Dear reader,

Welcome to the September 2020 edition of The Director's Dilemma. Each month this newsletter looks at a real-life scenario that happened to a board, perhaps to a board like yours, and considers a range of responses. The scenarios are de-identified to protect the individuals concerned.

Our dilemma this month looks at cleaning up the mess left by an unscrupulous MD. I honestly could not have made this up; however, when it came to me with a request for assistance, I did enjoy the challenge and resolving the tricky relationship issues that arose from it.

I have over twenty-two years' experience consulting to, and serving on, boards. It is a pleasure to share some of it with you in this newsletter and I would be even more delighted to share it with you when your board needs a performance review, strategy workshop, or director education session.

To read this email in a web browser, go to www.mclellan.com.au/newsletter.html and click on 'read the latest issue'.  I hope you will enjoy the latest dilemma:

Zachariah recently accepted the role of Managing Director with a medium sized private company. The previous MD resigned when $400K of unauthorized withdrawals was discovered. She left the company with an increasing, unscheduled debt problem.

The now ex-MD owns around 12% of the shares, held through a trust, with a possible value of $200K. The board offered to extinguish the ex-MD's debt if the shares are sold and 100% of the proceeds are paid to the company. They also agreed not to pursue the ex-MD for the remainder of the outstanding amount or to report her to the authorities. Deeds of separation have been signed and contain strong confidentiality provisions.

Now, one of the directors, who is a friend of the ex-MD, owns 40% of the shares, is an unsecured creditor, and also a key international vendor, has given notice he's found a buyer for his shareholding and will invite the ex-MD to sell to the same buyer. Thus 52% of the equity is now going to an unknown party.

Zachariah's concern is that this new shareholder will have a majority interest, effectively controlling the company and, if allied with the ex-MD, could make his role precariously uncomfortable. The Chair owns 15% of the shares and is the son of the founder. He is greatly loved by the other directors and chairs an inclusive meeting, but has no idea how to proceed under these circumstances.

What should Zachariah do?

This is a private company so the first thing Zachariah should do is scrutinize the shareholders' agreement. Private companies are very chary about protecting their shareholding structure and it would be most unusual not to have a clause dealing with pre-emptive shareholder rights, which effectively gives the current shareholders right of first refusal.

Even if there are no takers, and the shareholder then offers them to an outside buyer, they can't do so at a discounted rate, unless they have previously offered the same discount to the current shareholders.

Zachariah should approach the Chair, who has a vested interest in the company, and float the idea of a management buy-in, even if it means approaching an institution to fund a portion of the purchase or find a friendly purchaser (White Knight).

However, careful scrutiny of the shareholders' agreement might also reveal a penalty clause in the event of fraud or misconduct. This normally means that those shares can be acquired at cost from the transgressor, and not at market value. As MD, he is also within his rights to check if the deeds of separation and confidentiality provisions pass a common-law test and whether they are in fact, enforceable in law.

Zacharia should also meet the proposed new shareholder and get a sense of who they are and what value they would add to the business. Finally, the Chair and MD should insist on some form of redress from the ex-MD in the form of a payment plan to return the unauthorized withdrawals, and in the event the former MD can't meet this, then consider a bond against her existing assets.

Stephen Dallamore Chairman of AltoPartners and Managing Director of Search International. He is based in Johannesburg, South Africa.

Zacharia is in a bind. He should get a legal opinion on the deed of separation and the shareholders' agreement and/or constitution. The company agreed to accept the proceeds of the ex-MD's share sale in lieu of complete reimbursement of the unauthorised withdrawn funds; does that supercede any shareholders' agreement that might include constraints on the sale?

Control now rests with the incoming investor; Zacharia needs to meet and understand their position. He had the skills, qualifications and reputation to gain the MD appointment but must now prove it again. He should also get legal advice on his contract and how it may protect or compensate him if he is ousted.

A new majority shareholder has power to call a meeting and replace individual directors or the whole board. This could be followed by a decision to change to an MD the new board has chosen. Zacharia needs to be the best choice available. The best way to do that is by building a relationship and sharing with the investor his plan for reporting to the board, managing the debt, and establishing positive cash flows.

Zacharia is suffering his board's failure to provide good governance. Better controls and oversight would have prevented the ex-MD stealing from the company. Moving quickly to agree on a 'quiet exit' has opened the door to a potential comeback or vengeful action.

It is important, when taking on a CEO or MD role, to look beyond the business and focus on the board. While he grapples with this problem Zacharia needs to also lay the foundations for building a better board in the future. Ethics and governance training is clearly needed.

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

Take a moment to reflect, weigh up the situation and investigate what win-win outcome is in alignment with the highest good for all stakeholders.

Discerning questions to answer before being able to plot the best course of action.

1. What is the extent of the debt problem? Was the $400K everything or just that which was found? Is it time critical?
2. How do the remainder of the existing board feel about the possibility of having a new controlling interest?
3. What impact might the sale of the 40% shares have on the key international vendor's continuing vendor position within the business?
4. How might the business be affected if they lost the key international vendor? Are they replaceable?
5. Does the founding family want to retain a stake within the business?
6. What are the personal objectives of Zachariah in this?

From answering these and other relevant questions, we can understand individual objectives and available leverage. The priority is to find a solution that creates a win-win where possible.

Meet with the new potential buyer to understand their motives, investigate the possibility of the existing board finding a buyer as an alternative or restructuring the deal of the separation to trade the debt write-off for the shares, as opposed to forcing their sale.

If a win-win is not possible and things look dicey, use any and all leverage to execute the best outcome for the business. Such as consulting with legal and working with the current board to create unfavourable conditions to negatively affect the sale of both the 40% and the 12% to one party.

However, this all depends on the terms of the shares, the shareholder laws and the intentions of all parties. Always best to approach every situation with open communication, negotiation and seeking a win-win for all stakeholders as your starting position.

Thomas Green is Senior Digital Transformation Advisor at the Really Conscious Group, Board Member of Australian Suicide Prevention Foundation, and Advisory Board Member - Digital Transformation & UI/UX at Infoplu. He Is based In Melbourne, Australia.

Book Review – Start-up Boards; Getting the Most out of Your Board of Directors by Brad Feld and Mahendra Ramsinghani

As a company grows a board becomes necessary. Good boards can launch a great company but bad boards can sink a venture faster than you can say 'Titanic'. This book shows how founders can recruit a good board, how staff can relate to the board effectively, and how directors can add value to the enterprise.

The book is written and presented in a colloquial, up-beat modern manner. It will appeal to younger entrepreneurs although it would add value to even the greyest haired founder. It is a highly practical book. The inclusion of some unhappy endings in the selection of case studies is one of the factors that lifts this book out of the ordinary and into an exceptional class of its own.

Available on amazon.com

Julie's News - In August

As the second wave rolled through Victoria and NSW I had a busy month.

One of the highlights was presenting for Stone & Chalk on 'How to Position your Board, Advisors, and Company for Success'. The presentation touched on the standard governance concepts and their application to theoretical established boards, followed by a deep dive into the specific governance needs for startups and scaleups.

The recording is available on YouTube.com

I enjoyed meeting (online) the members of Answers for Associations, a network of people dedicated to providing tangible solutions to Australasian Associations when I presented to them on 'How to Handle a Challenging Board Member'.

My own boards were busy building the best outcomes possible for the organisations we govern while my clients kept me on my toes providing service and support to their boards and directors.

I am always happy to help if your board has a need. Just call me on +61 411 262 470 or reply to this email for a discussion of how I might help your board.

Inspirational quote for September

Really - just keep going. This is not a good point at which to stop providing good governance and proactive leadership.

A note on names - A few readers have asked me where I find the names for the protagonists in each case study; I 'borrow' them from people I meet or things that I read. Zachariah is an old Hebrew name and means 'God Remembers'. Our protagonist Zachariah will need to help his board to remember that lax controls can lead to unhappy outcomes whilst rebuilding their confidence and ability to lead the company.

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. They are greatly appreciated. I will answer them all eventually. I could not write this newsletter without your help and without the generous help of all the experts who respond each month to the case studies.

Be a contributor - If you would like to attempt a response to the dilemmas for publication you will be most welcome. Simply reply to this email and let me know.

Let's connect - I use LinkedIn to share information about boards and directorship with my friends and acquaintances. If you use LinkedIn and we are not yet connected I will welcome a connection from you. You can find me at linkedin.com/in/juliegarlandmclellan.

Let me help you - If you would like me to speak to or train your board, staff, audience and/or group please contact me at julie@mclellan.com.au.

Farewell until the next issue due 1 October 2020. I look forward to greeting you again then. In the interim I hope you will enjoy health, happiness and hard work: Enjoy governing your companies; we are privileged to do what we do and every day is a blessing!

Best regards,

Julie

Photo Credits: Personal images in this newsletter are provided courtesy of the contributors, course attendees and conference participants.

Disclaimer: The opinions expressed above are general in nature and are designed to help you to develop your judgement as a director. They are not a definitive legal ruling and do not constitute legal advice. Names and some circumstances in the case study have been changed to ensure anonymity. 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.

Privacy: I am privileged to have your contact details and keep them as safely as possible. I will alert you if they are ever accessed by any unauthorised person (the technical staff at ayuda help with publishing and issuing the Director's Dilemma and have access so they can send the newsletters to you). I do not sell your details to anyone; they are kept only for the intended purpose - sending you this newsletter and helping to build the judgement of company directors by providing a safe way to consider potential responses to real life events.

Main Photo by Snapwire from Pexels