Advising clients offered equity in a business

First published by the solicitors Journal and reproduced with their permission.

Most clients will be enthusiastic about being offered equity in a business; you role as their adviser is to make sure this is not a poisoned chalice, says Jonathan Silverman

Not infrequently I am consulted by a client who is already working in a business in some capacity or other, who has been approached by the proprietors offering some form of equity participation.

One of your dilemmas as a practitioner is the extent to which you should offer practical commercial advice as against simply explaining the legal formalities surrounding the offer. Even where shares are being offered for a nominal consideration they may be part of an overall proposal which may have unforeseen consequences – perhaps the share offer is combined with a directorship, but on the understanding that the director bears some of the commercial risks, perhaps by giving personal guarantees. Maybe the business is not financially stable and the possibility of placing personal liability on the third party is really what is behind the offer.

In most cases your client will be enthusiastic to take up shares, but it is perhaps worthwhile running through a number of questions and scenarios with them to see whether the deal on the table is really worth taking. Here are some of the points to consider:

1. Is the client being offered equity or profit share?

Equity and profit share are very different options. It could be that a simple profit share participation or bonus scheme may well yield swifter returns to the client if he is risk adverse. What is important is to work out what your client’s principal objectives are, both short term and long term.

2. Is the client being asked to buy the shares?

Having to advise on whether the share price is right is particularly challenging. It’s easy to refer the matter to the client’s accountant, but a commercially experienced solicitor should be able to express a view. This usually means drilling down with the client into the financial well-being of the business, asking him how much up-to-date financial information he really has been provided with, and encouraging him to have an open dialogue with the proprietors sooner rather than later.

3. How receptive are the current proprietors to entering into a shareholders agreement

This can often be a delicate aspect for the client to raise, especially where the shares are being gifted or transferred for little consideration. A minority shareholder can easily be overreached and somehow you have to give the client a workable understanding of what issues need to be covered; it is simply no use being a shareholder unless there are minority protection rights, pre-emption rights in place, and proper consideration of such matters as ‘drag and tag’, and perhaps even bank mandates and dividend policies.

4. Look behind the offer to see what’s really intended

The current owners may be looking to bring in your client with a view to eventual transmission of the business. Or is it a way of trying to lock them in long-term, appearing to offer something which appears substantial but may have little value – a case of “jam tomorrow”?

5. Talk through the proposition carefully to ensure the client understands the implications

There’s more to the client acquiring shares in the business than accepting a share certificate. Is there a genuine common interest between the parties, have they discussed the real objectives for the business over a realistic period of time forward? Is the proposition likely to generate real commercial advantage for your client or is it simply going to lock them into a business with no real gain?

6. Look carefully at both the timing and extent of any negotiations

A further factor tends to be that of timing. It can be difficult to work out whether the first offer being made to the client is the best on the table. Each particular set of circumstances will require the practitioner to evaluate that and to decide whether to try and negotiate the offer. The danger is that any “push back” may be misinterpreted by the other party.

7. Are there any skeletons in the cupboard?

The incoming party, even if he or she is to become only a minority shareholder, should have as full and frank discussion as possible with the existing proprietors so that any problems from the past are disclosed. The aim must be to avoid the parties falling out as a result of non-disclosure. There may be merit in offering a confidentiality undertaking to give comfort to the existing shareholders.

What is central is to ensure that there is genuine mutual respect and confidence at all times between the parties. Even if the negotiations collapse the underlying relationship between the client and the proprietors must remain intact.

Overall, the objective should be to ensure that the client genuinely understands what is on offer and goes into the venture confident that he is making a sound decision based on all the available information and with an agreed business plan. Getting a client to that stage may require fairly serious discussion, but it is one well worth having. And if you can demonstrate that you have added value to the negotiations there is a stronger chance that you will be retained by the company itself when it is next seeking legal advice.