Could informal arrangements put your growing business at risk?

Our common experience in advising early stage businesses is there that there is often a level of informality and a lack of documentation.  This is understandable as any differences of opinion are usually resolved amicably, due to the closeness of the relationship, or the small nature of the business.  However, this lack of corporate governance can give rise to problems and disputes as the company develops and grows or as the original key people move on.

The common law is not well adapted to dealing with a breakdown in a long-standing business relationship and unfortunately, the lack of proper documentation (such as a Shareholders Agreement or ‘SHA’) can  lead to time consuming and expensive litigation.

‘Internecine warfare at its worst’ ¹

Nellbar v Jones Partners is a recent case in point: the business involved was conducted through a ‘myriad of companies’ within a complex corporate structure, but conducted with a very informal approach.  After a death in the family, interests were passed onto the deceased’s children, who wished to separate the businesses within the existing structure.

The mechanics of this separation became contentious, with negotiations proving fruitless and leading to five years of costly and time consuming legal action.

Two possible common law outcomes were considered by Sanderson M:

1. the possible buy-out of Nellbar; or
2. Nellbar would file a consent of a liquidator, where all companies would be placed into liquidation, possibly resulting in the liquidation of a highly profitable company,

described by Counsel for the defence as the ‘Armageddon Scenario’  ².

Sanderson M made orders for outcome (1), a buyout of Nellbar.

Growing pains

If your business is quickly outgrowing its current corporate structure, there are a couple of key structural considerations to keep in mind:

1. Corporate governance
   The board of the company is ultimately responsible (and personally liable) for actions and decisions made, and more robust governance practices would assist in guiding the company’s behaviour and improving the overall company performance.  Conducting a review of the company’s corporate governance will facilitate effective management, which is likely to have an impact on the long-term success of the company.
2. Shareholders Agreement – An alternative to Armageddon
   A shareholders’ agreement (SHA) is put in place to establish transparent relationships between members within the business, by providing clarity in regard to how the business operates and what happens if a dispute arises.  A well drafted SHA will usually deal with a whole range of matters, including the total breakdown of a commercial relationship between venturers.  If done well, an SHA can save large amounts of time and money in case of a breakdown in the relationship, as well as allowing disputes to be kept confidential. Having an effective SHA is vital for private companies as it sets out a pre-determined framework, addressing common situations where conflict may occur.

Takeaways

If conflict arises and there is a lack of corporate governance and/or no SHA in place, this can often place significant cost and damage on the business. There is no ‘one size fits all’ solution to these considerations and each aspect needs to be tailored to suit the specific circumstances of the company.

Through incorporating good corporate governance and a SHA into an early stage company, parties will reduce (or hopefully eliminate) the need for expensive and time-consuming court proceedings, should there be any questions as to the management of the company or a breakdown of relationship.

Keypoint Law has considerable expertise in advising on all aspects of corporate relationships, including governance and SHAs.

1 Nellbar Pty Ltd v Jones Partners Pty Ltd [2018] WASC 292 [1].

2 Nellbar Pty Ltd v Jones Partners Pty Ltd [2018] WASC 292 [23].