Life of a Litigator: Setting up a Company – The Pitfalls

Susanna Heley, solicitor of Sykes Anderson LLP’s Litigation and Dispute Resolution department offers a litigator’s insight into setting up your own company…

Please note that this area of the law is a complex subject and you should not take or refrain from taking any step without full legal advice on your particular circumstances. The content of this article is of a general nature and no liability is accepted in connection with it or if any reliance is placed on it.

At the start of a business venture participants are usually confident that their new company will flourish and they can put aside thoughts of potential problems. However most new companies fail within the first three years and 78% of existing companies have faced litigation within the last 12 months according to a recent survey.

Here are a few hints to help you navigate your way through the minefield of potential issues which could embroil you and your embryonic business in litigation.

Prevention is better than Cure

Effective planning is the best way to ensure that the company is run effectively and to avoid disputes or manage them in a way which does not damage the company.

• ALWAYS have a properly drafted shareholders agreement in place. Although it may be difficult for non-lawyers to check the drafting of an agreement, use your common sense and do not accept an agreement if it does not cover all the bases. A badly drafted agreement causes more problems than no agreement at all. If in doubt, seek a second opinion. Remember, if you don’t understand what you’re signing, chances are that your co-participants also do not understand. This is likely to lead to litigation.
• NEVER assume that good friends will make good colleagues. Ensure that service agreements are in place for all employees and directors.
• Consider exit provisions carefully. In cases of equal partnership consider whether a breakdown in the working relationship will lead to the dissolution of the company or one party buying out the other on agreed terms.
• Consider what will happen if one of you becomes ill, incapacitated or dies. Will representatives be allowed to take over and get involved in running the business? Can the business continue? Getting embroiled in probate, family and court of protection proceedings can cause massive headaches. Insurance may be a good idea but you will need to agree the beneficiaries of any policy and you will also need to make provision for who gets any money, shares or distributable assets of the company in these circumstances.
• Effective use of restrictive covenants preventing shareholders and directors from competing with the business of the company or diverting business for personal profit is essential. Always take legal advice on these clauses as widely or badly drafted restrictive covenants will not be enforceable.
• How the company is to be funded, by equity (shareholder capital) or debt (loans from shareholders or institutions such as banks).
• Consider personal liability for directors and shareholders. A new business will not usually have a trading history and therefore trade accounts, leases and other regular payments and credit agreements may need to be backed by personal guarantees. How will these be met if things go wrong?

It is not possible to plan for everything. Although planning reduces risks, problems still crop up. Spotting the problem early and taking appropriate steps and, where necessary, advice is essential.

• Any agreement between the shareholders will not absolve you from statutory liability. Ensure that you and all other directors, agents, employees and professional advisers understand your legal obligations and, if in doubt take legal advice. A recent survey indicates that failure to comply with regulatory matters is the prime reason that directors come before the court.
• Look for the warning signs that directors and employees are not taking their duties seriously. Early leaving and late arrival, an overabundance of sick days, suspicious behaviour such as unnecessary or unusual contact with clients can all be indicators that a director is looking to move on and may not be devoting his full time and attention to the business. Bear in mind though that there can always be innocent explanations for such behaviour and do not condemn your colleagues too soon.
• Take complaints and grievances seriously. Take positive early action to address complaints and be professional and commercial.

The vast majority of disputes come down to money. How much people are getting; where the money is being spent; opportunities for personal profit; insolvency…

• Plan funding thoroughly in the beginning. Consider the source of the funding and any security offered and its attendant risks. Remember:
• A minority shareholder is entitled to statutory protection and rights even where the shares held are non-voting in certain circumstances.
• Holders of ‘floating charges’ over the whole of the company’s assets will have the right to appoint an administrator if the underlying loan is not paid.
• Check the finances of your company regularly. Ensure that you have sufficient resources to pay your creditors. The last thing that you need is to have creditors applying to wind up your company or seeking to take control through the appointment of an administrator.
• Ensure that you understand your contractual obligations. Claims for breach of contract can be expensive to bring and defend. The principle of understanding contracts may sound like a no-brainer but you would be surprised how often disputes arise as to what contracts actually mean.

Do not disregard regulatory matters. Company law is complex and covers many different areas.

• Ensure that you understand and can comply with statutory and common law obligations. The full scope of director’s duties and regulatory requirements are outside of the scope of this article. See Our Director’s Duties page on our website for full details but note in particular:
• Statutory responsibility for filing company documents
• Offences set out in the Insolvency Act 1986 for directors who continue to allow their companies to trade when insolvent
• Breach of statutory requirements is sometimes a criminal as well as civil offence
• Directors may have personal liability in certain circumstances
• The general all encompassing duty to act in good faith in the best interests of the company.

I have not covered every step you need to take in this article. I hope I have highlighted some key areas which will minimise the risk of your company getting caught up in litigation.