Guide

Setting up a business: the legal considerations

Gateley Legal

Article by

Setting up a business can be a complex process, especially when regulating arrangements between shareholders. In this podcast we sit down with Leigh Whittaker and Sandip Khroud, from our Corporate team at Gateley Legal, to explain the essential building blocks to set up your business.

In this episode:

  • How to regulate arrangements between shareholders
  • The types of documentation required
  • An overview of shareholders' agreements
  • Documentation requirements for majority and minority shareholders
  • How to approach two equal parties both looking to invest in a business
  • Top tips for anyone wanting to set up a business

Subscribe to the podcast series

This episode is part of our straight talking business success podcast series. Learn more about the series and what we cover. This podcast is available on iTunes, Spotify and Soundcloud.

Read the transcript:

Host: Welcome to straight talking business success, your guide to growing and developing your business. Today I'm joined by Leigh Whittaker, Senior Associate in our Corporate team at Gateley Legal, as well as Sandip Khroud, Partner in our Corporate team at Gateley Legal. We're going to be discussing setting up a business. In particular we're going to be looking at regulating arrangements between shareholders. When you're setting up a business, why do you need to regulate those arrangements between shareholders?

Sandip: So it's to document the relationship between the parties and ensure that they have a set criteria of how to run that business going forwards. It's also helpful in ensuring that if there is a dispute between the parties, that they can regulate it subject to the terms that they've agreed.

Leigh: Yeah, I think that's right. And I think as well, by having that discussion right at the outset and getting those issues on the table from from day one, it helps to focus everybody's attention in their minds on the issues at hand.

Host: Okay. So we have talked about documenting this. What are the main types of documents that are used?

Leigh: Yeah. So I think the two key documents really are the articles of association, and the shareholders agreement. The first thing to point out I guess is that there is no requirement for a company to have a shareholders agreement. It's a discretionary contract between the parties. There is however a requirement for every company to have a set of articles of association, and if a company doesn't have any bespoke or tailored articles of association, then the standard articles of association will apply to that company.

Leigh: In terms of the differences between the two, the articles are the internal rules of the company, and they set out the company's constitution. It's a contract between the shareholders and the company and it regulates the relationship between the two. And very importantly, and as is not the case with the shareholders agreement, the articles of association automatically apply to any shareholder in the company.

Leigh: So there isn't a requirement for that person to agree or adhere to be bound by the rules that are in the articles of association. In terms of what they cover, typically it's matters concerning the parties in their capacity as shareholders. So things like voting rights, the right to receive dividends, the right to receive proceeds on a sale. And again, one of the key differences to a shareholders agreement, is that the articles of association is a public document. So it's filed at Company's House and is available to be inspected by anybody at any time. And for that reason that often dictates the content of the articles of association.

Host: And the other document that you mentioned is the shareholders agreement. Sandip. Could you tell us a little bit more about that?

Sandip: The shareholder's agreement is a private contract between shareholders and its contents are private between those parties and very flexible. So whatever you want to put in them, you can, and they are not open to the public so that if you want certain elements of your business to remain confidential and secret, this is a document that you would use to insert that detail. I mean, each shareholder agreement largely follows the same process and the same sort of mechanisms, but very different for each business and can be completely tailored to your needs. And unlike the articles, the shareholders agreement is only binding between the parties that sign up to that document. And so if any new shareholders do join, if they haven't signed up to that document, they're not bound by it. And any other the shareholders that are not signed up to that document art by and by, but there clearly is an option for people to be bound by that document after the event.

Host: Okay. When drafting these documents, what factors determine the type of content that's included?

Sandip: So I think it depends on whether there's going to be majority shareholder involved. There's going to be a number of minority shareholders. There's going to be equal number of shareholders. I think it just depends on the nature of the relationship between the individuals. So let's say for example, if you were setting up a brand new entity, and there were three individuals all come up with an idea together, you would all ensure that that relationship is fair between those parties. If you have a shareholder who's come up with a great business idea, but he needs investment from three or four other investors, who are not really going to contribute to the day to day business but are going to be investing money in that business, then the relationship between those parties then, is going to be completely different and it's going to be documented as such.

Sandip: So effectively you could have, in that example, silent partners who are investing money and just wanting to make sure that their investments being protected. And then you can also have joint ventures where you have different entities that are working towards an aim, such as a project. Let's say in a building company they're looking to build a hotel. They will all enter into that arrangement with a view to providing either cash or staff or ideas and there'll be regulated in that way.

Leigh: Yeah, and I think in that situation as well, the document would look very different because the interested parties would have different interests ultimately. Using Sandip's example, in a situation where you've got a couple of shareholders who all have very similar economic rights. The economic rights attaching to the shares is going to be fairly straight forward. They're going to be more concerned probably in the regulations that deal with running the business on a day to day basis. In relation to a business that's more project based, I think the parties would be more interested in regulating the return of proceeds from a sale, rather than things like the day to day management of the business.

Host: Excellent. So on shareholder agreements it would be really useful if you could outline some of the key clauses that are included.

Leigh: So the key provisions of a shareholders' agreement. Firstly, it will deal with regulating the internal structure of the company. So that would mean the composition of the board, who makes up the board of directors, how often they meet for board meetings and how many directors need to approve a board resolution in order for it to be passed. It would also deal with what we often call reserved matters. So these are matters that require the consent of the shareholders in order for the company to carry them out. And again, depending on the balance of power amongst the parties, would often dictate what percentage of shareholder approval you would need to carry out those reserved matters.

Leigh: But often it's anywhere between a shareholder majority to the unanimous consent of the shareholders. And the reserve matters typically cover a range of items from more constitutional issues, such as issuing new shares or amending the articles of association, to more day to day trading matters, such as entering into large contracts or long-term contracts, or varying the remuneration of the management team. The key thing really, for the reserve matters, is to make sure that they're set at the right level so that the business can continue to operate unimpeded, whilst giving the shareholders the restrictions and the ability to veto certain rights of the company.

Leigh: Another key clause for shareholders agreements would be restrictive convenance. So this would prevent the shareholders of the company from competing with the business, and ensuring that the value remains as much as possible within the company itself. And then finally provision of information. So, if you're a shareholder in a company who's not necessarily a director on the board, or involved in the day to day management of the business, then it would be reasonable for you to expect certain information rights in respect of that company. So you'd expect to be able to receive regular accounting or financial information. If you are a director to receive notice to board meetings. If you're not, you might want to receive copies of minutes from those board meetings. But all just information that allow you to monitor the shareholding and the investment that you've got in the company.

Host: That's really useful. So what about the articles of association? What would be included here?

Sandip: I mean the articles of association, you'd generally find that you have similar clauses in both documents, so there often is some overlap. But generally in articles you would find that they would be there would describe the rights attached to the share. So for example, if dividends are to be paired once a year, twice a year, three times a year, if it's to be determined by the directors, or if it's to be determined by the shareholders at the time. It would also determine how you would deal with capital, for example on an exit. So if you were to... If each of the shareholders were going to get a pro rata or entitlement to any exit proceeds on the sale, if it's weighted towards one shareholder over another. It would also determine whether your shares are voting or non-voting potentially. So certain investors may be investing cash but not really wanting to have, or have been offered to have, the share in that a say in that business going forwards. So it would determine those individual rights as well.

Host: So staying on articles of association for a moment, would there be any specific provision in there about transferring shares?

Leigh: Yeah, typically there would be quite a large part often, of articles of association, regulates. If you would like to transfer shares, how those shares are to be transferred. And also the situations in which you might be forced to transfer your shares. A key point to make, I think, is that if the articles are silent on transfer of shares, then there's, firstly, no obligation on anybody to offer the shares that they want to transfer to the other shareholders of the company. They'd be free to transfer them to whoever they want. But also there would be no requirements for them to transfer their shares in any situation. So if for example, an individual ceased to be a manager or an employee of a company, and they were also a shareholder, in such a situation, there'd be no obligation on that shareholder to transfer the shares that they hold to the existing shareholders of the company.

Leigh: What you do often find though in articles of association are specific rights that deal with transferring shares. So one of the key provisions that you often see is preemption rights. And what these provisions outline is that in a situation where a shareholder wants to transfer shares that they hold in a company, that they are obliged to first offer those shares to the other shareholders of the company, before they transfer them externally outside the shareholder group to a third party. And the rationale for that is to ensure that the shares in a company remain within the existing shareholder group.

Leigh: There are also often provisions in the articles of association that look to circumvent the preemption rights. So in certain situations a shareholder might want to have the ability to transfer shares that they hold to certain specified individuals. So for example, an individual might want to transfer shares to their spouse or to a member of their family for tax reasons. And similarly a corporate shareholder might want to transfer the shares that it holds to another member of its corporate group to aid a reorganisation.

Sandip: And then you would also have potential compulsive transfer provisions within the articles, which are there to protect the other shareholders and the organisation. For example, where an employee shareholder has left the business and you want to then use those shares to incentivise another employee. And also in the circumstances where you don't want that individual to reap the benefit of other shareholders work, or other employees work when they've left that business. So the provisions in the articles would force them to sell their shares when they leave. And it's not necessary that they would have to sell their shares at that moment in time, but sometimes the value of the shares just freezes at that moment in time. And so then obviously that's then determined between the parties as to how they want to organise that. There's also protections for minorities and majorities to ensure that if there is a transfer within that shareholder group, that a majority isn't then held to ransom by a minority by not being able to sell 100% of the shares.

Sandip: So for example, a 90% shareholder, had an offer for a sale for the whole of the company, but a 10% shareholder was just being restrictive and didn't want to sell. You often have drag along rights within the articles that would force that shareholder to sell their shares as well. That minority shareholder would still then get the same price as the majority shareholder, but just for its minority share. So it's not really any disadvantage. And obviously in these obligations and within the articles that are agreed in advance, so it's not as if these are sprung onto minority shareholders at a time of a sale.

Sandip: Then so the opposite right for that is a tag along right, where a minority shareholder can tag along to a sale. So let's say for example, the 90% shareholder had arranged a deal where he was selling his shares only and was leaving that 10% shareholder behind, that 10% shareholder would be vulnerable at that point because his 10% shares may not be that valuable in isolation. But as a group, 100% of those shares would be more valuable. And so the tag along rights allows that minority shareholder to tag themselves on to that same transaction.

Host: In those documents, what sorts of things are you likely to be more focused on if you are either a majority or minority shareholder?

Sandip: So as a majority shareholder, the kind of matters that you would be thinking about when you're drafting these documents would essentially fall back onto control. So you'd want to make sure that a minority shareholder can't block an exit, if it's fair on all the parties. You'd also want to make sure that a minority or any investor in fact is not going to set up in competition with you after they've left the business. So you'd have restrictive convenance within that agreement, as we've discussed. You'd also need to make sure that if any employee shareholders left the business that holds a minority stake, also has an obligation to sell their shares, if that majority shareholder wants them to do that. You'd also wants to make sure that any shareholder that's leaving the business keeps the information that keeps the value in that business confidential, to ensure that any trade secrets or any accounting information that might be important to someone else, or that might be useful to someone else say of a similar business or setting up in competition with that business, that they can't use that then going forwards.

Leigh: Yeah. For a minority shareholder, I think the key concern is to ensure that they have rights of veto over certain actions of the company. So we talked earlier about reserve matters in the shareholders agreement and there are a few key areas of those reserve matters that will be very, very relevant for a minority shareholder. That's going to centre more around the constitutional rights of the company rather than the day to day trading matters. So a minority shareholder will be quite keen to ensure that things that are going to affect the value of the shares that they hold, aren't done without their consent. So things like issuing new shares in the company, which would dilute their shareholding. Or amending or adopting new articles of association, which would affect the rights that their shares are entitled to. All of these things are going to be key for them in ensuring that they're not unfairly prejudiced.

Leigh: Another key concern of a minority shareholder would be to ensure that they have the benefit of tag along rights, which we talked about earlier. So that would ensure that in the event of a sale of a majority of the shares, they're able to also participate in that sale, and sell the shares that they hold to the proposed purchaser. And again, what that means is that they're not left behind as a shareholder in a company with new shareholders, that they weren't originally envisaging and potentially putting them in a more vulnerable position.

Leigh: The final minority shareholder protection, I think you'd be looking for, again, depending on the level of involvement that you have in the business would be a right to receive information in respect to the business. So if you're a director or a member of the management team, you're likely to be privy to certain financial and other trading information relating to the business. But if you're not, if you're a silent shareholder who doesn't participate in the day to day operation of the business, then you're going to want to ensure that you're receiving regular financial information to monitor the shareholding that you've got.

Host: Excellent. Okay, so we talked about majority and minority shareholders. What happens if we had two equal parties who both wanted to give consent on their declarations of business?

Sandip: I think quite often we do get approached by, for instance, two individuals that want to set up in business together and they want to split the profits and all the decision making 50/50. Which is fine. It's usually people that have known each other for awhile and they've thought of an idea together and they want to progress that together. They want it to be completely fair and to start off from that fair position, people often want the shareholding to be split equally as well, and therefore the profits of the business should it make any profits going forwards.

Sandip: But the problem lies there, is when those parties potentially could fall out at some point in the future. And so within those documents we then have to determine what happens if those parties do fall out. And it doesn't have to be a serious fall out. It could be a decision on a senior recruit. It could be the direction of the business. It could be that one of the shareholders, or the directors, just stops attending the meetings and the other shareholders left with a business that they can't run because of the way the documents are set out, and the way that business was first envisaged to be run was that both of them had to be there to make any decisions. So within those documents, we have to ensure that there is provision within there and mechanisms within there to enable them to resolve moving that business forwards.

Leigh: And part of our role in advising the shareholders is to make suggestions to them as to how those disputes or disagreements can be resolved. The options available to them could be anything from attending a mediation session with an independent mediator, or instructing an expert to determine an issue at hand. And if the issue can't be resolved, a more drastic solution might be to provide for one party to have the ability to buy the other party out. Or even in a very extreme circumstance, just call it all quits and wind the company up.

Host: Brilliant. So we talked about the different ways that these documents can be drafted and what needs to be considered. What happens then once they are signed?

Sandip: Ideally nothing. You don't really want to have a look at them again, but people quite often do, but it's only when there's a problem. And so 90% of people will draft them with the knowledge of knowing that if there is a problem, they know how to resolve it, and they can resolve it amicably and subject to the agreement that they set out at the very beginning. Sometimes you can set out a shareholders' agreement and details within the articles, but you don't actually have to look at them ever again. If you have a disagreement, as long as the parties agree between them, the course of action, you can just continue with that course of action. But if there is a serious dispute and people are falling out and they can't agree a way forward, if there is a disagreement, then that's when you would get these documents out.

Leigh: Yeah, and that's why I think as well it's really important that the documents are entered into quite early on in the relationship between the parties, when everybody is friendly and rational and willing to agree a way forward in such a dispute situation. Because quite often trying to then put in place an agreement later down the line, when perhaps the dispute has already started to move on, is more difficult.

Host: Okay. So to finish, what are your top tips for anyone who's wanting to start up a business?

Sandip: I think top tips would be ensure that between you, or the people that are setting it up, you have understood exactly what people's roles and responsibilities are, the direction of that business and what it's going to look like now and in the future. Make sure all of your business aspirations match so that you know that you're going to work well together. And then come and see one of us and make sure you document all of that so we can ensure that if there is any disputes in the future, that they will be dealt with amicably and in line with your agreement when you're all friends.

Host: Thank you for listening to Straight Talking Business Success. To find out more about the series, please visit Gateleyplc.com/businesssuccess. From here, you can subscribe for updates, meet our speakers, and get more information on all of the topics that we've covered.

SubscribeHide

Forward thinking insight

Direct to your email inbox

Subscribe now