Disputes, Confidentiality & Share Agreements: Why formalising Agreements in Business makes 100% sense.

A surprising number of business owners still rely on a shake of a hand or a verbal acknowledgement to secure new business. Confidentiality is not regarded as a high risk area of concern and businesses are run in an unregulated manner. The 21st Century business world is a very volatile environment. We are witnessing huge changes. The more you can do to formalise your business arrangements, the better the chance you give yourself of thriving whilst others struggle.

So what is the so-called ‘Gentlemen’s Agreement’?

More often than not a Gentlemen’s Agreement will be a verbal agreement, i.e. the terms of the contract agreed orally.  Although verbal agreements are enforceable and valid (contracts do not need to be in writing), where a dispute arises between parties to an agreement, the absence of written terms can be problematic, to say the least.

Disputes are inevitable…

A contract, whether written or made orally, is rarely safe from the potential of parties disputing its terms and one party’s obligations to another.  However, it is generally easier to determine where a party stands when the terms of an agreement are set out in writing and further, drafted clearly.

You have to ask yourself, if say a judge, an arbitrator or a mediator were required to intervene with your dispute, whether you would you feel more confident relying on written evidence on the table, or your word against that of another?

Of course, a written agreement does not always present the full story and parties may vary the terms of an agreement as matters progress.  It is important to ensure records are retained of agreed variations and supporting correspondence (again… in writing!).

Risk Management

Drafting clear and effective terms will often allow disputes (if they arise) to be resolved before they escalate.

Gentleman’s Agreements will inevitably not cover all aspects of a deal and disputes often arise from issues that are not considered or expected at the outset. Hindsight is a wonderful thing…

An experienced legal advisor will help you to fill the gaps and incorporate safety provisions after contemplating potential future risks.

Costs of litigation when attempting to resolve a dispute can be high and in cases have the potential to escalate beyond the value of the goods or services on which the contract is based.

Disputes can be very time consuming and can be disruptive to your day-to-day running of a business.  Trying to pull together evidence to support the oral terms of a Gentlemen’s Agreement can take away time better spent sourcing new customers for your business.

You should also consider the damage that a dispute may cause to goodwill and/or relations you have spent time building over the years.

Written agreements do not have to be long and complicated and do not have to take long to prepare.

Disputes can be damaging but a breach of confidentiality can be even worse for your business.

When you need a Confidentiality Agreement

If you are looking to be involved in a sale or purchase of a business then the answer, almost certainly, is “yes, you need a confidentiality agreement”. Information is power and a breach of confidentiality either by accident or on purpose can cause embarrassment or/and financial loss.

Get it signed at the outset

Whether an asset or share acquisition, parties will need to get together to start negotiations.

It is recommended that a full Confidentiality Agreement is signed between the parties at the outset.

Won’t Heads of Terms deal with confidentiality?

Generally, Heads of Terms will be drafted in such a way that its terms will not be binding on the parties.  However, certain terms can be drafted as binding and would usually include confidentiality and exclusivity provisions.

However, Heads of Terms may take several weeks (if not longer) to agree before they are signed.

In the meantime the parties will usually be holding discussions and forming the ‘deal’ and will wish to have some security with regard to disclosure of confidential information.

For example, parties will not want their trade secrets released into the public domain by rogue enquirers, assumed to have genuine interest in buying or selling a business.

Parties may require more in-depth confidentiality provisions than might usually be covered within Heads of Terms.

What provisions would typically be contained in a Confidentiality Agreement?

  • A definition of what constitutes confidential information
  • Provisions specifying those entitled to use confidential information and regulating how confidential information can be used
  • Provision specifying If and when confidential information can be disclosed
  • Provision specifying when confidential information shall be returned to its owner (if applicable, whether in hard copy or soft copy).
  • Provisions dealing with Intellectual Property protections
  • Restrictions and non-solicitation provisions (e.g. relating to staff, customers and suppliers)

So what’s an NDA?

NDA stands for Non-Disclosure Agreement and is often referred to in the alternative to the term Confidentiality Agreement.  Both will generally cover the same types of provisions i.e. defining confidential information and regulating how this can be used.

Shareholders’ Agreements – Regulating Shareholders and Directors

Why have a Shareholders’ Agreement?

The Articles of Association of a company will bind all shareholders automatically and as soon as they become a shareholder in a company.

A shareholders’ agreement is a contract between specific named individuals and so is incapable of binding anyone else unless they also become a party to it.

The Articles of Association and other company formation documents are documents of public record available to the world at large, whereas a shareholders’ agreement is a confidential contract that is not open to public scrutiny.

Shareholders’ agreements are frequently used for small private or family companies and particularly where additional rights are required for investors or minority shareholders.

Shareholders & Directors

It is also quite often the case that a shareholders’ agreement will regulate the affairs not only of the shareholders but also of the directors (if they are also shareholders) and will frequently regulate how votes are exercised either in respect of shareholder votes or director votes or both.

Deadlock

It is also common for a shareholders’ agreement to deal with a deadlock situation; a situation in which company stagnates and is unable to move forward at management level.

There are various options for dealing with deadlock situations and none are attractive – that is essentially the point.   It is essentially a mind-set issue designed to prevent rather than cure.  If shareholders have in the back of their mind a fear of deadlock (i.e. triggering an unattractive resolution) it is hoped that this will prevent the deadlock from arising in the first place.

Typical deadlock resolution clauses could provide for the ultimate sale of the business or for one or other of the shareholders to be able to buy out the other. Glorious remedies along the lines of “Russian roulette” or “Texas shootout” clauses have been devised.

Share Transfers

Share transfers are frequently covered in a shareholders’ agreement sometimes on a basis which is entirely inconsistent with the Articles of Association.

A question often asked is whether or not this inconsistency should result in an amendment to the Articles of Association.  On occasions, this is desirable but it is not always necessary as the shareholders’ agreement should have a “prevail” clause which means that, in the event of any inconsistency, the shareholders’ agreement will prevail over the Articles of Association.

Indeed, for the reason given above (the Articles are open to public inspection and a shareholders’ agreement is not) sometimes people feel “comfort” knowing that they are in a sense screened from public inspection.

However, this may be dangerous in certain circumstances. A new shareholder will not be bound by a shareholders’ agreement until he or she has signed up to it (normally through a deed of adherence) whereas he or she will as a new shareholder automatically be bound by the Articles of Association.

It is also a frequent minority shareholder protection device to insert either “tag along” or “drag along” rights.

Tag along rights would protect a minority shareholder from being left “stranded” by an existing majority shareholder should the majority shareholder receive an offer for their shares.  The clause works on the basis that, if triggered, a majority shareholder must require a buyer of shares to purchase all the other shares in the company.

Drag along rights, on the other hand, are designed to protect a large shareholder who may be considering selling and wishes to avoid any resistance from the minority shareholders.

It works on the basis that a shareholder holding at least say 75% can deal with the transfer not only of that shareholding but of all other shares in the company on similar terms.  This will avoid any difficulty for a prospective buyer of shares to be offered merely 75% rather than 100% of shares in the company.

Share Valuation

There should be valuation provisions for the shares that specifically exclude discounting provisions that would otherwise apply to a minority shareholding.

It has frequently been said that up to 90% of the value of the company is represented in 51% of the voting shares with the effective remainder of the value being in the level of shares 52% to 75%.  A minority shareholding of up to 24% could, therefore, be argued to be virtually worthless although it is frequently agreed in a shareholders’ agreement that all shares are equal as far as valuations are concerned.

It would also need to provide that valuations for a prospective sale or transfer of shares would be agreed between the parties or in default of agreement assessed by an independent party.  Great care would need to be taken in deciding who the appropriate party should be and who should make a decision on appointment of the independent expert if the parties are unable to agree.

In the case of a small private company, whilst it is tempting to think that the company’s auditors would be a good starting point, there is some risk of bias here which could affect independence of assessment.

So, there you have the journey from the pitfalls of trying to do business based on a handshake and a few words, to protecting your business from confidentiality breaches and then finally ensuring you structure the ownership of your business.


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