Forming a company is inexpensive and fast. A typical formation agent charges around £12 for a most basic service that takes a couple of hours or less. A newly incorporated company can start trading immediately – provided there are customers and a means of taking or making payment.
By contrast, putting in place the legal documents that a new company needs to regulate the relationships between shareholders and directors can take much longer and cost much more.
So it is unsurprising that many founders put off dealing with these documents. Often, it seems there is no immediate need to have them – just a large cost. What owners don’t realise is that it is much harder (both in time and cost) to put these documents in place later than earlier on.
The most important documents for your new company
The three key documents to have in place for a new company are: a shareholders agreement, directors service contracts and the articles of association.
These documents set out how the company works (a framework of general operational rules) and the powers, rights and responsibilities of individual owners and directors (who are responsible for the management on a day to day basis).
Why it is important to put these documents in place early
Founders often think that they are “aligned” with each other, only to find out later that what they assumed had been understood in the same way by everyone was actually understood to mean something else.
In other words, it is only when there is disagreement that the value and benefit of having these legal documents in place becomes apparent. These document can set out what happens in certain circumstances so that nobody can claim that he was under the impression that something different would happen. In other words, they ensure clarity.
The longer owners leave putting these documents in place, the more likely that it will be to negotiate the contents of them.
At the start of any business, the owners are likely to have fairly similar ideas about the general direction they want the business to take (the strategic goals), and how they will achieve the goals. As time passes, the business will diverge from the original expectations the owners may have. There may be unforeseen outside pressures, such as tighter competition or lower demand for a product, or the internal functioning of the company might be different to how the owners imagined. For example, it might become apparent that a shareholder-director is less experienced in a certain job position than he claimed when the company was started.
In a small company, the founders are often the directors as well – the majority of shareholders will work in the business. The difficulty with this is that the powers that owners have in their roles as directors can conflict with the powers they have as shareholders. Directors may be able to make decisions quite legitimately as directors that benefit themselves as shareholders to the detriment of other shareholders. Examples are:
- awarding contracts to suppliers where the director owns part or all of that supplying company
- entering into lending agreements that put at risk capital injected by other shareholders
- voting to increase directors’ salaries
- employing family members or friends who perhaps don’t have the necessary experience for the position
- paying dividends to shareholders that perhaps benefit that director-shareholder more than others
You should plan for exit as soon as you start up
The big “elephant in the room” comes when one shareholder wants to sell up. If there is a disagreement, the easiest way out might be to part company. But unless you have decided how this might happen in advance, you might find yourself left holding the short end of the rope.
Using a shareholders agreement, you can specify under what conditions shares can be transferred, and give preferential rights to existing shareholders to acquire those shares before outsiders can. So you might be able to prevent a share sale to the owner of a competitor company, or to another shareholder (who might gain more power than you would like him to have over the direction of the company), or to an inexperienced nephew who might decide he wants to play director with your business.
The only way of smoothing out potential future problems…
…is to put the documents in place early. It doesn’t have to cost thousands of pounds and you don’t have to use a solicitor. You can use template documents and prepare the majority of the agreements yourself, as we explain in this post.