With a potential recession on the horizon, entrepreneurs are anxious to safeguard their businesses if a slowdown occurs. Because customer retention can be a problem for companies in a recessionary dip and inflation rates sometimes run high, cash flow challenges are common.
Investors and funders can also get edgy when a recession looms. Because of this, attention often turns to the terms of legal agreements such as shareholder agreements. All sides will be keen to make sure their interests are protected should business slow.
Shareholders’ agreements commonly cover the payment of dividends and contain protections for both founders and funders. If cash flow is less than forecast, and in fast-moving situations triggered by recession, these terms can quickly become out-of-date.
In this article, we explore what entrepreneurs can do to shore up their legal agreements ahead of a recession, and how they can adapt their shareholder agreements so that offer maximum protection for all parties.
The importance of an up-to-date shareholders’ agreement
When you’re new to business, legal formalities can seem a bit of a chore. Many entrepreneurs, in the rush to get their business off the ground, buy a company ‘off the shelf’ and trust that the standard provisions in their Articles of Association will protect their interests if times get tough.
However, unless you’re the sole shareholder of your business, an additional shareholders’ agreement is an essential tool for helping you lay the framework for how the business should be run. They describe the rights and responsibilities each shareholder will have. And, if you’ve external investors, they will likely insist on a shareholders’ agreement to protect their interests.
A professionally drafted shareholders agreement will contain provisions that:
- Limit the powers of shareholders in certain key areas, for example to sell their shares or pass certain resolutions that change fundamentals of the business
- Regulate the payment of dividends, and how much and who can receive them
- Who has the power to appoint a director
- What happens in the event of a dispute among shareholders
Even if you’ve had the foresight to enter into shareholders’ agreement, when circumstances change it can quickly become out of date. Owners’ priorities can alter, the business may need additional investment, or cash flow issues may mean that dividend payments may no longer be possible.
The key pinch points for businesses in a recession
The main pinch point for businesses in a recession is likely to be cash flow. As sales drop off, or customers wish to change their payment terms to allow for longer credit periods, cash can become tight. And if a business is not in profit, it won’t be able to pay dividends, and may struggle to make bonus payments to staff and executives.
During the COVID-19 pandemic, the government offered some solace to business owners facing difficulties by offering government-backed loan schemes or subsidies, yet many of these prohibited businesses from paying dividends or bonuses as a condition of support. And if you’ve borrowed, you may find that financial and other covenants in your loan agreements may affect your ability to run your business if you fail to meet expected milestones or financial metrics.
So, it’s of primordial importance to ensure that your shareholders’ agreement remains flexible enough to accommodate any issues you face.
Bringing in new funders
If your business is facing issues in a recession, one option may be to source additional funding to ease your cash flow position. If that’s your plan, you need to make sure that your shareholders’ agreement allows for this. If it doesn’t, then you’ll need to approach your existing investors and ask for the agreement to be amended. And, even if it does envisage further funding, there may be terms that would be too favourable to existing investors such as drag or tag along rights, or anti-dilution provisions. These may be unacceptable to new investors and need to change.
A new shareholder may also alter the voting position within the company, so you’ll need to review the shareholders’ agreement alongside your cap table to check that you’re happy that you can retain control of crucial decision-making.
Changes to dividend rights
One way to take the pressure off your business in a recession is to change the way dividends are paid so that you can retain as much cash as possible. If the provisions of your shareholders agreement are too inflexible, then asking for these to be amended can give you vital breathing space.
You may find that a recession causes a shareholder or investor to want to an exit from the business. Unless this has been envisaged by the shareholders’ agreement, and that terms of the exit are reasonable, you may need to alter your shareholders’ agreement to avoid disputes.
For example, the leaving shareholder may want to keep some of their shares and you’re not in favour. Or you’d like to place other restrictions or restrictive covenants on the leaving founder so that you can protect your business against competition. You can accomplish this by adapting or adding leaver provisions.
Adapting leaver provisions
Leaver provisions are terms typically found in a shareholders’ agreement that dictate what will happen if an individual leaves a business, whether that be a shareholder who is or isn’t also a director or employee.
If someone leaves on good terms, then the consequences for them should generally be favourable. On the other hand, if they leave on bad terms, then the terms of the departure will be less positive, as they’re deemed a ‘bad leaver’.
You may want to now revisit the terms of the leaver provisions to cover the circumstances surrounding a founder, employee or investor’s decision to leave. Or, if your shareholders’ agreement doesn’t contain leaver provisions, now’s a good time to add them.
Decision-making in a recession
Normally, company administrative decisions are taken either by a majority vote of directors, or a shareholders resolution by a majority (51%) or, in the case of a special resolution, by a super-majority of 75%. Some director and shareholder decisions may have higher approval threshold or even need to be unanimous under the shareholders’ agreement, particularly where a company wants to make a strategic change of direction and all the shareholders want to have a say.
In a recession, however, you may find that you need to make decisions on the fly, and so you may want to revisit your shareholders’ agreement to allow you to pass such resolutions more easily. A failure to make such an amendment can cause gridlock if you can’t get the requite majority to agree to your plans.
If you do find yourself in a dispute with shareholders about how to take the business forward, you might find your existing dispute resolution process is too rigid or cumbersome. The danger of such inflexible terms is that you find yourself in a position where you can neither agree how to proceed or faced with a long and costly process to resolve matters. Far better to pre-empt matters and agree amicably to appropriate amendments so that you can weather the economic storm knowing that you are all working together to make your business a continued success.
To find out more about shareholders’ agreements, view our articles Can I write my own shareholders' agreement? and What should a shareholders' agreement contain? If you need assistance with drafting or reviewing a shareholders' agreement, consult our corporate solicitors. Get in touch at 0800 689 1700, email us at firstname.lastname@example.org, or fill out the short form below with your enquiry.