Dear reader,

Welcome to the September 2014 edition of The Director's Dilemma. To read this email in your browser, go to www.mclellan.com.au/newsletter.html and click on 'read the latest issue'.

Companies, and their boards, usually start small and then grow. Good boards manage to keep governance development aligned to the needs of the growing company; more normal boards progress in a series of uncomfortable readjustments as the governance model that worked in the past becomes constricting in the present and potentially lethal for the future. This month our real life case study considers what to do when the governance model needs to evolve from meeting the needs of founders who work in the business to incorporating the more diverse requirements of shareholders as circumstances change.

Consider: What would you advise a friend to do under these circumstances?

Kim is one of six founding directors of an unlisted company supplying IT services and web hosting to local businesses. She has greatly enjoyed being part of a small team that operated with high levels of friendship and trust. Two of the other founders have now reached retirement age. They want to stop working and sell their shares to the remaining directors or to external parties. They really no longer care who has ownership of the business as long as they get a fair price for their equity which is a major asset needed to fund their retirement.

One of the other directors, the largest shareholder, is a passive investor who also wants to have a high share-price and would now like to see the company start paying dividends as he, also, will retire soon and would like the income stream.

Kim’s two other board colleagues, like her, want to continue working and being ‘masters of their own destiny’. They would like to retain control of the company but cannot afford the price the other three directors are willing to sell at. They also want to expand into cloud computing services and invest earnings back into the business so don’t want to pay dividends.

The shareholders agreement stipulates consensus as being required for all decisions of the board regarding equity and dividends. The board has fallen into two camps, of three directors each, that are each accusing the other of suffering from a conflict of interest and not acting in the best interests of the company and its shareholders. Investment and strategy decisions are argued but not resolved and Kim knows the company will soon suffer if this continues.

How can Kim help her board to resolve these conflicts and move forward?

Vivien's Answer

This is a good lesson on the importance of an independent Chair with a determining vote. There are several choices:

One way forward for Kim and her supporting directors is to bring in external parties at the asking price while retaining the current shareholding ratio. The director who wishes to retire and draw dividends could be paid a dividend in lieu of future profits on his shareholding - similar to a reverse mortgage. 

Another is for them to pay the high price being asked, providing it has been independently determined as fair value, and accept the increased level of debt as an investment into their future strategy. Once the sellers are no longer shareholders, it may be easier to reach a consensus with the remaining retiree who is asking for a dividend. One option could be to pay the retiree shareholder an income stream in the form of a salary or director's drawing (or a dividend which Kim and her supporters could re-invest). Should the new strategy succeed, once the company begins to pay all directors (in whatever form), the payments already made to the retiree could be deducted from his future earnings, or his capital realisation should he sell his shares. This arrangement could be managed contractually without too much expense or effort. 

Fairly urgently, they should address the issue of board composition and the shareholder's agreement to ensure they are not at stalemate again in the future.

Vivien Gardiner is an Executive Director of Erase Group. She is based in Melbourne Australia.

Julie's Answer

This problem is born of business success; Kim must recognise the contribution of all shareholders to making this success a reality and rebuild the relationships.

Kim should state her appreciation of her colleagues’ contributions and ask them what they now need in a series of one-on-one face-to-face meetings. She should not to disagree with any statements; just ask for more detail to help understand.

Once Kim has re-established trust she can map out a future that will meet the needs of all parties. The business’ strategy has not evolved to take account of changing shareholder needs. It must.

All six should meet and look strategically at sources of finance and ownership structures. What investments are needed and when? Where are the next level of managers? Can they buy in? Are there potential external investors? What dividend payout ratio is common in the industry? What arrangements exist for sale of shares outside of the current directors and what arrangements may be useful in the future? There is more to strategy than ‘just’ the business!

If Kim believes she can chair that meeting she should; if she doubts she can keep things positive she should get an external facilitator. The aim is to design a future that satisfies everyone.
Bringing in new shareholders at a price that meets the needs of the exiting parties is not impossible and does not necessarily result in a loss of control for the remaining parties. Agreeing a timeline and parameters for a new shareholders’ agreement is crucial. When all six founders agree they can brief a lawyer to draft the document. Drafting whilst in disagreement will be costly and slow.

They should also design a governance structure to fit the desired future shareholding structure and implement processes to help them to review their governance at regular intervals so that it is appropriately aligned as the organisation grows. That way they will not face a rerun of this issue when Kim and her colleagues decide to step back and look to the next generation of investors to provide for their retirement.

Julie Garland McLellan is a practising non-executive director and board consultant based in Sydney, Australia.

Chipo's Answer

This is a classic problem that confronts owners/directors of private companies. They are quasi-partnerships. Marketability of the shares is a big problem. And failure to pay dividends could be grounds for winding up the comany on the just and equitable basis because owner/directors obtain their returns on investment through directors’ fees or salaries.

If Kim wants to retain the ownership of the company amongst familiar owners, and maintain a no dividend policy, she had better obtain a loan and pay-off the other shareholders. She should hope there is a clear share valuation clause in the articles. They may be entitled to sell to whomever or force the winding up of the company.

Chipo Kazako , ACIS, is an independent corporate governance professional based in Sheffield, England.

What's new

Utilising the economic potential of the mature aged worker - As a mature aged worker myself I was delighted to be invited to comment on board positions and the pros and cons of a portfolio lifestyle at this upcoming CPA Australia seminar. If you are in Sydney on 9 September I hope I shall see you there. View details of this event.

Inspirational quote - I subscribe to a service that delivers an inspirational quote every day. It stimulates me to think differently than I otherwise might. This month my favourite quote was not from the service but was a comment made, with vehemence, at an Australian Institute of Company Directors discussion:

If you think you can run a company with no ethical foundation, you are kidding yourself.

~ Trevor Bourne, FAICD, Non-Executive Director, Caltex ~

If you would like to subscribe, the quotes service is run by Darren La Croix at:

http://365inspirationalquotes.com

If you want to have great discussions with your director peers join your local director institute!

Going Global - On 30 September I shall be speaking on ‘Dilemmas for Women in the Boardroom’ in Sao Paulo with Women Corporate Directors and B.I. International  On 24 October I shall be participating in a panel discussion and hosting a dilemma live with the group at the South California NACD conference in Las Vegas. I am really looking forward to meeting all my old friends in those areas and to making some new ones!

This newsletter - If you have any ideas for improving the newsletter please let me know. If you are reading a forwarded copy please visit my website and sign up for your own subscription.

Suggestions for dilemmas - Thank you to all the readers who have suggested dilemmas. I will answer them all eventually.

Disclaimer
The opinions expressed in this newsletter are general in nature and are designed to help you to develop your judgement as a director. They are not a definitive legal ruling. Names and some circumstances in the case study have been changed to ensure anonymity and simplify the issues. Contributors to this newsletter comment in the context of their own jurisdiction; readers should check their local laws and regulations as they may be very different.

Farewell until the next issue (due 1 October 2014). I look forward to greeting you again then.

Enjoy governing your corporations; we are privileged to do what we do!

Best regards,
Julie