Guiding Principle
It is common amongst business operators to invite third parties to become shareholders in the operators’ commercial entities. This article aims to shed some light on whether or not this is usually a good idea.
A. Expression of Gratitude
Every entrepreneur will know the situation where a future expansion of the business requires additional funds, which a third party (other than a commercial bank) is willing to provide. Sometimes it also just seems appropriate to team up with a third party in order to make use of such party’s experience, access to potential customers, etc. There are also situations where a business operator receives a substantial amount of assistance from another person and wants to show his gratitude. Quite often, all of the above scenarios result in shares being offered in the entrepreneur’s commercial entity.
Is this a good idea? In our opinion, in most cases it is not, and this is why:
B. Problem
“Too many chefs spoil the broth” is a saying that probably all of us are familiar with. It is a proverb that most probably finds its translation in many languages and there is a good reason for it. It applies to many situations in life and commercial entities’ operations are no exception.
The reason why shares are being offered to third parties is usually such that the third party is supposed to be put in a position where it can participate in the company’ profits. While this is a perfectly understandable and noble thought, the role of a shareholder in a commercial entity such as companies with limited liability (LLC) far exceeds the status of mere dividend recipient though. For example, each shareholder in a LLC has both the right and the obligation to take care of the LLC’s wellbeing. Shareholders, even those owning only a comparatively small minority share, are obliged to be aware of the company’s financial status at all times. This includes a duty to provide the company with fresh liquidity, should this be required in order to keep the company operational. Hence, being a shareholder is not a one-way street to profit participation, but, in unfortunate circumstances, may also become a cash burden on the shareholder.
Inviting third parties as shareholders is also not necessarily a very good idea for the business operator / entrepreneur. The highest authority in every commercial entity are the shareholders. The shareholders take the major decisions including the appointment and dismissal of the general manager. The general manager as such derives all his or her powers from the shareholders. This means that general managers have only those powers that the shareholders have granted them. There is no such thing as “built-in” powers for general managers. If, however, the shareholders are the highest decision-making authority in each commercial enterprise, being generous with company shares automatically restricts the entrepreneur’s ability to run the company.
It is quite a common sight for lawyers to see entrepreneurs who have effectively lost control over their enterprise and are then quite surprised to see how others run „their“ enterprise, who usually have their very own ideas on how best to run the company. Conflicts are often unavoidable and sometimes even lead to the downfall of the whole operation. Good for lawyers to generate extra income, not so good for the enterprise and its owners.
C. Solution
The solution to the above is as simple as it is effective: be careful with offering shares to third parties. The intention for doing so may well be honourable, but the potentially negative consequences for both, business owners and incoming shareholders are often underestimated. In most cases, offering shares as a symbol of gratitude or reward is not even necessary.
If, for example, a third party has invested funds in the entrepreneur’s business, a well-drafted loan agreement offers much better protection for both, the investor and the entrepreneur. It is absolutely permissible to pay back the loan by way of profit participation. Hence, the investor receives back his investment plus interest over time and the repayment is tied to the profits actually generated. Such loan agreement gives the investor the same benefit that such investor would have had by becoming a shareholder, less the risk of having to make available even further funds in events where the company does not manage the turnaround.
Where another person’s experience or access to potential customers is required or desirable; why not enter into some form of referral arrangement with this person? With such arrangement in place, the third party will be paid only if such party has actually delivered, thus avoiding the all too common trap where such third party is very good in “talking the talk”, but not so good in actually delivering on its promises.
Finally, if the main motivation for granting shares is gratitude for assistance already received, do not offer shares, but show your appreciation by other means, such as the payment of certain amounts, opening doors for such person, etc. As mentioned above, being a shareholder does not just equal “profit participation”. Being a shareholder is not only a benefit, but comes with its very own set of both, rights AND obligations.
