MARTIN O'NEILL
Seasoned entrepreneurs should not have any unwanted surprises in the company constitution. For those newer to business or who don’t get good advice, it’s not difficult to make some assumptions about the balance of power in a “standard company” that don’t ring true in practice.
Private limited companies are the most popular vehicle for UK entrepreneurs, and every such company must by law have articles of association. They form the basic constitution of the company with key rules on decision making and governance, for both shareholders and directors. Unless specific tailored articles are adopted, the company can be incorporated with the set of default articles that the law provides.
These standard terms do provide mechanisms to allow shareholders and directors to decide on matters affecting the business, but they provide some basic propositions for the balance of power, which may not be appropriate for your new company.
The rules can be modified by adopting the default articles with some amendments, or by framing an altogether more customised set of articles. With either approach you also have the option of entering into a Shareholders’ Agreement. These agreements, unlike articles of association, are not required by law. They also differ from the articles in that they are private documents that do not require to be filed on the public register.
Answering some key questions will allow you to decide upon the extent to which you are happy to rely on the law’s default provisions, with little or no modification. Customised articles may be more appropriate, and a Shareholders’ Agreement may also be desirable.
By way of example you may want to provide that in certain circumstances a shareholder should be forced to sell their shares. The default articles do not allow shareholders to force another to sell, nor do they provide for a party who wants out to force others to purchase his/her shares. The right of a forced sale could apply if for example the relevant shareholder had been removed as a director or employee of the company. Consideration also needs to be given to what happens if one shareholder would actively like to sell his/her shares. It will usually be desirable that any such shares must firstly be offered for sale to those shareholders who will remain with the company. The parties need to be mindful of what may happen if the remaining shareholders can’t afford to pay for them at market value. They also want to consider in what circumstances the remaining shareholders should not be obliged to pay a full market value for them.
Another illustration of the potential unsuitability of the law’s default provisions relates to the rights of a minority shareholder. You might think that someone with a 20% stake in the new company would have a reasonable amount of power at shareholder level. The default provisions however do not in fact afford much protection to such a shareholder, who can be outvoted on crucial business decisions unless provisions are introduced to protect that minority shareholder.
A shareholder who has a seat on the board along with 2 co directors may similarly be assumed to have sufficient rights at board level to ensure matters require his/her approval. In the absence of providing to the contrary however, the basic legal position is that majority rules at board level, and that director can easily be outvoted.
Considering these key questions around the balance of power and potential exit of shareholders will go some way to helping you decide what rules you want for your new company, and the extent to which you can rely on standard provisions. Well crafted rules can’t prevent fall outs altogether, but they can act as a deterrent, and can mean a lot less turbulence in more difficult times.
Martin O’Neill holds a Masters Degree in IT Law and is a Senior Associate in Scottish independent law firm Wright, Johnston & Mackenzie’s Corporate & Technology teams.
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