How early corporate governance mistakes can become deal-killers
At the start of a company’s life, building a business is all-consuming, especially for founders going it alone. For those with an entrepreneurial background, juggling the quest for investment, continuous product or service development and a huge amount of administration is taxing.
For first-timers, learning to do this on the go is even more tricky. One symptom of this - which happens in many startups - is that, at the earliest stages, founders may make some basic corporate mistakes that cause problems later down the line when they look for investment or decide to exit.
These problems can vary wildly in severity. Poor drafting of documents or failure to properly deal with company administration can usually be corrected later (even if it does require expending legal fees to do so). However, there are circumstances where what may appear at first glance to be a minor corporate governance oversight can give rise to painful tax consequences, potential penalties, or have the potential to put any future investment or sale process at risk.
Because of this, many entrepreneurs dread the due diligence process that accompanies a sale or investment process - where potential investors or buyers put the business under a microscope and scrutinise its financial and legal position. However it needn’t be this way. If the management team gets into the habit of recording corporate activity correctly right from the start and focuses on avoiding the major pitfalls, they can dramatically reduce the chance of a due diligence review revealing something catastrophic.
So, where should founders be extra vigilant?
Maintaining appropriate records
Directors of a company have an obligation under company law to keep certain registers, including a register of members which identifies the shareholders of the company and records when they were issued or transferred shares.
The register of members is the first port of call for anyone looking for evidence of who holds the shares in the company. It is therefore particularly important during a sale that this register is accurate, as a buyer will need to know that it is acquiring all the shares in the company. If mistakes in the register of members are found, lawyers acting for the buyer will often advise their clients to halt proceedings until such errors can be resolved, or require that the shareholders indemnify the buyer for any loss associated with the error. This can cause long delays for both parties, or potentially painful or drawn-out negotiations that detract from the key issues at hand, and may involve the company having to apply for a court order to rectify its register.
Many companies tend to hold their statutory registers electronically - typically as a spreadsheet - which is far more convenient than keeping paper records, but can lead to them being overlooked. Founders should ensure they understand precisely what information needs to be recorded and maintained in the statutory registers, or consider using an online cap table platform (such as Carta).
In the early days of a business, founders or valued service providers may be issued shares in the company in lieu of salaries or payments. It’s not uncommon, though, for management teams to change as the company evolves or for service providers to no longer be considered part of the future of the business. Rather than allow such people to retain their shares and participate in the economic growth of the company when they are no longer contributing, many companies put in place shareholders’ agreements with a mechanic allowing the company to buy-back that person’s shares.
However, exercising that mechanic needs to be done properly. Company law is very prescriptive regarding the steps that must be followed (including when payments can be made for the shares).
A share buy-back which is not carried out in accordance with the process set out under company legislation will be void, which may have the consequence that the relevant shares are still in issue. Discovering during due diligence in the run up to a sale that a shareholder who left the business years ago still holds his shares can have devastating consequences: tracking that person down can be difficult and the whole sale process could be at risk if they prove to be uncooperative. It is highly improbable that any buyer would overlook this issue if it were discovered, or proceed with the purchase until it was resolved.
Additionally, failure to comply fully with a buy-back process constitutes a criminal offence by the company and each of its directors in default, punishable by a prison sentence of up to two years, an unlimited fine or both.
EMI share option schemes
One further issue which can potentially derail a transaction is the discovery of a poorly set up share option scheme.
These schemes are designed to incentivise employees by supplementing their income with the right to acquire shares, which helps businesses retain top talent. EMI share options schemes are extremely popular as they are particularly tax efficient. They are crucial to fast-growth UK startups, which will typically offer significantly lower base salaries, so much so that some of Britain’s top startups have written to the Prime Minister asking for the cap on EMI schemes to be increased to £100m in revenues or 500 employees.
However, if the scheme has been badly drafted or the correct procedures have not been followed, employees may find that they are paying significantly more tax than expected at exit. Suddenly a prospective buyer has a disgruntled future workforce on its hands, whilst the founders face a large headache and potential deal killer.
For early-stage founders, making sure things are done correctly is a hugely beneficial trait in the long run. Think of recording information as providing tangible value for future investors or buyers - it really will pay off.
Written by Amanda Solomon, Head of Tax at Kemp Little LLP and Rebecca Denton, Senior Associate in the Corporate team at Kemp Little LLP.