Starting a Company with Business Partners in Australia: 6 Legal Issues to Address Early

Two or more friends, colleagues or business partners decide to establish a company together. At the beginning, attention is usually focused on developing the product, finding customers and generating revenue — not preparing legal documents.

The founders may trust one another and assume that important issues can be resolved informally. However, problems often emerge only after the business becomes profitable, acquires valuable assets, employs staff or attracts outside investment.

By that stage, disagreements about share ownership, decision-making, founder contributions or access to financial information may be much more difficult and expensive to resolve.

Key point: Registering a company is only the beginning. Founders should clearly document ownership, decision-making, funding, financial access and exit arrangements before the business grows and disagreements arise.

In this article:

• Preparing a tailored shareholders agreement
• Confirming who actually owns the shares
• Managing deadlock and major decisions
• Documenting shareholder loans and founder contributions
• Considering individual or family trust ownership
• Controlling access to company information and finances

1. Put a Tailored Shareholders Agreement in Place

A shareholders agreement regulates the relationship between the shareholders and establishes how important business decisions will be made.

Founders often postpone preparing a shareholders agreement because their immediate attention is focused on developing the business. However, once the company begins generating revenue, taking on liabilities or increasing in value, disagreements about ownership, control, funding and founder responsibilities may become much harder to resolve.

A shareholders agreement should therefore not be treated as a generic document added to the company file after registration. It should reflect the company's actual ownership, management, funding and operational arrangements.

Depending on the circumstances, a shareholders agreement may address:

• the roles and responsibilities of each shareholder
• appointment and removal of directors
• voting rights and decision-making procedures
• access to financial and company information
• founder salaries, bonuses and dividends
• future funding requirements
• shareholder loans
• the issue of new shares
• protection against dilution
• restrictions on share transfers
• rights of first refusal
• tag-along and drag-along rights
• confidentiality and intellectual property
• restraint and non-solicitation obligations
• death, incapacity, bankruptcy or misconduct
• valuation of shares
• founder departure and compulsory transfers
• deadlock procedures
• dispute resolution

The agreement should also be reviewed together with the company's constitution. If the shareholders agreement and constitution contain inconsistent voting, transfer or governance provisions, the documents may create uncertainty rather than prevent it.

A carefully drafted agreement should also distinguish between the shareholder's different capacities. A person may simultaneously be:

• a shareholder
• a director
• an employee
• a lender to the company
• a personal guarantor of company obligations

Each capacity creates different rights and responsibilities. Losing employment, for example, does not automatically mean that the person ceases to be a shareholder.

2. Confirm Who Actually Owns the Shares

A founder may sign a shareholders agreement, contribute the agreed funds and begin working in the business on the understanding that they own an agreed percentage of the company.

While the business relationship remains cooperative, the founders may not check whether the agreed shares were formally issued, whether the company's share register was updated or whether the change was notified to ASIC.

The problem may only come to light after a dispute arises. For example, a founder may decide to leave the business and ask for their shares to be purchased or their investment to be returned, only to discover that an ASIC search does not record them as a shareholder.

This may create significant uncertainty about the founder's legal position. They may face difficulty establishing their voting rights, entitlement to dividends, access to company information or ability to sell or require the purchase of their interest. It may also become more difficult to determine whether the funds contributed were paid for shares, advanced as a loan or provided under some other arrangement.

However, the fact that the founder is not recorded as a shareholder in an ASIC search does not necessarily mean that they have no legal rights in relation to the shares or the funds contributed. Depending on the agreement and the surrounding circumstances, the founder may still have contractual or other legal rights.

The position will usually require a review of the shareholders agreement, payment records, communications between the parties, the company's register of members, relevant resolutions, share certificates and ASIC records. It may mean that:

• the company did not complete the agreed share issue or transfer
• the company's internal share register was not updated
• ASIC was not notified of the change
• the agreement created a right to receive shares, but the required corporate steps were never completed
• the parties never clearly documented whether the payment was for shares, a loan to the company or another form of contribution

At that stage, the founder's position may depend on the wording of the shareholders agreement, evidence of payment, communications between the parties and the company's internal records.

3. Plan for Deadlock and Major Decisions

A company owned equally by two shareholders may appear fair and balanced. However, a 50/50 ownership structure creates an inherent risk of deadlock.

The shareholders may disagree about matters such as additional borrowing, founder salaries, the distribution of profits, employing senior staff, admitting a new investor or selling the business. If neither shareholder has sufficient voting power to approve a decision, the company may be unable to proceed.

A shareholders agreement should therefore include a clear process for resolving deadlock. Depending on the business, this may involve internal negotiation, mediation, expert determination and, as a last resort, an agreed buy-out or sale process.

Some agreements allow one shareholder to offer either to buy the other shareholder's shares or to sell their own shares at the same price. While this type of mechanism may be effective in some circumstances, it can operate unfairly where one shareholder has substantially greater financial resources than the other.

A deadlock clause should therefore reflect the founders' respective financial positions, roles in the business and intended exit arrangements. It should not simply be copied from a standard precedent.

Reserved matters

The founders should also identify decisions that are too important to be made by one director or an ordinary shareholder majority. These decisions are commonly referred to as reserved matters.

Examples may include:

• issuing new shares or admitting a new shareholder
• borrowing above an agreed limit
• purchasing or selling a major asset
• changing banking authorities
• entering a transaction with a founder or related party
• materially changing the nature of the business
• selling the business
• winding up the company

The agreement may require unanimous approval or another specified voting threshold for these matters.

The appropriate threshold will depend on the company's ownership structure. A threshold that protects a minority shareholder in one company may give another shareholder an unintended veto in a different company.

There is no single deadlock mechanism or voting threshold that is suitable for every company.

Starting a company with one or more business partners? Legal advice obtained before the company begins trading can clarify ownership, decision-making, funding and exit arrangements before substantial value is created.

4. Document Shareholder Loans and Founder Contributions

Money contributed by founders is a frequent source of later disagreement.

For example, one founder may transfer money to the company believing that it is a loan that must eventually be repaid. The other founders may understand the same payment to be an equity contribution made in exchange for shares.

The difference may not become important until the founder wishes to leave the business, asks for the money to be returned or the company experiences financial difficulty.

Terms such as "investment", "capital contribution" or "funding" do not, by themselves, show whether the money was paid for shares, lent to the company or provided under another arrangement. That distinction may affect whether the founder can demand repayment, seek to enforce a right to receive shares or pursue another legal remedy if the relationship breaks down.

Depending on the arrangement, money or value provided by a founder may represent:

• subscription money paid for shares
• a loan made by a founder, shareholder or director to the company
• payment of company expenses by the founder, with an expectation of reimbursement
• services or other non-cash contributions provided in return for shares or other agreed rights
• an advance intended to be converted into shares at a later time
• an undocumented payment whose purpose and repayment terms were never clearly agreed

These arrangements may create very different rights when a founder leaves the business or seeks to recover the funds contributed.

If the payment was subscription money for shares, the founder may not be entitled simply to demand repayment when they leave. They may instead need to negotiate a sale or transfer of their shares or consider whether a company share buy-back or another lawful exit arrangement is available.

If the payment was a loan, the right to repayment will depend on the agreed loan terms.

Where a founder advances money to the company as a loan, the arrangement should be documented in writing. A separate loan agreement will generally be appropriate unless the full terms are already clearly set out in another binding document.

A founder loan should address matters such as:

• the amount and purpose of the loan
• whether interest is payable
• whether the loan is repayable on demand, on a fixed date, by instalments or subject to agreed cash-flow conditions
• whether the loan is secured or unsecured
• whether the founder must wait until a bank or another external lender has been repaid
• whether the loan may be converted into shares and what approvals and documentation would be required
• how any future funding requirements will be handled
• what happens to the loan if the founder leaves or the business is sold

If security over company assets is intended, separate security documentation may be required. The parties should also consider whether the security interest should be registered and whether any priority issues need to be addressed.

The company's accounting records should be consistent with the agreed arrangement. However, an accounting entry or bank-transfer description does not, by itself, establish the parties' legal rights or repayment terms.

Spreadsheets, bank-transfer descriptions and informal messages may become important evidence of what occurred, but they often do not record all relevant terms clearly.

Founder funding should be documented when the money or other value is contributed, rather than reconstructed after a dispute has arisen.

5. Consider the Ownership Structure Before the Business Grows

Founders sometimes register shares in their personal names because this appears to be the simplest arrangement when the company is established.

Later, they may consider whether the shares should instead be held by the trustee of a family trust, including for succession planning or asset-protection reasons, or after receiving separate taxation advice.

Where shares are held through a family trust, the registered shareholder will generally be the individual or corporate trustee — not the trust itself. The company's records should also correctly identify whether the trustee holds the shares beneficially or on behalf of the trust.

Changing the ownership arrangement after the business has developed significant value may be more complicated than considering the proposed structure at the outset.

A proposed transfer may require consideration of:

• restrictions in the company's constitution
• pre-emptive rights or transfer restrictions under a shareholders agreement
• approval from the directors or other shareholders
• the value attributed to the shares
• lender or investor consent
• existing personal guarantees or security arrangements
• share transfer and supporting company documents
• updating the company's register of members and notifying ASIC
• potential taxation or duty consequences, on which separate specialist advice should be obtained

Holding shares through a family trust does not guarantee asset protection. It also does not remove a director's statutory duties or any personal liability assumed under a guarantee or other contract.

Where the company is already operating, the transfer should not be implemented without first reviewing the constitution, shareholders agreement, trust documentation and the company's existing financing arrangements.

Henton Legal can advise on the relevant company law issues and prepare the necessary legal documentation. We do not provide taxation, accounting, financial or financial planning advice, and separate advice should be obtained where required.

6. Agree on Financial Access, Authority and Company Controls

A founder may own a substantial percentage of a company but still have limited practical access to its financial information or day-to-day operations.

For example, another founder may be the only director, the only authorised bank signatory and the only person with access to the company's accounting system.

Being a shareholder does not automatically mean that a person is also a director, employee or authorised bank signatory. It also does not automatically give them authority to operate the company's bank accounts or enter into contracts on its behalf.

A shareholder may therefore have limited access to:

• the company's bank accounts
• accounting and payroll systems
• financial and compliance records
• management accounts
• customer and supplier contracts
• budgets and financial forecasts

Directors have a statutory right to access the company's financial records at all reasonable times. A shareholder who is not also a director does not automatically have the same continuing right of access.

A shareholder may have particular information rights under the Corporations Act, the company's constitution or a shareholders agreement. The extent of those rights should therefore be clearly considered and documented.

The founders should agree on practical controls, including but not limited to:

• who may view or operate the company's bank accounts
• whether two approvals are required for payments above an agreed amount
• who may access accounting and payroll systems
• what financial reports must be provided and how frequently
• who approves founder salaries, bonuses and expense reimbursements
• how payments involving a founder or related party will be approved
• who is authorised to enter into contracts on behalf of the company
• which expenditure requires board or shareholder approval

Any agreed controls should also be reflected in the company's banking authorities, accounting-system permissions and internal approval procedures.

Clear financial controls can reduce the risk of unauthorised payments, undisclosed related-party transactions, disputes about salaries and expenses, or one founder withholding important company information.

Common Warning Signs

Legal advice should be obtained promptly where:

• a founder was promised shares but the shares were never formally issued
• ASIC records do not match the company's register of members
• the company cannot locate its constitution or share register
• a 50/50 company has no deadlock procedure
• there is no shareholders agreement
• one founder controls all banking and financial information
• substantial founder contributions have not been documented
• a founder wishes to transfer personally held shares to a family trust
• a founder has stopped working but continues to hold shares
• the parties disagree about salaries, dividends or expenses
• new shares have been issued without clear approval
• an investor or purchaser has identified defects in the company records

Obtaining legal advice does not necessarily mean that a dispute is expected. The objective is to identify uncertainty while the founders are still able to resolve the issues commercially.

How We Can Assist

Henton Legal can assist founders, shareholders and privately owned companies with:

• company establishment, governance and legal ownership arrangements
• reviewing company constitutions
• drafting shareholders agreements
• deadlock and reserved-matter provisions
• shareholder and director loan agreements
• share issues and share transfers
• legal advice and documentation relating to shares proposed to be held by an individual or corporate trustee for a family trust
• review of ASIC and company records
• founder exit and succession arrangements
• intellectual property assignments
• director, employment and contractor agreements
• negotiated shareholder buy-outs
• early-stage advice, negotiated resolutions and shareholder buy-outs in relation to shareholder disputes

Obtaining advice when the company is established, or before a proposed change is implemented, is generally more effective than trying to reconstruct the parties' intentions after a dispute has arisen.

If you are establishing a company, introducing a new shareholder, restructuring an existing shareholding or dealing with uncertainty about shareholder rights, contact Henton Legal to discuss the appropriate documentation and next steps.

Speak with our Commercial Lawyer

This article provides general legal information only and does not constitute legal advice. Henton Legal does not provide taxation, accounting, financial or financial planning advice. Any references in this article to taxation, duty, valuation, accounting or financial consequences are included only to identify issues on which separate advice may be required. You should obtain advice from appropriately qualified advisers regarding your particular circumstances before implementing any transaction or restructuring. Reading this article does not create a solicitor-client relationship with Henton Legal.