05 May 2021 by Yuly Yung

The commercial marriage of starting a business with friends – Are you a director, a shareholder, or both?

With more people feeling fed up with a day job and choosing to create a dream career of their own by entrepreneurship, it also means navigating a very different playing field hands-on rather than having most administration taken care of as an employee. The most common area of confusion for most early entrepreneurs is the paperwork of corporate governance. This is often overlooked when co-founders are good friends, who tend to rely on oral contracts. We share below a case study of the lack of proper discussion leading to inaccurate records and leadership ambiguity.

Ada, Ben and Charles are close friends who have started a party room business. While each of them has contributed the same amount of initial capital, Ben has been taking up a leading role in business operation including carrying out company incorporation and leasing the business venue under his personal name. Besides, Ben always insists on his own opinion when making daily business decisions after consulting Ada and Charles. Given their close relationship, neither the matter of shareholding nor the appointment of director and shareholder have been officially discussed. It is tacitly agreed that profit would be distributed monthly after the deduction of expenses.

A month later, Ada and Charles realised Ben was given more of the profit distribution. Upon inquiry, Ben claimed that he was entitled to a larger percentage as he contributed the most to the business. It was further discovered that Ben had registered himself to be the sole director and sole shareholder of the business. Ada and Charles expressed their wish to be duly recognised as shareholders on official records as well. Ben did not object to this but reminded them of the potential liabilities they had to bear as a result.

Ada and Charles came to seek our advice. “We have assumed everyone to be a shareholder and be given equal shareholding. How should we deal with this unexpected situation now? How can we voice out our disagreement under this arrangement?”

Indeed, this is a common scenario in the process of running a startup, especially for first-time entrepreneurs who start businesses with like-minded friends as co-founders. It is worthy to spend time and take basic steps in the beginning to smooth out potential conflicts that may not only disrupt business operations but also tear apart long-time friends. Below are several questions that Ada, Ben, and Charles should have discussed before starting the business.

1. As the tenancy agreement of the business venue was entered into under Ben’s personal name, what are the potential liabilities and consequences?

In this case, since the lease is in Ben’s name, he is held personally liable for paying the rent in arrears and in the event of breaching the terms of the agreement. The landlord can take legal action against Ben to recover the amount owed and even petition for his bankruptcy if he fails to keep up with the required payments.

It is, therefore, preferable to enter into a tenancy agreement in the company’s name to obtain protection afforded by limited liability.

2. Does the same capital contribution by co-founders necessarily mean an equal shareholding among them?

No, so it is crucial to put a Shareholders’ Agreement in place from the outset to protect everyone involved in the business collaboration.

A Shareholders’ Agreement is a formal contract between co-founders which regulates their rights as shareholders and governs their interests. It outlines everybody’s intentions and obligations as well as their rights, responsibilities, and liabilities which are agreed upon by all the shareholders, including but not limited to the details on share transfer, management structure, exit strategies, and dividend or shareholding distribution.

Putting a Shareholders’ Agreement in place thus creates a vital legal foundation for startups and minimises risk. When differences of opinion inevitably arise, the Shareholders’ Agreement is much more beneficial than trying to negotiate terms when parties become aggravated.

3. How to decide who shall be the director of the business? What are the differences between director and shareholder?

Power struggle can potentially disrupt a business. When the roles are unclearly defined, there would be a big risk of who is really in charge which leads to leadership ambiguity.

In general, shareholders own the company’s shares while directors manage the company. If the co-founders wish to involve in management and operation, they can be appointed as the board of directors together and make daily operational decisions..

In case you, as a co-founder, are not the one who registers the business or takes care of administrative matters, it is important to make sure all statutory records indicate your rights in the business as a shareholder. For instance, check if the shareholding information aligns with your entitlements and your name is shown on the register of members.

4. How should business income be distributed to directors and shareholders respectively?

When a business earns profits, it can choose to reinvest funds in the business and pay portions of profits to its shareholders as dividends. Dividend frequency and payout rate would be decided by the board of directors. Meanwhile, directors are entitled to receive director’s fees from the company which is decided by shareholders.

5. What to note when making payment by the business?

A corporate bank account should be set up to manage the monetary issues of the business. Remember to set out the number and criteria of authorised signatories required upon money payment or withdrawal.

To conclude, startup co-founders need to pay attention to and reach a consensus regarding the above matters upfront, to avoid incurring unnecessary time and cost which vitiate business operations in the future. Oral contracts are not as good as written ones, and written ones are not as good as proper ones advised by a lawyer. If you need help drawing up a shareholders’ agreement or would like to book a simple training on director’s fiduciary duties and liabilities, you may contact us at info@jcco-hk.com.

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