Many small businesses come into being by two people combining their skills and expertise. Taking one person’s ideas and complementing that with another person’s hands-on approach can quickly turn a small business into a budding enterprise. And very often, companies like this allocate an equal number of shares for each business partner, creating a 50/50 division of ownership. Unfortunately, unless this division of shares is carefully governed, many growing companies may find that they soon run into trouble.

Shareholders Agreements are a primary tool for charting the future of your company and establishing key internal processes. Below we set out three important features of Shareholders Agreements and how they help prevent conflicts.

Pre-Emptive Rights:

As a starting point, it is important to note that the Companies Act 1993 (“the Act”) does not provide for the right of one business partner to buy out the other (called “pre-emptive rights”) in the event that the other partner wishes to sell their 50% stake. This becomes a problem for two reasons. Firstly, a 50% shareholder will want a right to purchase the departing shareholder’s interest rather than end up in business with a stranger. Secondly, if you want to sell your shareholding you want to have a process for the eventual sale of the business. If you do nothing you risk being either in business with a stranger or if your business partner will not agree to sell the business you will need to apply for a court order at prohibitive cost.

Shareholders Agreements typically provide for pre-emptive rights as a means to ensure that one business partner can continue the business on their own after the former partner decides to leave. They can be triggered when a voluntary sale of shares is requested (as above) as well as where one partner “defaults” under a Shareholders Agreement, such as where a partner becomes insolvent. A further issue can be determining the price set for the exiting partner’s shares, and where the partners cannot agree, the Shareholders Agreement can provide for a process of independent valuation.

Day to Day Management:

The day to day management of the company can also be prescribed in a Shareholders Agreement. Besides allocating particular duties and responsibilities of the directors (assuming each shareholder appoints their own director), the Shareholders Agreement may also limit the decision-making powers of the directors by requiring particular decisions to be approved by all shareholders. This way, the shareholders may decide, up front, what decisions will always require the approval of all shareholders, which can be especially useful when shares are issued in the future and the 50/50 division no longer applies.

Material Deadlock:

Nevertheless, deadlock can also arise where the shareholders fail to agree on a matter that requires both of them to agree and where the failure to agree is hindering the company from carrying on its business. This is where formal dispute resolution procedures should be considered (such as negotiation, mediation and arbitration). In addition, a buy-out option can become part of this process so as to enable the disputing parties to either sell their shares or buy-out the other partner.

There is a wide ranging diversity of small businesses in New Zealand and so it is important that a Shareholders Agreement is tailored to each particular company’s needs. Generally speaking, the more prescriptive a Shareholders Agreement is, the better, as working out all the fine details while the business is still in its infancy can help alleviate future concerns that may arise as the company grows.

This post was published in the FMCG Business magazine.