In one of the final scenes of iconic movie Forrest Gump, Forrest discovers he’s a shareholder in “some kind of fruit company,” and that he “don’t have to worry about money no more.”

He unwittingly bought shares in Apple Computers, and if for argument’s sake he’d spent $100,000 in 1977, his shares today would be worth close to $7 billion dollars.

Of course, we all want to get as lucky as Forrest, but it’s pretty rare to blindly wander into a fortune. Becoming a shareholder can be a useful way to diversify your portfolio, and many people enjoy the experience. In our experience, many people in NZ become involved as a shareholder in a small company with a few other mates or acquaintances with a great idea and the best of intentions.

Over 80% of NZ registered companies are small to medium sized and do not offer shares to the public.

Things can and do go wrong however, so before you jump in with investing in a company, it’s important to conduct due diligence to protect your investment and ensure you’re safe should something go wrong.

Conducting Shareholder Due Dilligence

When you come into a business, there are several key drivers you should investigate. First of all is the relationship you have with the other owners. If things are uncomfortable now, they could become toxic at the first sign of trouble. Secondly, you should have some understanding of the industry. Is it in a growth market, or on the decline? What is the market saturation/share? What’s the product’s reputation with consumers? Having inside knowledge of the market can help you see opportunities and add value, as well as avoid disasters.

As part of due diligence, you need to assess the returns from the proposed investment. The expected return may not always be financial, but often it will be. For example, one company we know of asked shareholders to inject a couple of million dollars into the business to allow it to continue to trade. Many factors were considered during the due diligence process, but the decision came down to the fact the particular industry worked on slim profit margins, the company concerned did not have a track record of profitable trading, had many competitors, and it would’ve taken the company approximately 20 years to repay the initial investment.

In that case, when comparing the costs of the shareholders either borrowing the funds or what they could get as a return on the same money elsewhere, the shareholders decided against making the additional investment

The company was placed into liquidation as a result of the shareholders’ decision. From what we have seen the prospect of liquidation should funds not be introduced had been one of the factors that the company directors had asked the shareholders to consider. Which leads to another due diligence point, that you need to consider the common grounds and potential conflict points between shareholders’ interests and those of the directors as they may be different people, and what agreements are in place to deal with these.

Forrest clearly didn’t involve any due diligence techniques, but it is a movie and he got lucky. In the real world, you can’t count on Forrest’s luck. If you’re looking at investing or becoming a shareholder due diligence is important. You must know about the people and company you’re about to enter into business with.

Due Dilligence Checklist

Here are elevan simple questions to ask when conducting due diligence for a shareholding. Finding the answers could save you big time in the long run:

• - Does the business own all its key assets, including property, vehicles, and IP?
• - What obligations and liabilities will impact on your buy in? (Check the contracts!)
• - When will either value or a regular return on investment be available?
• - Does the business have any upcoming or current court proceedings for lawsuits?
• - Has the business been to court in the past? What for? (This may highlight potential weaknesses).
• - What are you expected to bring to the table? Skill? Ideas? Money? All of those?
• - Can you and do you want to commit to the resources expected? Or are you conflicted?
• - What are the company’s revenue, profit, and margin (RPM) trends?
• - Do you trust the managers and board? Research profiles and past business histories.
• - What risks (both industry-wide and company-specific) do you expose yourself to?
• - Will your reputation be harmed by associating your name with this company?

Investing in a company is a bit like hiring an employee. With a formal process to work through, you will usually end up with a solid, dependable asset. But without that process, you are gambling based on instinct and first impressions, and that’s not ideal. There are always fish hooks when becoming a shareholder – disputes can ruin a business – but by following the process outlined above, you’ll avoid the majority of potential problems.

If you haven’t gone through due diligence, or you need some advice on what to do next, come and talk to the McDonald Vague team and they can help guide you toward a confident decision.

If your company is experiencing financial difficulty, download our free guide for NZ Companies to discover your different options.

It seems like a typically Kiwi thing to do - a couple of mates decide to go into business together and start up a company to operate the business.  Everything is split down the middle - each director owning 50% of the shares and all agreed on a handshake.

What could go wrong?

The recent liquidation of a small business shows just what can happen.  Things went well for the first couple of years.  Business was going okay and making a small profit but then things started to go wrong.

The relationship broke down between the shareholders and got to the stage where they couldn't agree on anything to do with the business including staff management and business direction.

Legal advisors became involved and an attempt was made to resolve the issues by one of the shareholders buying out the other's interest.  Unfortunately, they couldn't agree on the value of the business.

As a result, the decision was made and agreed to by both shareholders to liquidate the company.  The liquidation process was made more protracted and costly by the sniping between the shareholders leading to higher liquidation fees and therefore a reduced payment to creditors.

There are no guarantees of course but this situation may have been avoided, or at least the damage mitigated to a certain extent, if there had been a shareholders' agreement put in place at the time the company was incorporated.

Shareholder agreements usually include

A shareholder agreement is like a business pre-nuptial agreement.  It sets out the basis of the relationship between the shareholders and can include matters such as:

• Defining the type of business the company will engage in;
• How the business will be managed and who will be responsible for particular areas of management such as staff employment etc;
• What types of decisions can be made by individuals alone and what types need majority or unanimous agreement;
• How any of the parties leaving the business will be handled - what happens to their shares etc;
• How any disagreements or disputes that arise will be handled.

It can contain confidential information as, unlike a company's constitution, it does not have to be filed with the Registrar of Companies and be available for public viewing.

Shareholder agreements may also include

They may also cover:

• Non-competition restrictions;
• Appointment and retirement of directors;
• Professional indemnity insurance;
• Transfer of shares and pre-emptive rights;
• Disability and insurance - what happens in the case of a trauma or death to insurance proceeds - does it pay company debts or does it go to the estate?  Who is the policy owner?
• Shareholder approvals, consent and voting.

The complexity and size of the shareholders' agreement will depend to a certain extent on the size of the business, the number of shareholders involved and the areas to be covered.

It will be different for every company and shareholders should seek proper legal advice when putting together any such agreement and before signing one.

How McDonald Vague can help

We regularly see the result of fallouts between company directors and shareholders.  We would advise all company directors and shareholders to put together a Shareholder Agreement at the time the company is incorporated to avoid prolonged and unnecessary expense to shareholders and their creditors.

If your relationship with fellow director(s) and/or shareholder(s) is breaking down contact us for free and confidential advice to find out how we can help.

Alternatively, download our Free Guide to Avoiding Business Failure