As Autumn starts and the evenings draw in, I find myself compelled – if only by the presence of my sons (both of whom have a more entrepreneurial mind-set than my own) and their absolute control of the TV remote – to watch, with gritted teeth, a program cmartinalled “ Dragons’ Den.”
In this program, as I am sure most of you are aware, various unsuspecting members of the public (“UMOPs”) ask “the Dragons” (denizens of the business world who have all, incontestably, made vastly larger sums of money in their business careers than I have in mine) to provide them with funds (and, no doubt, guidance) in exchange for a share in the UMOPs’ business ventures.
The program is fairly formulaic:
The UMOP presents their brilliant invention (with sad regularity this is either some new gluten free/non-dairy super food or an “app” to do, in one way or another, something which people had until now been quite capable of doing for themselves) and outline the successful dealings they have already had with Waitrose/Tesco/Sainsburys etc. They then offer a percentage in their business venture to the Dragons for a price.
The first question which always springs to mind is that if – as they often claim – the UMOPs already have a successful business venture with turnover in the hundreds of thousands and healthy profit margins why on earth are they trying to sell part of it to the Dragons, whose attitude seems – at best – somewhat predatorial? Why can’t they just approach the commercial arm of a local bank for any funding they need?
Anyway, the Dragons frequently get off to a good start – querying the Intellectual Property rights behind the invention (“IP”) and who they are owned by. (The fact that they are on the right track here can be seen from the number of UMOPs who turn out to be trying to sell the Dragons a percentage in a business venture which doesn’t own the IP behind the product on which the business is based.)
If the UMOP passes this hurdle, the Dragons then launch into a series of financial questions on which the UMOPs almost inevitably stumble: “What was your net/pre-tax/gross profit for the last two years? What was EBIT three years ago?” etc. Quite how the UMOPs are meant to carry these figures around in their head (particularly when in front of a television camera) is slightly beyond me, indeed the entire concept of the UMOPs turning up to sell a substantial part of a business on which they frequently put a value in excess of £1M without an accompanying team of accountants and, whisper it gently, lawyers seems a little bizarre in the first place.
The Dragons and the UMOPs then enter into a detailed discussion of what percentage of their business they are going to sell/buy and for how much (UMOP is seeking £150K for a 5% share in the business, Dragon 1 is willing to pay £150K for 30% etc). Every now and then, a “deal” is done (almost invariably on the terms being offered by the Dragon rather than anything like those proposed by the UMOP) and, I presume, a certain amount of money changes hands.
I am forced to observe, however, that most of this supposed “debate” is, in reality, meaningless.
Starting from basic principles, the business entities being talked about here are private limited companies with share capital. So the questions which the Dragons should be asking are as follows:
- What is the existing capital of the company, how is it divided and who is it held by?
- Is the proposal to issue and allot to me new shares in the company or to transfer existing shares?
- In either case, what are the relevant provisions in the company’s Articles of Association in this regard (are there any pre-emption rights or restrictions on transfer) and how will they be dealt with?
Moving on to the next series of issues: as many of you will – I am sure – know, whilst a company is owned by its shareholders, the day to day business of the company is carried on by the directors. The issue, then, of who the directors are and how and by whom they are to be appointed is key.
So the Dragons’ next question should be:
- Who are the current directors/officers and are they going to stay in position; and
- How many directors am I going to be allowed to appoint?
(In addition to a quick look at the company’s Articles of Association to ensure that what is proposed gives some kind of board control.)
This then brings us on to a further issue – there is a power under the Companies Act 2006 for the shareholders of a company to remove a director by majority vote. In the absence, then, of protection by way of a shareholders agreement and/or bespoke Articles of Association (see below) the holder of a minority interest in a limited company (so less than 50% of the voting rights) has very little protection – the majority shareholder can simply remove any “unfriendly” directors until control of the board is achieved.
The holder of less than 25% has even less protection – the holder of 75% can pass “special resolutions” to dis-apply rights of pre-emption on allotment of shares and further dilute the minority holding and even completely change the Articles.
Theoretically these entitlements are somewhat counter-balanced by:
- The possibility of “derivative actions” – where a (minority) shareholder forces a company to take action against its own director(s) for breach of duty; and
- “Unfairly prejudicial conduct” petitions (in which a minority shareholder alleges that the affairs of the company are being conducted in a way which is unfairly prejudicial to their interests).
Both of these possibilities are however slow and costly and involve complex Court procedures.
In the commercial world protection for minority shareholders is therefore normally achieved by drafting non-standard Articles of Association (often referred to as “bespoke Articles”) and/or a shareholders agreement (an agreement between the individual shareholders of a company which is directly binding on each of them) encapsulating specific protections. These can include:
- Reserved matters: specifying matters a decision on which will require the agreement of the minority shareholder;
- Entitlements to appoint directors and governance more generally;
- Provisions relating to finance – for example a requirement that a specified percentage of realised profit be paid out as dividend; and
- So called “tag along” and “drag along” provisions – which ensure, for example, that if the majority shareholder finds a buyer for her shares on favourable terms then the minority shareholder will be entitled to require that the buyer also purchase her shares at the same price.
So the next questions the Dragons should be asking are:
- Are we going to change the articles of the company; and
- Are we going to have a shareholders agreement, who is going to draw it up and what protections are you going to allow me to build into it?
It is only once this has been done (and done satisfactorily) that all the talk of “I want £50,000 for 5%,” “No, I’ll give you £40,000 for 15%” makes any sense. There is a strong argument to say that – in the absence of proper protection (shareholders agreement and/or bespoke Articles) – a share of anything less than 50% in a company the shares of which are not listed on an exchange (such as the London Stock Exchange or AIM) is zero. This argument is even stronger in relation to a share holding of less than 25%.
The value of what is being purchased (and hence what is a sensible price to pay for it) depends just as much on what is being offered (and what will be accepted) by way of minority shareholder protection as it does on the merit of the underlying invention (or, indeed, the EBIT figure from two years ago). Without clarity in this regard, detailed debate/negotiation on figures serves very little.
I have no doubt that, once the reflectors are turned off, detailed work is done and that the Dragons’ lawyers (who are no doubt just as fearsome as the Dragons themselves) coral the “lucky” UMOPs who have managed to do a deal into massively restrictive shareholders agreements and/or Articles. (This brings me on to my own great idea – a company which advises people on how to have set aside agreements in which they sold substantial parts of what are now valuable businesses in circumstances in which there was manifest disparity in bargaining power and without proper legal advice. Perhaps the Dragons would care to advance me £200K? They can have 49.9% of the business and I will draw up the shareholders agreement.)
In the meantime, I am happy to offer my services to anyone who may be appearing on Dragons Den, to stand behind them and look suitably sombre while they are fielding the Dragons’ questions. (Don’t forget however that we will also need an accountant to deal with all those tricky questions about numbers – lawyers don’t do maths.)
For now,however, all I can do is sit in front of the television and hum to myself the line in the song “If I Were a Rich Man” from Bock, Harnick and Stein’s musical “Fiddler on the Roof”:
“And it won’t make one bit of difference, if I answer right or wrong,
When you’re rich, they think you really know….”
I have written a book about business law. To download a free copy of the book go to Martin Reynolds’ Book on Business Law.
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