What does a multi-headed creature from Greek mythology and a
dispute between business founders have in common? When one of
Hydra’s head is chopped off, another two grow in its place and
a similar peculiarity can occur when relations between founding
shareholders break down.
A dispute between founders can quickly resemble a Rubik’s
Cube of legal issues relating to employment rights, board
composition, shares and tax. If the multi-faceted problem is not
gripped quickly and solved holistically, the drain on management
time and the financial cost of stumbling into litigation can very
quickly stifle a business with high growth potential.
It’s imperative to nip the matter in the bud, as a messy
dispute between founders will be a red flag during any fundraising
and block the investment often needed to scale-up. This Article
looks at the potential sources of founder disputes and how to
resolve them.
Employment rights
At the epicentre of a founder dispute is often an allegation of
misconduct, including the misuse of funds or the diversion of
opportunities elsewhere. A founder who works “in the
business” on a full or part time basis at an operational level
may well have a written employment contract or, at the very least,
may acquire statutory employment rights as an employee. Such
employee status sits entirely separately to, and is mutually
exclusive from, the founder’s role as a statutory director.
Employee status brings with it a raft of legal protections which
need to be considered when working out how to address any
allegations of misconduct. Legal advice is most often sought for
the following issues:
- How to carry out a suspension (on full pay), conduct an
independent investigation and, if there is a case to answer,
conduct a disciplinary hearing that may result in the founder’s
dismissal. - If the founder has more than two years of service, managing the
investigation and disciplinary process to minimise the risk of a
claim for constructive or unfair dismissal.1 - Any counter-allegations of discrimination2, which the founder
suggests is the real reason for the action taken against them,
rather than a genuine belief in their misconduct. Such a claim can
be made irrespective of length of service and compensation is
uncapped. - Any counter-allegations of detriment and/or automatic unfair
dismissal following a ‘whistleblowing’ disclosure, where a
claim can be made irrespective of length of service and
compensation is uncapped. - The enforceability of restrictive covenants such as
non-compete, non-solicitation (of staff or customers) or
non-dealing (with customers) clauses, in addition to the ownership
of intellectual property or inventions and use of confidential or
commercially sensitive information.
Litigating over the fairness of a founder’s dismissal in an
Employment Tribunal (ET) can quickly become a
proxy war. Highly sensitive issues such as the enforceability of
covenants and whether the founder is a “good” or
“bad” leaver (for the purposes of an automatic share
transfer upon the cessation of their employment or directorship)
frequently come into play.
Any ET claim must be carefully delineated and deployed or
defended tactically so as not to prejudice or compromise other
legal claims and rights (as described below).
Board composition
From a practical point of view, issues can arise as to how to
call a quorate board meeting and who has authority to make
decisions relating to the employment rights of a founding
shareholder, especially if the individual concerned is the
Chairperson or Managing Director of the business.
Even if a board meeting can be called and decision to suspend
pending investigation taken, it is not uncommon for a founding
shareholder/director to have an express right (in a Shareholders or
Investment Agreement), or an informal agreement, course of dealing
or legitimate expectation, to participate in the management of the
business. Therefore, dismissing a director as an employee may
prejudice this right (see unfair prejudice below) and it will not
automatically also remove that individual from the board of
directors.
Subject to any rights of entrenchment to count in the quorum,
vote or veto their removal, a founding shareholder will have to be
removed as a director by either the board of directors or,
particularly if that is not possible, an ordinary resolution of the
shareholders following a detailed and prescribed process with
“special notice” set out in section 168 of the Companies
Act 2006.
To understand what can and can’t be done, it is important
that the company’s Articles of Association and, if there is
one, Shareholders’ Agreement (or equivalent) are considered as
early as possible in the dispute.
Unfair prejudice
Founder disputes do not always engage HR issues. They can
emanate from a difference of opinion about the strategic direction
of the business and/or a personality clash. In these instances, the
initial focus of a dispute tends to be on past, present and future
compliance with the company’s Articles of Association and any
Shareholders or Investment Agreement. In particular, regarding the
holding of board meetings, the sharing of management information
and the validity of board or shareholder resolutions.
A dissatisfied founder will probably try to build up a picture
of the other founder(s) acting in breach of their director duties,
the Articles and/or their obligations under a Shareholders’
Agreement. He or she may allege improper motives such as their
co-founders jostling for a “share grab”. The reason for
building up a narrative of wrongdoing is to try and reach the
threshold for bringing a legal claim for relief from conduct that
is unfairly prejudicial to their shareholding, known as an unfair
prejudice petition (UPP) under s.994 and s.996 of
The Companies Act 2006.
An UPP is an extremely flexible legal remedy for shareholders.
It is a forum in which any number of allegations and examples of
dissatisfaction can be aired. Also, the judiciary have a very wide
discretion to make a range of orders regulating the conduct of the
board or ordering one shareholder to buy-out another and if so, at
a specific value or valuation basis. In business-critical
scenarios, injunctive relief can be sought in support of a UPP
claim to “hold the ring” whilst a claim is resolved.
However, the financial risks are high since the default position is
that the “loser” of a claim will be ordered to pay the
legal fees and expenses of the “winner”. Perhaps more
importantly, founders going to war is likely to be utterly
debilitating for the business and have effect of putting it into
stasis. Therefore, whilst a well-articulated potential UPP claim
set out in a pre-action letter can be a useful tactical device to
spark an initial settlement dialogue with some high ground, a
respondent will be alive to the ability of all parties to fund
fees, risk adverse cost consequences and what the lost opportunity
cost is of being distracted from driving the business forwards.
Importantly, a UPP is a shareholder remedy that is brought
against other shareholders in the first instance (although the
company may be joined to proceedings in order to be bound by the
outcome rather than to actively participate in them). Therefore,
company funds should not be used for legal fees and expenses
relating to a threatened or actual UPP claim. Where a UPP claim
alleges breach of director duty, that may engage cover under a
director’s and officers insurance policy
(D&O) to meet the costs of defending that
aspect of the claim (but a D&O policy would not ordinarily
cover the costs incurred relating to shareholder issues).
Share Transfers
The upshot of a founder dispute is often the full or partial
exit of a founding shareholder. The Articles or any
Shareholders’ Agreement may provide for circumstances in which
a founder who ceases to be an employee or a director can be
compelled to sell some or all of their shares, whether that be to
the company, other shareholders or a combination of both (otherwise
known as ‘leaver provisions’). The value at which they can
be compelled to sell their shares will typically depend on the
circumstances of their departure (i.e. whether they are a
‘Good’ or a ‘Bad’ leaver, for example), but this
will often form part of the negotiation as part of any settlement.
The successful outcome of an Unfair Prejudice Petition is usually a
share purchase order requiring the claimant (petitioner) to be
bought out by the other shareholders. Or an exit is part of a
negotiated resolution.
Whichever route the founders take to arrive at an exit, they
will have to decide how to complete the transaction. The Articles
will almost certainly set out a process that must be followed when
a shareholder wants to transfer shares, including the application
of pre-emption rights in favour of other shareholders. In addition,
if the transaction involves a buyback of shares by the company,
then it will be important to ensure that this is done in accordance
with the requirements in Part 18 of the Companies Act 2006 whereby
the company acquires and cancels the shares or retains them in
treasury. Further, the exit might prompt the establishment of an
employee benefit trust which acquires the shares in conjunction
with setting up an Enterprise Management Incentives (EMI) or
non-EMI share option scheme for the current and future management
group. In advance of agreeing a negotiated settlement that involves
the transfer of shares, it is therefore necessary to understand
what process needs to be followed and what, if any, shareholder
approvals or investor consents are required.
The future balance of power between shareholders and compliance
with the company’s Articles or The Companies Act 2006 will be
at the forefront of discussions. To the extent that a founding
shareholder is retaining shares in the business, additional
discussions will be required in relation to what (if any) ongoing
role they might have with the company (for example, can they
continue to be a director or nominate a non-voting board
“observer”), are they entitled to any ongoing information
rights, and/or will their shares be voting or non-voting.
Tax
Whilst litigation or negotiations are ongoing, a number of tax
points require consideration at the outset:
- How all payments are allocated as between an ET claim,
consideration for a share transfer, compensation in relation to any
other claims or consideration for all other obligations entered
into (regarding loss of office as director, any cap on share value,
covenants, IP ownership and full and final settlement etc).
- The first £30,000 of compensation that is a termination
award relating to loss of employment can generally be paid tax free
without deduction of income tax and national insurance
contributions (although it should be borne in mind whether any
other taxing provisions could apply to the award, such as it being
treated as an ’emolument of employment’ and therefore
taxable as general earnings). However, payment of a termination
award relating to an ET claim above this threshold should be
subject to PAYE. HMRC may investigate the purpose of settlement
payments and therefore, the paying party will usually be authorised
to deduct PAYE and the recipient will indemnify the paying party
for any tax liabilities they are obliged to make to HMRC
directly.
- Upon the sale of shares by a founder they will need to consider
their liability to pay capital gains tax and in particular, the
potential application of business asset disposal relief on a total
exit and the possible loss of this relief in relation to any
remaining shareholding on a partial exit (since they would no
longer be an employee or officer of the company).
- If the company has raised funds under the Enterprise Investment
Scheme (EIS) or the Seed Enterprise Investment Scheme (SEIS),
thought should be given to preserving the EIS and/or SEIS status of
the company during litigation or settlement negotiations. For
example, the money raised under those schemes must be spent on the
relevant qualifying business activity and not on dealing with the
dispute. In addition, any founder who has secured EIS or SEIS tax
reliefs on the purchase of new shares in the company will need to
bear in mind the possibility of such relief being clawed back (for
example if EIS or SEIS shares are sold within three years of
acquisition).
What pre-planning can be done to mitigate disruption?
Without trying to tempt fate, a company’s Articles and a
Shareholders’ Agreement can be written with the potential exit
of founding shareholders/director, who might also be a Chairperson
or Managing Director, in mind. These documents can specifically
cater for scenarios where these individuals cease to be an employee
or director. For example, they can provide for how board meetings
are to be called, quorum established, casting votes exercised,
sub-committees created, when shares can be acquired on a compulsory
basis, what value should be attributed to them and how they will be
acquired.
Without being too morose, it’s a question of role-playing
the scenario on a hypothetical basis. It can be in the best
interests of all parties to have clarity at the outset as to how a
relationship breakdown will play out, since a pre-planned
resolution is a better outcome for all than a dispute inflicting
critical damage or scuppering a fundraising. If a business is
incorporated with these risks in mind, it will significantly narrow
the scope of a dispute between founders to focus on whether the
conduct of an individual does or does not trigger good or bad
leaver provisions and eliminates the ability of parties to exploit
other issues as tactical leverage.
If a dispute between founders does develop, it must be managed
with a clear understanding of what the end goal is and what issues
need to be navigated in order to arrive at that point without
unnecessary escalation. Compartmentalising a dispute can be
tempting but knowing where the contamination risks are lurking and
how to pre-neutralise them is key.
Footnotes
1. Where
compensation is capped at the lesser of £105,707 or a
year’s gross salary (subject to mitigation of
loss).
2. On the
grounds of age, gender reassignment, marriage and civil
partnership, pregnancy and maternity, disability, race, religion or
belief, sex or sexual orientation.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
