Letting Someone Into Your Business: The Legal Risks of a New Shareholder or Business Partner

There is a common saying in business:

It is easy to let someone into a business. It can be very difficult to get them out.

This is particularly true when the person is not merely an employee, consultant or business associate, but becomes a shareholder, director or partner.

At the beginning, everything usually looks straightforward.

Two business owners meet. They have complementary skills. One has capital. The other has the business, customers or know-how. They get along. They discuss their plans over coffee. Everyone is excited about what the business could become.

Then someone says:

“Why don’t we do this together?”

A few months or years later, the problems begin.

The problem is not necessarily that anyone has cheated anyone.

In fact, many shareholder and business-partner disputes do not start because one person is dishonest, a scammer or a bad person.

They start because two perfectly reasonable people want different things.

One wants to grow aggressively. The other wants a stable business.

One wants to reinvest profits. The other wants dividends.

One wants to sell the business in five years. The other wants to build a family business for the next twenty years.

One is prepared to work seven days a week. The other wants the business to provide financial freedom.

One wants to bring in investors. The other does not want outsiders involved.

None of these necessarily makes anyone dishonest.

They simply make them incompatible business partners.

That is why bringing a new shareholder or partner into a business is not simply a commercial decision. It is also a legal and governance decision.

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1. The biggest mistake: treating the new shareholder like a new employee

Business owners are accustomed to hiring people.

If an employee does not work out, there is usually a contractual mechanism for termination, subject to applicable employment laws and the terms of employment.

A shareholder is fundamentally different.

When you issue or transfer shares to someone, you are potentially giving that person:

• an ownership interest;
• voting rights;
• economic rights;
• information rights;
• rights to participate in shareholder decisions;
• potentially board representation;
• the ability to influence the company’s future; and
• statutory remedies if the shareholder considers himself or herself unfairly treated.

Under the Malaysian Companies Act 2016, the board manages or directs the business and affairs of the company, while shareholders exercise various rights through the statutory and constitutional framework.

The important point for business owners is this:

You are not merely giving someone a job. You are giving someone a legal position in the ownership structure of the business.

That position may remain long after the relationship between the parties has deteriorated.

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2. “We trust each other” is not a legal strategy

One of the most common statements I hear in business is:

“We don’t need a shareholders’ agreement. We trust each other.”

That may be true.

But a shareholders’ agreement is not necessarily about protecting yourself from dishonest people.

It is about protecting a good relationship when circumstances change.

Imagine two founders who have been friends for fifteen years.

They start a company together.

Five years later:

• one gets married;
• one has children;
• one wants to retire;
• one wants to move overseas;
• one needs cash;
• one wants to take another business opportunity;
• one becomes more ambitious;
• one becomes less ambitious.

Suddenly, the original understanding no longer works.

Nobody has necessarily done anything wrong.

The problem is that the business has changed and the people have changed.

A well-drafted shareholders’ agreement is therefore not a document based on distrust.

It is a document that answers the difficult questions while everyone is still getting along.

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3. The Companies Act gives you a framework — but not necessarily the deal you actually want

The Companies Act 2016 provides an important framework for companies in Malaysia.

It deals with matters such as:

• directors’ duties;
• shareholder rights;
• meetings and resolutions;
• share issues;
• transfers;
• disclosure of interests;
• corporate governance; and
• remedies for shareholder oppression.

For example, the Companies Act imposes duties on directors to exercise their powers for a proper purpose, in good faith and in the best interests of the company.

But the legislation is not designed to record the specific commercial bargain between your particular shareholders.

That is where the shareholders’ agreement becomes important.

The law may tell you what rights a shareholder has.

Your agreement should tell you how the parties have agreed to operate the business together.

For example:

• Who appoints the managing director?
• Who controls day-to-day operations?
• What decisions require unanimous approval?
• Can a shareholder sell shares to an outsider?
• What happens if someone wants to leave?
• What happens if someone dies?
• What happens if someone becomes disabled?
• What happens if shareholders cannot agree?
• How are shares valued?
• What happens if one shareholder stops working?
• What happens if one shareholder wants to retire?
• Can the founders force a sale?
• Can a minority shareholder participate in a sale?
• What happens if additional capital is required?

These are commercial questions with significant legal consequences.

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4. The most dangerous assumption: “We can remove him later”

This is perhaps the most important lesson for business owners.

Do not assume that you can simply remove a shareholder because the relationship has broken down.

Removing someone as a director and removing someone as a shareholder are two very different things.

A shareholder owns shares.

Those shares are property.

If the shareholder refuses to sell, there may be no simple mechanism allowing the other shareholders to say:

“We don’t want you anymore. Here is your money. Goodbye.”

The position can become considerably more complicated.

The Companies Act 2016 provides statutory remedies in appropriate circumstances, including where the affairs of a company are conducted in a manner that is oppressive to, or in disregard of, the interests of members.

However, going to court should not be the exit strategy you planned from the beginning.

Litigation is expensive, slow and disruptive.

More importantly, by the time a statutory remedy becomes relevant, the relationship has usually already broken down.

The better approach is to agree the exit mechanism before the relationship breaks down.

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5. The real problem is often a difference in ambition

Consider a simple example.

Ali owns 70% of a successful company.

He brings in Bala, who receives 30%.

Ali has built the business for ten years.

Bala joins because he has industry contacts and believes he can help the company grow.

Three years later, the company is profitable.

Ali says:

“Let’s keep the company small. I want to take dividends.”

Bala says:

“We should borrow money, hire more people and expand into three countries.”

Both may be right.

The problem is not dishonesty.

The problem is different objectives.

If the shareholders’ agreement does not address major strategic decisions, the dispute can eventually become a governance problem.

This is why a shareholders’ agreement should not merely deal with what happens if someone dies or sells shares.

It should deal with how the shareholders intend to make decisions while they are alive and still working together.

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6. The second problem: different expectations about money

Money is one of the most common sources of shareholder disputes.

Questions that should be discussed at the beginning include:

How will profits be used?

Will profits be:

• distributed as dividends;
• retained in the business;
• used for expansion;
• used to repay shareholder loans;
• invested into new businesses?

Will shareholders receive salaries?

A shareholder who works full-time in the company may expect a salary.

A passive investor may expect dividends instead.

What happens if the working shareholder wants to increase his salary?

What approval is required?

What happens when the company needs more money?

Suppose the company needs RM1 million.

One shareholder can contribute RM700,000.

The other cannot.

Does the first shareholder:

• provide a shareholder loan?
• subscribe for additional shares?
• receive more shares?
• dilute the other shareholder?
• require both shareholders to contribute proportionately?
• allow a third-party investor to come in?

These issues should be agreed before the money is needed.

Because when the company is already running out of cash, shareholders are unlikely to negotiate calmly.

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7. Dilution can become a serious dispute

Bringing in a new shareholder also changes the ownership structure.

Suppose A owns 60% and B owns 40%.

The company then issues new shares to C.

Suddenly:

• A’s percentage decreases;
• B’s percentage decreases;
• C has voting rights;
• the balance of power changes.

This is particularly important where the shareholders want to control:

• future fundraising;
• new investors;
• dilution;
• founder protection;
• preferential rights;
• new classes of shares; and
• strategic investors.

A business owner should therefore understand exactly what percentage of ownership and control is being given away, not merely what amount of money the new shareholder is investing.

A 20% shareholding is not simply “20% of the profits”.

It may also represent 20% of the voting power, economic rights and future value of the company, depending on the structure of the shares and the company’s constitutional arrangements.

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8. What happens if the new shareholder wants to sell?

This is another question that is frequently ignored.

A founder may say:

“I’m bringing my friend into the company. He’ll never sell.”

Never is a very long time.

The new shareholder may later:

• need money;
• retire;
• relocate;
• die;
• change careers;
• receive an attractive offer;
• fall out with the other shareholders;
• decide that the investment is no longer suitable.

The shareholder may want to sell.

But to whom?

Can he sell to:

• a stranger?
• a competitor?
• another shareholder?
• a family member?
• an overseas investor?

These questions should be addressed before the shares are transferred.

Existing shareholders may want a right of first refusal or pre-emption right before shares can be sold to an outsider.

They may also want to prevent shares from falling into the hands of a competitor or someone who is fundamentally incompatible with the business.

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9. The “bad leaver” and “good leaver” problem

This becomes particularly important where a shareholder is also an employee or director.

Imagine a founder receives 20% of the company on the understanding that he will actively run the business.

Five years later, he resigns.

Does he keep the 20%?

Maybe.

But perhaps the remaining founders believe:

“Those shares were given to him because he was going to build the company with us.”

This is where good leaver/bad leaver provisions can become important.

For example, the agreement may distinguish between someone leaving because of:

• retirement;
• death;
• permanent incapacity;
• redundancy;
• termination without fault;

and someone leaving because of:

• serious misconduct;
• fraud;
• breach of restrictive covenants;
• competing with the company;
• voluntary resignation during a specified period.

The agreement can then prescribe different consequences.

Without an agreed mechanism, a shareholder who stops contributing may nevertheless continue to own the same shares.

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10. The “family and friends” problem

Business owners often bring in people they know.

A brother.

A spouse.

A childhood friend.

A former colleague.

A trusted business contact.

This can actually increase the risk of avoiding proper documentation.

People are often reluctant to have difficult conversations with someone they care about.

They think:

“We don’t need to talk about what happens if we fall out.”

But that is precisely when it should be discussed.

A properly drafted agreement can actually protect the relationship because everyone understands the rules.

The agreement says what happens.

The parties do not have to negotiate those rules for the first time when they are angry.

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11. Death is another issue people avoid discussing

Nobody likes discussing death when starting a business.

But shareholders die.

What happens to their shares?

Do they pass to their estate?

Can the beneficiaries become shareholders?

Does the surviving shareholder have a right to buy them?

How is the price calculated?

Where does the money come from?

Is there insurance?

A well-designed agreement can create a mechanism for dealing with death and, where appropriate, be coordinated with life insurance or other funding arrangements.

Otherwise, the surviving founder may suddenly find himself in business with the deceased shareholder’s estate or beneficiaries.

Again, nobody has done anything wrong.

It is simply the consequence of not planning for an entirely foreseeable event.

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12. Valuation is often where relationships collapse

Suppose the agreement says:

“If a shareholder wants to leave, the other shareholders may buy his shares.”

That sounds good.

But at what price?

Is it:

• book value?
• net asset value?
• market value?
• a multiple of EBITDA?
• an independent valuation?
• a pre-agreed formula?
• a discounted value?
• a value without minority discount?
• a value including or excluding shareholder loans?

This is where an apparently simple exit clause can become the subject of a major dispute.

The exit mechanism is only as good as the valuation mechanism behind it.

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13. What happens when someone stops working?

This is one of the most common practical problems.

Imagine three shareholders:

• A — 40%
• B — 30%
• C — 30%

All three work in the business.

A works every day.

B works occasionally.

C stops working almost entirely.

But everyone still owns the same shares.

A may eventually ask:

“Why am I doing all the work while C receives 30% of the profits?”

This is not necessarily a shareholder dispute.

It may be an expectation dispute.

Was share ownership supposed to reflect:

• capital contribution?
• work contribution?
• business connections?
• intellectual property?
• future contribution?

If work is an important part of the bargain, the legal documents should reflect that.

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14. Deadlock: the 50/50 problem

A 50/50 business can look fair.

It can also be a legal and commercial nightmare.

Imagine:

A — 50%

B — 50%

A wants to expand.

B does not.

A wants to appoint a new director.

B refuses.

A wants to sell.

B refuses.

B wants to borrow money.

A refuses.

Nobody has enough votes to force the other person to agree.

The company is now stuck.

This is called deadlock.

A good shareholders’ agreement should consider what happens when shareholders cannot agree.

Possible mechanisms include:

• escalation to senior representatives;
• mediation;
• expert determination for technical disputes;
• casting rights in limited circumstances;
• buy-sell mechanisms;
• put/call options;
• agreed sale processes;
• ultimately, an agreed exit or winding-up mechanism.

The precise mechanism should be carefully considered because each can produce very different commercial outcomes.

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15. Reserved matters are particularly important

Not every business decision should require everyone’s approval.

But certain decisions may be too important to leave to ordinary management.

These are often dealt with as reserved matters.

For example:

• issuing new shares;
• borrowing above a certain amount;
• selling major assets;
• acquiring another company;
• entering a new business;
• changing the nature of the business;
• approving major capital expenditure;
• related-party transactions;
• changing directors;
• changing remuneration of key shareholders;
• declaring dividends;
• granting security;
• entering long-term contracts;
• selling major business assets;
• winding up the company.

The key is to decide which decisions require what level of approval.

Otherwise, shareholders may discover only after a dispute that they had very different ideas about who was supposed to control what.

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Conclusion: Do not only plan how to get into business together — plan how you get out

Business owners spend enormous amounts of time deciding:

Who should come into the business?

They should spend just as much time asking:

What happens if this relationship no longer works?

Bringing in a shareholder can provide capital, expertise, contacts, credibility and new opportunities.

But it also changes the legal structure of the business.

Once someone becomes a shareholder, removing that person may not be as simple as terminating an employee or ending a consultancy arrangement.

The better approach is to agree the rules before the disagreement happens.

The objective is not to prepare for a fight.

It is to avoid having the fight in the first place.

A good shareholders’ agreement should therefore answer one fundamental question:

“If we are no longer able to agree, how do we separate our business interests fairly, efficiently and with as little damage to the business as possible?”

Because the easiest time to agree on an exit is when everyone still wants the relationship to succeed.

Once the relationship has broken down, everyone has a different idea of what “fair” means.

And that is when a document that was once considered unnecessary can become the most important document in the company.

For business owners, the lesson is simple:

It is easy to let someone into your business. Make sure you know how they can leave — and how you can leave them — before you give them the keys.