Once you have established your business properly, have an extensive client base, have hired employees and protected your intellectual property, you have a proper business asset. A business asset is a business that has the right foundations in place to expand or be sold. Now that you have built a proper business asset, your next step is to consolidate your business to maximise the business and staff that you have into a well-oiled machine. By consolidating at this point, you will avoid the pitfalls that are commonly encountered as you move into the next phase of the Business Legal Lifecycle.
The Maximising your Business/Bringing in Investors phase (Maximising phase) covers maximising your business through your existing channels, fully utilising your staff, or attracting investors. As a business owner, you will have the choice between these options (or even doing all of them) but if you have not guided your business properly through all of the preceding phases of the Business Legal Lifecycle, any inherent problems or incomplete systems will be amplified during this process.
The Maximising Profits phase is the time when you review your business, identify your strengths and weaknesses, and decide how you will consolidate your business. This step involves investing a lot of time and energy into the business to ensure that all of the previous phases are finalised so you can move into the larger growth phases of the Business Legal Lifecycle. Inviting investors into a business is not a step that will work for every business or business owner. When an investor enters, you lose a portion of control, income and capital in your business. Many business owners I have advised over the years have not wanted to relinquish control and consequently never brought in investors. These owners built their business themselves and wanted to maintain control and continue to work in the business.
As a business owner, it is important that you know what you want before you go further. Just because you have been advised that it is a good idea to bring in an investor, if you are not ready or eager to take this step, it could have disastrous consequences. For example, an investor who wants too much day-to-day input into your business may not be a good fit as an active participant in your business if they lack the necessary knowledge or expertise.
This phase is at the bottom of the dip in the Business Legal Lifecycle (see image on page 11) for the simple reason that if a business successfully navigates this phase, it will be set for growth and prosperity in the future. In this chapter, I will discuss the different options, key documents and considerations that you need to think about during and after this phase. It is important to note that this phase does not include expanding the business, franchising or licensing your business (see section 8).
Before you start to maximise your business you need to ensure that you have properly navigated your way through the earlier phases of the Business Legal Lifecycle. If you skipped or rushed through the earlier phases, you will not be able to successfully navigate this and subsequent phases.
During this phase you need to revisit the previous phases to confirm that you have everything set up correctly; for example, ensuring that the:
Once you have these aspects of your business properly established, then you need to seek out new work for your business. Repeat business from existing clients or referrals from existing clients are great methods to build your business but you should also check that you have maximised your staff’s output to ensure that you are sufficiently protected. Doing this will mean that you have maximised the money that you can make out of your existing employees.
When you accept an investor injecting money or expertise into your business, you usually surrender some control of your business in return for the investment. Depending on how your business is structured and the terms of the investment, the investor becomes a co-owner of your now joint business. Even if the funds are in the form of a loan and the investor does not take any actual ownership, the investor may still feel they have certain rights or entitlements to the business.
In section 2.5 I discussed some of the perils of taking out loans when third parties invest in a business. The same principle applies here. My experience in this area has shown time and time again that this phase only fails when the owner and investor do not clearly establish from the outset what role the investor will play in the business, the expectations and the return on their investment.
There are a number of different legal mechanisms you can utilise to carefully introduce an investor into your business.
This usually involves the sale or issuing of new shares in the company, or units in a unit trust. It is important to consider the amount of the investment from both sides of the transaction. Usually, if you operate your business through a company or a trust structure, the person having the majority of the ownership will have control over the business.
For instance, most day-to-day decisions of a company or trust can be made by those that have a 50% interest, plus one of the voting rights in the entity that owns the business. Some bigger decisions may require a bigger percentage; say 75%, plus one of the voting rights in the entity. Whilst it may seem trivial, when a business owner is bringing in an investor, you need to consider the implications of that investment, what the investor gains for their investment, and what the business owner loses
As discussed in section 2.1, the directors of a company control the day-to-day running of the company. Bringing in an investor as a director will often give the investor a lot of control over the business.
Ideally this option should only be considered where the investor makes a large investment and intends to work in the business; otherwise, the investor will have too much control without the business receiving a corresponding benefit.
In these cases, the new investor assumes an immediate and significant degree of control in the entity, which is a big disadvantage for these types of entities. One implication that can’t be overlooked is the need for the dissolution of the old partnership or joint venture, which can have significant tax consequences in certain circumstances.
This is a common strategy for businesses such as property development, where an investor may lend funds at a certain interest rate for a limited period of time to allow for the property to be completed. As discussed in section 2.5, both parties need to give careful consideration to the business’ capacity to repay the loan.
Where you seek to bring in an investor, the unique structure of your business will require careful consideration of both the business owner and the investor’s point of view to ensure that all parties are satisfied with the outcome. A clear understanding at the beginning of this phase will enable you and the other owners to successfully navigate your way through the further phases of the Business Legal Lifecycle to ensure that you build a strong and profitable business.
Where a business operates through a discretionary or family trust, it is important to remember the discussion of the different roles in the trust in section 2.1. Where an investor looks to invest through this structure, careful consideration needs to be given to who controls the business.
There are various examples of where this approach has worked, one being a client who operated a computer sales and service business. The business was a successful one, turning over around $2 million a year in revenue. The owner decided that he wanted to take the business to the next level and try to reach $5 million in turnover. He knew, however, that he could not fund this himself and that he needed to bring in an investor to inject capital into his business. He had to increase his capacity and find bigger premises; considerations that he could not do on his own. Whilst trying to decide what to do, the business owner was approached by an investor who wanted to work in his business. The investor negotiated that in return for injecting a large sum of money into the business, he would take a portion of the equity and work in the business with the owner, effectively making them business partners. Both parties followed the process closely and they were able to successfully bring the investor into the business which now trades with a turnover in excess of $5 million with both the original owner and the investor making a significant profit every year.
There are other examples where the process was not followed and the investor’s relationship was doomed to fail. One example was a hairdressing business which was looking to expand. A hairdressing business requires a great deal of investment at startup – it needs capital to buy the fitout, equipment, and devices needed to operate the hairdressing business. The business owner was looking for an investor who did not want any hands on control of the business but simply wanted to take a stake in the ownership of the business. A suitable investor was found but the parties neglected to document any of the agreements, in particular their expectations and roles. Neither party realised that their understanding of the agreement was totally different. When a dispute arose, as no agreement was in writing, they were not able to resolve the dispute, the relationship broke down and the business had to cease operating. All of this could have been avoided at the outset, had the parties properly documented their agreement.
As previously discussed, the most common structure used to operate a business is a company or unit trust. One of the main benefits of this structure is that it allows for the easy sale of a percentage of the company to third parties via a documented agreement between the parties. The reason for this is that when a business owner starts a business or brings in an investor, they are usually looking at the world through rose-coloured glasses.
However, as in any aspect of life, you need to consider what will happen if things go wrong. Every person in the world has a different personality, things in their lives change, so you need to consider what will happen if that occurs to ensure the continued operation of your business. A shareholders’ and/or unitholders’ agreement is a crucial document that needs to be carefully considered during this phase of the Business Legal Lifecycle. Properly drafted, the agreement will set out the expectations of the parties, the rights and responsibilities of each of the parties, and what happens at the end of the business venture or if there is a dispute.
Generally, the matters considered in a shareholder and/or unitholders’ agreement are matters that are not dealt with by a company’s constitution or trust deeds, such as (this is not an exhaustive list):
As stated above, some points may not be applicable to certain businesses and owners.
The purpose of this list, however, is to emphasise that drafting this type of agreement requires a great deal of care, consideration and professional advice. A properly drafted agreement will set out the rights and obligations of all parties concerned.
An example where such an agreement was used was for an accounting practice which had been in operation for over 10 years with a sole owner. The owner had built the business into a well-oiled machine with a number of employees, one of whom decided that they wanted to buy into the business and the original business owner saw this as a good succession plan. The parties engaged our firm to draft a comprehensive shareholders’ agreement that set out a very clear and concise process for the parties to run the business and a procedure for when the business was to cease. In the event where there is a dispute between the parties then they have a clear exit path and whilst the business continues to operate, the business partners have a clear understanding of what they are doing and where they are going. Had a proper agreement not been in place they could not have had this reassurance that in the event of a dispute, they are Protected.
The term ‘joint venture’ is generally used where at least two parties enter into a partnership but do not want to incorporate a separate structure such as a company or unit trust. This type of arrangement is very common in property investment or speculative ventures.
Given the nature of a joint venture and its close relationship to a company/unit trust structure, many of the considerations that I discussed above in section 6.3 apply to a joint venture type of agreement, the most important features being:
I have seen many cases where proper consideration was not given to these documents to the detriment of all of the parties to the joint venture’s investment. One such example is of a property developer who decided to enter into a joint venture with a third party with whom they had never done any work previously. The joint venture was for the purchase of land, to then obtain development approval on that land to construct a 30 storey building, and then to sell the property on to a third party as they had no experience in building that type of construction. We were approached by one of the joint venturers after it became apparent that the other joint venturer had decided that they no longer wanted to sell the property but wanted to construct the 30 storey building. This was despite the fact that neither of the joint venturers had put up any capital, neither had any significant equity in their properties, and neither had ever constructed anything more than a house previously. As there was no agreement in writing though, a dispute arose over what the intentions of the parties, and there was no mechanism to easily resolve a dispute. Therefore, the parties engaged in protracted litigation and lost tens of thousands of dollars in attempting to resolve their dispute. Had they simply discussed the outcome and direction at the beginning of their joint venture, this would not have occurred and a clear path would have been set. It is also likely that they would not have entered into the relationship to begin with as they clearly had different ideas of the ultimate outcome of the project.
Obtaining advice in relation to this type of agreement is also crucial. Getting the right advice from your lawyer, accountant and other business advisors will mean that you save yourself a lot of problems and costs in the future.
Before you set up a structure and draft documentation for third party investment you need to have your business processes and procedures in place to ensure you successfully navigate your way through this phase. You are also acknowledging the strength of what you have put in place for the future of your business. The next phase of the Business Legal Lifecycle is to focus on business expansion.
Questions to ask before you progress to the next phase:
How can you invest in an aspect of your business to maximise your returns?
Do you have sufficient systems and procedures in place?
Have you identified another market for your business?
Have you properly documented any agreement with an investor in your business?
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