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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 discrimination[2], 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.
[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.
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