Real Value of Due Diligence and Independent Advice.

The enemy within

It never ceases to amaze me how people can be so trusting when entering into a business transaction with someone they don’t know very well.

As part of small business management, it is usual when acquiring an asset that the director exercises a reasonable level of due diligence before committing to the transaction. Certainly, a high level of scrutiny is given to the purchase of such items as plant and equipment or stock. One can only wonder why a director would leap into a financial or structural change without the same degree of scepticism.

Recently, I encountered another example of a business that had been created with a potential significant time bomb lodged in the structure.

My clients were skilled construction individuals who had created a unique method of surface material application and decided to start their own business.

Lacking the acumen, advice and funding, they accidentally discussed the matter with an unknown third party, who decided to offer them start up finance. A company was duly formed and, on the advice of the accountant for the third party, a change in the constitution occurred.

This was a significant moment in the life and destiny of the business. The accountant made it clear that he was acting only in the interests of the third party investor, but for some inexplicable reason, this did not trigger a warning to the other two to seek independent advice.

As a result, a special class of shares was issued to the third party and highly restrictive voting powers imposed upon the two original shareholders. In fact, the third party forced a change to the constitution to the extent that, at any time, the third party could appoint himself as a director.

The two working directors, who had taken the majority of the business risk, were left having no real control over the company, could not seek out further or alternative funding and certainly could not complain about the management style of the third party.

Regardless of their predicament, they set about working hard in the business seven days a week; taking risky contracts with difficult time lines; employed and managed the staff; juggled cash flow; and somehow managed to repay the third party the principal and interest on time. To make matters worse, from the outset, the spouse of the third party shareholder had a registered first charge over all the assets and undertaking of the company pending receipt of the final payment of principal and interest.

Effectively, upon a minor or technical default, such as production of figures or reports, the spouse could have appointed a receiver at any time.

Eventually, the two original directors reached the end of the period of repayment and, due to the growth in the business and increasing complexity of financial management, they finally sought independent accounting advice. The accountant was surprised to find the change in voting rights and the registered charge had been orchestrated from the outset and gave the directors their first independent view of their position.

It came as a shock for them to understand that they could lose all that they worked for at any time and that, in fact, they at no stage really controlled the company.

No formal meetings were ever held and surprisingly, the third party sat back and let the principal and interest repayments come in without inquiring further.

The next stage of the relationship became critical. Now they had obtained this independent advice they were angry at the way that it had occurred, but understood all to well that now was not the time to incite an argument with the third party or his spouse as secured creditor.

Two crucial outcomes were sought:

  1.  To ensure that at the point that the loan was repaid in full, a release of charge would be provided in exchange; and
  2. At the same time, a change to the constitution would occur whereby the voting rights would become equal again.

You can well understand that they felt a little intimidated, calling a meeting to resolve the matter. On advice, they were open about the agenda for the meeting, the changes they were seeking and produced an independent valuation for the shares. They now realised that they were not guaranteed to free themselves of the existing shareholder with higher voting rights and that, as the company improved its financial position, so too did the value of the shares. The longer they waited to address the matter, the higher the exit price would become for the third party.

From an innocent first handshake discussion they had been outmanoeuvred carefully and had indeed helped create an enemy within.

The choices were:

  • Pay a premium on the shares; or
  • Liquidate the company and start again.

All the hard work could be undone in a matter of one moment of disagreement with the third party.

Thankfully, the share price reflected a very good capital gain for the third party and the element of risk for the future was enough to convince them to take a clean exit. The two original directors have learned a valuable lesson about business due diligence and they are addressing several other outstanding issues:

  • A formal shareholder’s agreement and a business succession plan, and
  • A review of their trading terms and conditions and the structure of their finance.

They have formal meetings which are recorded and copied to the accountant. The lesson is always the same: If it sounds too good to be true, it usually is.

ATC Digest Edition #75

Do You Know Your Shareholders?

You probably can’t stop disputes, but you can diffuse them more easily.

It is a critical step for a business owner to understand the implications of an agreement with the people they own the business with and the rules, should they have a dispute.

Commonly, parties confirm how a company should be managed by the terms of a Shareholder’s Agreement.  However, often I find that people do not bother with such an agreement. They feel when times are good there is less chance of an argument, or they have a perception the costs of preparing this document are too high.

The reality is that, if the parties have a dispute, the costs will be enormous.

Here are a few tips and pointers in preparing a document and understanding its importance.

Directors

  • Directors should be carefully chosen to ensure that control and daily management of the company occurs in a way that reflects the understanding of all concerned.
  • There are very serious obligations on directors, including Workplace Health and Safety liability, tax liability and Corporate Act penalties for non-compliance. This includes keeping proper accounts, acting in the interest of the company as a whole and not obtaining a benefit where there is a conflict of interest.
  • The specific roles of each director should be set out clearly, whether it is finance, accounting, marketing, legal or management of staff.
  • The degree of delegation and authority to a director, including signatures required on cheque accounts or transfer of funds from a bank, should be clearly stated. Often small companies have at least two directors that must sign for the capital account and just one director or a secretary for a smaller operational account.

Limitations

  • A Shareholder’s Agreement should describe the limitations placed on directors in acting on behalf of the company. That might be the credit limits that apply for which they can commit the company and should state the maximum debt a single director can write off or compromise. It should also state how many directors must sign cheques and other negotiable instruments or contracts.
  • The quorum or number of directors required to form a valid meeting should be clearly outlined. The ability to appoint a proxy or alternate director in writing should be described. If there is a managing director with a casting vote, then that should be very clearly enunciated within the document.
  • The role of managing director should be described sufficiently including the process and frequency of appointment.

Voting

  • The equality of votes, or otherwise, by the directors appointed to the board should be clearly stated.
  •  If there is to be a casting vote on certain issues by a managing director, or if there is a deadlock, that should be included.
  • Whether a shareholder has the right to one vote at a shareholder’s meeting or whether votes are attributable to the number of shares held, then that should be clearly stated.
  • Whether the shareholders votes are affected by restricted issues should be included and it should identify the input of a non-shareholding director in the management of the company.
  • Any Shareholder’s Agreement should be resolved in general meeting to override the constitution, when appropriate, on specific issues.
  • Points such as a full sale of the business might need a unanimous decision of shareholders, as well as the admission of new shareholders or transfer of shares.
  • The events of default of a director or shareholder, including breach of agreement, insolvency, disability or perhaps death should be dealt with.
  • The process of meetings including how regular, where and agenda decisions should be included.
  • On exit of a shareholder there should be a reference to an independent valuation and perhaps a conditional grant of options subject to the event. A notice of retirement of director and whether that triggers a compulsory sale of their shares should be considered.
  •  The methods of dispute resolution should be canvassed including compulsory mediation and whether that appointment is by way of a professional expert.

Other issues

  • In reality, this Shareholder’s Agreement will be the document that is used if the parties cannot agree. It should have a positive emphasis, including the specific vision for the company and perhaps growth targets anticipated by the shareholders within an agreed time frame if they aim to grow the business or sell within a specific period.
  • If there are specific business planning issues, targets such as achievement of quality control or accreditation, then they should be included.
  • Specific qualities of a director or financial position of a shareholder should be specified as well.
  • Requirements regarding retirement of a director or exit of a shareholder by voluntary notice should be clearly stated in writing. This should take account of the position of the company and the financial framework.
  • If the shareholders are contributing capital then they should record any loans on the balance sheet.

If the directors require further loans from working capital or stock or plant and equipment, then each director and perhaps each shareholder should guarantee the loan equally in accordance with their shareholding to make sure there is fairness between them. If there are different levels of contribution of capital loans by shareholders or directors to the company then that should be recorded in formal loan documents and interest paid.

By having a clear checklist of these issues completed by the parties at the outset, it is less likely that a surprise or a point of dispute will occur in the future.

Independent accounting and legal advice should be obtained by each shareholder on a proposed Shareholder’s Agreement to ensure that all parties understand their obligations and requirements.

At the end of the day, people get together to create company value. It is, therefore, important to ensure that the rules are understood so that that value is preserved wherever possible.

ATC Digest Edtion #85