Martin: Welcome to the business owners podcast where we throw aside taboos and share strategies for growing, protecting and exiting your business. My name is Martin Checketts and I represent Mills Oakley’s Private Advisory Team.
So hello everybody we’re now deep into Season 4 of our Podcast. Just a refresher, this season I’m interviewing some of Australia’s finest lawyers, being my partners at Mills Oakley. Now, in the Private Advisory Team looking after business owners and high net wealth individuals, we certainly have some of the answers for our clients but we don’t have all of the answers and it’s really wonderful to have a coterie of specialist partners around us who can help us with various issues and advices that are outside our direct expertise and one of those partners and with whom I particularly enjoy working is James Tobin. Welcome James.
James: Good afternoon Martin. Thanks for having me.
Martin: Not at all. So just a small introduction. James is a partner in Mills Oakley’s commercial litigation team. So James works on the dark side. There’s kind of two types of lawyers, there’s the nice guys like myself who are, we’re fun town lawyers, we get involved in giving advice, setting things up, negotiating, positive constructive kind of legal work and then we’ve got the bulldogs. (Martin laughs) We’ve got the litigation partners who come in and very effectively deal with things for our clients when things go wrong and James is my “go to” litigation partner for a range of matters but particularly where he has an awful lot of skill and experience is in shareholder disputes and unfortunately it has been a future of practice and I think our industry in the last few years that we’ve seen more and more disputes and disagreements between shareholders and, often ending up in the courts. So, yeah, James, tell us what typically goes wrong for shareholders in a business?
James: Thanks Martin, well what I tend to see and as you say, I come in on the dark side when things go wrong and things go bad and it comes to me in circumstances where you’ll have founding partners or founding shareholders of a business who will come together and they’ve invested. It might be two or three of them and for whatever reason they fall out of love with one another, things start to go wrong and they can’t progress. Now in those circumstances it might be that someone thinks that the other party in the business is doing more, they’re not doing enough, they’re not getting paid enough, there’s some inequality and this can lead to a significant breakdown in the relationship and therefore a breakdown in the business and everything comes to a grinding halt.
Martin: And thank you James and let me pick up on that because I think that is such an important point. In a closely held private business, in the minds of the business owner, your equity ownership, your shareholding if you like, it’s really linked to your executive effort. It’s linked to the sweat of your brow and you’re a shareholder generally, not because of the capital you’ve invested but because you’re one of the key people driving this business forward. But of course legally it’s quite different isn’t it? If you own shares, they’re your shares and they’re your property and they’re not in any way linked to your executive effort and I’d agree with you James that’s often a real source of tension?
James: Absolutely. You know there’s the “sweat equity” which the business providers and the shareholders put into the business which equate to it and more often than not I see that often people come together because they’ve got a great business idea and they decide to set up a business and so they go into a business. They might incorporate and they issue themselves, there might be two or three shareholders and everything gets off and going. My biggest advice as being on the dark side and advising these people when it all becomes too bad is that is the point of time at which you need to get into a shareholders agreement. There are so many benefits to a shareholders agreement. Unfortunately by reason of the fact that people think “oh we’re in a start-up mode, we don’t really want to spend money doing all this” and plus you know Fred will say “oh but I’ve been, I’ve known Johnny since we were in kindergarten together, we’re best mates, we’ve grown up together, I trust him like my brother”, well can I tell you I’ve seen a lot of family members who go into very heated disputes, costing hundreds and hundreds of thousands of dollars which could of all been avoided if a very simple shareholders agreement had been set up at inception.
Martin: Thank you James and for those who might not know, what is a shareholders agreement?
James: A shareholders agreement is really a contractual agreement between the parties, namely the shareholders which sets out various rights which those shareholders have. Typically a shareholders agreement will deal with things such as what the business is to do and what it’s not to do. So various prohibited activities. It’ll set up rights with respect to the funding arrangements, how you are to raise capital and also how you are to distribute profits, it sets up the composition of the board and the management of the company, the decision making powers and obviously with the decision making powers, in circumstances where often you have only two shareholders, you get into a deadlock and you need to have, well does it need to have both shareholders agree unanimously in order to pass a decision, etc. And so in those circumstances if there’s two or sometimes if there’s three shareholders you might have two against one. Does it need to be a unanimous decision or does it have to be a majority decision? But more often than not, the two biggest areas come down to dispute resolution issues. So if there is a deadlock, if something happens, how do you break that deadlock and the other issue is the exit of the business. If for example, one partner or shareholder for whatever reason decides “I don’t want to do this any longer”, or “he’s not pulling his weight”, how do you get rid of that shareholder? Because the reality is, you can’t be forced to buyout your shares unless you are taken to court for an action by reason of a oppression of a minority shareholder action or where someone seeks to wind up the company on the grounds that it’s just and equitable to do so. But in order to succeed in either of those two actions you need to show that there is some catalyst or something which has been, some form of prohibited conduct or oppressive conduct which has caused you to go to court. And can I say, as a litigator, as I always say, prevention is fair cheaper than cure and that is the whole benefit of a shareholders agreement. You have a structured agreement between, which is agreed between the parties as to what is going to happen in certain circumstances and it can touch on things like in the event that one of the shareholders dies or one of them becomes incapacitated, what do you do with the shares? How do you deal with them? How do you value them? If you want to raise capital, how do you raise those things? So if I had a dollar for every time I had to give advice on shareholders agreements, where the lack of shareholders agreement has caused a huge dispute, I’d be a very wealthy man. Unfortunately, as I say, it comes down to sometimes you have these start-ups and people think “oh no, we don’t want to spend money on that but that’s not something we’ve got money to spend on” but all of a sudden sometimes you see these businesses go very fast and increase in significant value and then you’ve got a really big value asset and these shares but as I say, sometimes people fall out of love and they, the relationship breaks down and it’s how you deal with that can cost you hundreds and hundreds of thousands of dollars if you have to end up in the courts. So for the cost of a simple shareholders agreement which can be anywhere from $5-10,000, now I would say that a shareholders agreement is an investment and you invest in the company so that you have a clear direction, you have a clear plan and strategy as to what occurs in certain circumstances. In the absence of spending that $5-10,000 you get to situations whereby you’re 12-18 months into it, the business is going well, there’s significant value but for whatever reason, you don’t want to be in business together, you can’t make decisions together, you’ve had a significant breakdown in relationship and you end up in a deadlock dispute. Where do you go with that? You have to engage lawyers, you end up threating oppression of minority shareholder dispute, conduct or proceedings and/or you want to wind up the company and start again and you lose all the value in it and you pay lawyers tens if not hundreds of thousands of dollars which could have all been avoided if you’d taken that very simple step of entering into a shareholders agreement.
Martin: Absolutely, James and, and look I, I don’t have any hard data on this but I would guesstimate that probably for every $1 of legal fees that are spent on shareholders agreements I reckon, you know $10 or even more would be spent on litigating these matters at the back end, and that’s perfectly demonstrated in Mills Oakley’s practice where the largest team by quite some measure is the commercial litigation team. Just to pick up on one thing you said James and I think it’s so important and it’s not well understood, without a shareholders agreement you have no right to buyout your partner and you have no right to sell out your shares and we often see clients and they come in and things aren’t going well and they say well it’s ok I’ll just buy the other one out but of course they can’t do it, they have no legal lever to make that happen. So what almost inevitably happens is that the majority shareholder has to sweeten the pot to take out the minority and they often end up in their minds and eyes at least, over paying, and sometimes by a significant margin because they have no other mechanism to make that transaction happen. So, say if I was a major shareholder in a company James and I kind of came to you, maybe I own 80%, my co-shareholder owns 20% and he or she just isn’t performing, you know, I’m working 12 hours a day, 6 days a week. My co-shareholder is cruising along and taking a very handsome dividend out of this growing company and say if I haven’t got a shareholders agreement, what do I do?
James: Well that, that poses the problem and can I just make this clear distinction at this point Martin, because I think it’s highly relevant and that is that in order to incorporate a business you need to have a company and in order to do that you need to have a constitution but the constitution is not a shareholders agreement.
Martin: Yes. (Martin laughs)
James: It’s very different and the constitution is there because you’re required to have one under the Corporations Act and the Corporations Act causes that constitution to govern things such as the management and it provides certain rules over the business and the company and how you do things but the difference with a shareholders agreement is that that shareholders agreement defines your, firstly its contractual agreement, there’s no compulsion to enter into it, you don’t have to have one to enter into a company. However it’s there as the pre-emptive rights of the shareholders and to protect their rights and interest and to give some definition as to what is going to happen in the event of certain circumstances. So if I’m the majority shareholder and I’ve got 80% of shares and my minority shareholder, a 20% shareholder is not performing. Now you try and, if you don’t have employment contracts or some sort of contract which sets out what the role of that other shareholder is, then you have to start effectively asking the other shareholder to perform. You might need to start writing letters of demand and saying well this was our, if we do have a shareholders agreement, hopefully it’s all set out, this is your defined role, this is my defined role and in those circumstances you’re failing to perform and you can always ask that they transfer their shares and you buy them out at a certain value if you’ve got a shareholders agreement. Hopefully that value of what those shares and how they are to be determined will be set out so that you can understand how that can be simply done but in the absence of a shareholders agreement, what do you do? You can’t force them to sell their shares.
Martin: So, I’ve got an idea, I mean I could just like top up my salary, right? I mean they’re not working in the business so I’d say if I pay myself $100 I could just increase that to say $300 strip all the dough out that way and starve them of the dividends?
James: You could certainly do that but that’s certainly going to raise the eye of the minority shareholder who no doubt would go off to his lawyer and say “this guys just increased his salary from $100 to $300,000” and where we’re going now is you’re committing what is oppressive conduct in those circumstances, or allegedly oppressive conduct in the circumstances of the minority shareholder and that minority shareholder’s saying “that’s not fair you’re effectively doing that so you’re diluting any profits in the business, you’re getting the benefit of that extra $200,000, there’s no profits left to distribute so I, I’m being totally cheated in these circumstances.” So, that forces you to a head as to “ok, either I’m going to buy you out or you’re going to buy me out or we come to some other resolution, i.e. we get another shareholder in there to stop any deadlocks”. But that’s where things really start to, you start to force the hands and someone’s going to, normally, in those circumstances be the oppressed party, the minority shareholder will issue demands and threaten to issue oppressive conduct proceedings in either the Supreme or Federal Court.
Martin: Yeah. So, because there’s a lot that you can do isn’t there if you’re the minority, the allegedly oppressed minority because even though there’s no shareholders agreement, that shareholder has got all kinds of rights under the Corporations Act haven’t they and in my experience they can make life quite difficult for the major shareholder. Could you talk a little bit about that James? What do minority shareholders tend to do in this type of scenario?
James: So, yeah, in these sorts of scenarios they’ll go and engage a lawyer and then they’ll threaten that they’ve been oppressed and that if they don’t rectify that oppression by, for example, dropping your salary back down to $100,000 from $300,000 they’ll issue proceedings. Now, what does a court do, what is the remedy which you seek when you issue those proceedings? The remedy which a minority shareholder in those circumstances will be seeking, there’s really two. One is that he is bought out at fair value, for his shares and in order to do that obviously you need to have the company valued. Now if there’s no shareholders agreement which doesn’t determine what the value of those shares are, you’ll need to engage a, an accountant or forensic expert to literally value the company. Now if it’s a simple business, that’s probably not going to be too much but I recently did a, a valuation of a business which incorporated three different companies. That valuation cost $40,000, not an insignificant sum and so that can be very, very expensive but with the benefit of that valuation you can then make an informed decision and say to the minority shareholder “Ok, your 20% is worth ‘x’ amount and we’ll buy you out for that amount”. If you aren’t prepared to pay out that amount the minority shareholder may seek either the court enforces you to buy them out or secondly if you’re not prepared to do that, the other alternative is that they seek to wind up the company and that is that the business be wound up on the grounds that it’s just and equitable to do so. Now there’s numerous authorities cited whereby a court will find that it’s just and equitable to do so if there is such a breakdown in communication and a breakdown in the relationship between the shareholders so that they can’t govern the business correctly and that happens where there is a lack of communication, there’s lack of directors meetings, lack of shareholders meetings and literally you cannot move and cannot function in a way which is conducive to conducting good business and in those circumstances and they’re very rare circumstances and exceptional circumstances, will a court then order that the company is wound up and placed into liquidation and a liquidator is appointed to sell off the assets, satisfy any creditors which are there, you’ll each get what the value is left and, but you basically destroy your business. You destroy your business you spent a lot of money on a liquidator and lawyers and that is the worst possible outcome for everyone involved. So ideally what you want to try and do is come to a negotiated position as to whether you want to buy someone out or they want to buy you out and you overcome that deadlock.
Martin: Mmm…there’s a real lesson here I think about swallowing your pride and making concessions early to do a deal. From what I’ve seen of these situations, often the relationship between the parties is very bad, it might have festered for years and years and they don’t want to concede because they’re right. You know, they’re being oppressed or they’re not an oppressor and the other one is lazy etc, etc. But I think James you’ve illustrated so well it doesn’t take long for those fees to rack up does it and if we get into this dreadful scenario of winding up the company everyone loses, without a doubt. So that would be my advice to clients in this situation you’ve sometimes got to see the big picture and make, make some concessions. We’ve spoken a lot about the financial cost of litigation, what about some of the other costs James because these processes can go on for years right?
James: Yes, quite literally. There is certainly a significant ancillary cost to litigation and that is the stress associated with it on individuals. When you need to go into issuing a proceedings you need to file in this sort of proceedings, you need to file affidavits. That requires you to come in, sit down with me, I’d take a detailed proof of evidence from you, prepare affidavits. This means hours and hours and days and days which you are not in your workplace, you’re not focusing on your core business you’re focusing on things which are not within your core business and it just becomes a huge expense and so there’s the opportunity costs lost where you could be spending that time on your business and growing your business, you’re actually spending on a negative on the dark side with me in spending all those fees in the effort to try and come to some resolution and agreement. Can I say for all of those reasons when you do get into issuing court proceedings there is a compulsory mediation process in almost every jurisdiction in Australia now, certainly in Victoria you are and there is a, recently been a practice note with respect to the Supreme Court oppression proceedings whereby what used to occur is you would issue an affidavit setting out all the alleged oppressive conduct and you’d detail that in often hundreds of pages of affidavits. Now the court has recognised that the reality is that 95 out of 100 of these cases will never actually go to court and be determined by a judge. So they’ve limited the scope of those affidavits quite significantly down to 6 pages and they’ve said we’re going to limit it down to that because we see that, you know, we don’t want you to do all this hard work up the front and then it all just gets wasted because you resolve it ultimately. Let’s get the key issues up front, we’ll go and then have, the matter, the business, they will order the business to be valued and then they’ll order it off to a mediation. But even in those now the courts can appreciate that the majority of these cases do not resolve through a court determination you still have to prepare those affidavits. You still have to then engage a valuer. Now and that valuer either needs to be either agreed between the parties and if you can’t agree then the court determines who does. But there’s significant costs associated with that. Then you need to get a barrister to draw your pleadings. Then you need to attend the mediation. All of that, there’s no short change out of $50,000. Absolute bare minimum of $50,000 and that’s on the best possible case scenario. I’ve been engaged with shareholder disputes which have gone for 12 and 18 months where clients have spent upwards of $400,000 to $500,000 without going to final hearing. Because of the information involved and the amount of details and the like. Now these are involved in businesses which have got significant value but unfortunately, for whatever reason, the majority shareholder has spent $400,000 – $500,000 of actual legal fees, let alone you think of the opportunity costs that have been wasted in spending all that time and all that money out of the office which could have been spent in growing the business and focusing on what he’s good at. And that is, whatever the business model and whatever the product or service of the business is, as opposed to, you know, wasting money in litigation which is not a skill.
Martin: Wow. Well I mean that’s, yeah, that’s so powerful James and I’ve seen that myself many times as well. It’s just not a happy outcome. I guess on a more positive note to finish off with and thank you so much for your insights today. Clearly the message about a shareholders agreement is a very powerful one. Is there anything else that co-owners of businesses can do to protect against these risks?
James: Look I would just reinforce what I said about the shareholders agreement. If they, you know, as I say, Johnny says “Oh but Freddy is my best mate and I’ve known him since we were in kindergarten”. Well then in those circumstances it shouldn’t be hard to negotiate a shareholders agreement. You should say “right well we get along so well let’s just knuckle down and do it.” Now you can get, as I say, you don’t have to get the Rolls Royce of shareholders agreements. But you just decide on those key factors, such as the ones I’ve discussed and it doesn’t have to be war and peace. It can be quite a simplistic document but it just gives you that certainty at the end. So, that is, as I say, Martin if I had a $1 for every time I’ve said to a client “where’s your shareholders agreement?” “Oh we were going to do it but we just, oh we’re best mates and I’d never sue him” and it just turns into a disaster. So, that is the absolute front of mind and first thing you can do. I mean the reality or the other thing is, as to avoid these sorts of disputes and that is well be fair, be transparent, don’t do things which are going to upset your colleague, like paying yourself $300,000 when you were being paid $100,000 the year before. All those, you know, common sense business things which if it’s going to raise a red flag to your co-shareholder, well you would probably want to get some advice or discuss it rather than doing it behind his back or him finding out afterwards. So just common sense things like that are really the key.
Martin: That’s great advice James thank you. And I’d agree with all of that and particularly the shareholder agreement. Even if you don’t get the agreement that you would ideally want, make some compromises, negotiate something because you just need a rule book. And with a rule book you may still have a dispute but it’s going to really narrow and minimise the scope and the impact of that dispute.
So James I very very much appreciate you coming in and speaking with everybody today. Thank you.
James: Great thank you Martin.