment, dividend income, reinvested profits plus a return to the risk they have each taken up to that point and to the value of the original concept.

    At the point of the split they each have an equal share in the capital value of the company and both have received the salary they deserve for the effort they put in - note that the higher the salary the lower the profits and dividends and/or available funds for reinvestment and hence the capital value of the firm . If they have been underpaying themselves then the capital value of the firm will be higher at the point of departure

    By not asking for his share of the capital value of the firm in cash at fair value the departing director is in effect becoming a venture capitalist. He does this by saving the remaining director the time and trouble and potential cost of raising the the funds to buy him out at fair value. He is thus exactly equivalent to any new investor the remaining director finds to take over the 50% share in the business who would be due 50% of the sale value when the company is eventually sold even if she put in no other effort.

    Note also that if the remaining working Director employs someone to replace the departing director or chooses to work twice as hard and pay herself accordingly then any dividends and the eventual capital value at disposal will reflect that.

    So as far as I can see there is nothing intrinsically unfair in the departing director keeping his 50% of the business and receiving his £1.5m on disposal. If the remaining director is underpaying herself she is a mug. I am not sure that is the fault of the departing director or that he should be penalised for that.

    All that said the case for covering these circumstances in the shareholder agreement remains.

    BTW You are essentially being invited to a graduation with the installation of the new chancellor as an added bit of flummery. We might be there if some of our students are graduating at the same ceremony.

    have a good weekend
    Jim

  4. Penina Shepherd - 24/06/2009

    Oh no I just saw Jim’s reply.

    Maybe my previous email dealt with the relevant issues? (BTW- tip did mention salary. We’re only allowed 500ish words so couldn’t go on for too long).

    I don’t want to agree to disagree- I am too fascinated by it. So either I need to get out more or we must have the chance to debate this in person! We’ll need to find an excuse to make it happen.

    Finally, we would absolutely love to put your comments on our blog- http://acumenbusinesslaw.co.uk/blog/

    Would that be OK with you?

    Penina

    (PS- the event doesn’t sound too exciting for me I guess… Maybe I’ll give it a miss)

  5. Mark Hook - 26/08/2009

    Disputes between shareholders, directors and business partners can arise for all sorts of reasons, from disagreements over the direction and development of a company to poor personal relationships. Conflicts of interest where individuals have interests in another business can also cause problems.

    Establishing what the legal position is from the outset can help SMEs identify the best course to take. The right advice helps limit the amount of time and money spent sorting out a dispute and its effects on the business.

    A company’s articles of association, coupled with a shareholders’ agreement, can cover many of the potential areas of dispute between directors and shareholders. Anticipating potential problems often means it’s less likely that things will go wrong.

Leave a Reply