No businessman in their right mind would waste money on expensive lawyers at the very outset of the business development. When two old friends decide to unite their efforts in a joint venture, or an aspiring IT developer celebrates the first sale of a small share in his newborn enterprise to a business angel, legal issues rarely are regarded as a priority.
However, just as in marital relations, agreeing on certain crucial points with your business partner onshore, and properly formalising your agreement saves you a good deal of time, money, and trouble in the future.
Choosing the legal form for the joint venture
Once there is more than one person running a business, you can no longer act as a sole trader, and you and your business partner need to choose a legal form for your joint venture. Under English law, the ‘joint venture’ does not exist as a legal term, it only implies that there are two or more people co-operating with some common business goals. From a legal point of view, such cooperation can happen in the form of a company, a partnership, or even under a contractual arrangement.
The most popular choice for a joint venture would be a private limited company (LTD). Simply put, shareholders of an LTD enjoy their limited liability with very few formal requirements applicable: for example, they can start a company with a very small nominal capital, and virtually any person can serve as director of the company, including the shareholders themselves. They cannot, however, sell shares to the public.
To raise capital through the sale of stock to the general public, the company would need to be converted into a public limited company (PLC). This is an option for a business which is already really big and prepared to comply with a lot of formal requirements of the company law and the rules of the stock exchange.
The third wide-spread company type — companу limited by guarantee — is for non-profit organisations.
A partnership tends to be a choice (usually in the form of a limited liability partnership) for groups of professional advisors, such as lawyers or accountants, united and working together under one trade name.
Purely contractual arrangement may be an option for independent businessmen cooperating on a one-off project. It would not suffice for an average joint venture, which would normally require creation of a separate legal entity with its own account, assets, liabilities and contracts.
Business partners’ (in)equality and roles distribution: agreeing onshore
Partners can be more or less equal and distribute the responsibilities differently. Though 100% equal distribution of roles can hardly exist in practice, various configurations may exist, depending on the parties’ goals and arrangements:
- Partner A and Partner B start a business together and both actively participate in the running and financing of the business — this is the situation closest to equality.
- Partner A is running his own business for some time and then decides to let Partner B in as an (almost) equal manager and investor; Partner A keeps controlling stake (51%), but may be eager to share profits equally.
- Partner A is a founder who solely manages the business but needs Partner B as an investing shareholder; although Partner B may have a minority share (e.g. 10%), Partner B may well request extended controlling rights and blocking powers to make sure his money is used well.
While business relationships may have an infinite variety of shapes, it is important that the partners share a mutual understanding of their respective roles, ideally not only at present, but also with a view to a couple of years to come.
When the joint venture is just starting, there are some questions we recommend to consider. You may want to put the answers on paper.
- Will both partners take part in the operational management or will one of them be only involved in crucial decision making and high-level control? What decisions are ‘crucial’?
- Do both partners plan to finance the business out of their own funds, or invest in the business any of their own assets such as intellectual property? Or is it a founder-investor relationship? Will unequal financing affect the distribution of shares and rights between the partners? If dilution is possible based on unequal financing, what approach should be used to evaluate the joint venture business for this purpose?
- Will profit distribution be done based on the respective shares belonging to each shareholder, or will one shareholder have priority rights over the other in this respect?
- If a perspective of the joint venture business sale comes, will any of the partners have a right to sell separately from the other, or will they only be ready to sell together?
- Finally, what if the joint venture fails? Should the company be dissolved? Or should one of the partners have a right to buy out the other partner’s share and continue the business on his own?
Even if you don’t intend to formalise the arrangements from the outset, it is important to set things straight. Once the business has grown bigger, you will have a framework you agreed on from the very beginning, which will reduce the risk of disputes. It is always advisable, though, to have your business arrangements synchronised with the legal documents. Let us look at how this can be done.
Where to look for the rules, and where to write down your own
Once a private limited company (aka private company limited by shares) is chosen as a legal form for the joint venture, Companies Act 2006 default rules will apply, except for the cases where parties can and do agree otherwise.
The company will have its own memorandum and articles of association. A memorandum of association is a rather standard document that sets up the company, and the articles of association is a set of rules on how the company is governed and owned.
If no articles are drafted for a company, Section 20 of the Companies Act provides that such a company will be registered with model articles of association contained in The Companies (Model Articles) Regulations 2008. Model articles contain an absolute minimum of mostly procedural rules describing how the company should function and are an obvious and easy choice for a sole-person company.
For a joint venture company, however, model articles are unlikely to be appropriate. Model articles do not touch upon any aspects of the business partners relationship or interaction, their rights and obligations in respect of each other. Thus, it is necessary to have the articles tailored for the joint venture needs.
Legal work on adapting the articles of association does not require a sophisticated or an expensive lawyer, and it is definitely worth having this work done. Some consultants even sell ready-made enhanced articles of association online, though it may not be easy to make the right choice if you do not know what exactly you need.
The articles of association are the document where you should consider putting answers to the following questions:
- How will the joint venture be governed?
- What governance matters are crucial and always need votes of both partners?
- What classes of shares there are, and how do they differ?
- What restrictions on sale to third parties are in place (pre-emptive rights mechanics)?
- How will profits be distributed?
This list does not cover all of the important issues that concern the business partners’ relationship. For full formalisation of the existing arrangements, you may need another document called a shareholders’ agreement.
By its nature, a shareholders’ agreement is a contract, which makes it a very flexible instrument indeed. A huge variety of arrangements can be effectively put into a shareholders’ agreement and, if need be, enforced in court.
The shareholders agreement is a powerful document that may describe every aspect of the company’s governance in detail:
- every reserved matter that both shareholders must approve;
- the exact procedure of multi-tier financing process from seeking external financing to shareholder’s obligations to finance;
- the dilution and evaluation rules;
- the way out of deadlock situations;
- the ‘divorce’ procedures;
- the rules on how any sale to a third party should be arranged.
The list can go on.
This document can be anything from a very concise one to hundreds of pages. Of course, a small business does not need to spend too much money on a sophisticated shareholders’ agreement. It may be a good idea, however, to take legal advice on whether such a document is needed in your particular circumstances.
Many investors who agree to become a minority shareholder of a startup company may impose their forms of shareholders’ agreements on the founders. In such circumstances, founders are strongly advised to consult a lawyer and make sure they carefully read and fully understand what they are signing. Otherwise, they may well find themselves lawfully diluted, or dismissed from their managing role, or both, after a couple of years of successful business development.
- Once you are no longer on your own, but have a business partner, it is time to agree on the rules of your business life together. The necessary arrangements go far beyond the simple choice of the legal form of your joint venture.
- There is an infinite number of issues that can require regulation in each specific case of a joint venture. Make sure you agree at least informally upon basic things, and both partners understand how the company is to be run & financed, how it can be sold, how it will pay dividends and how you will ‘divorce’ if the joint venture fails.
- Consult a lawyer to make sure your company has proper rules included in the articles of association.
- Even if the business is still small, in some cases it is worth having a shareholders’ agreement drafted from the outset. Take legal advice on whether you need to have a formal document in place.
- If an investor is imposing a shareholders’ agreement from the outset, a startup founder should take it seriously and consult a lawyer.