In many New Zealand businesses, the same person may wear different ‘hats’ as part of their work. But when business difficulties or changes arise, these concurrent roles – employee, shareholder, and director – can collapse or collide, and then the only hat needed might be a crash helmet!

We frequently deal with the breakdown of working relationships involving a person who is simultaneously involved in a company as an employee, shareholder, and sometimes also a director. While this kind of multi-capacity is a common and practical structure, it can be complicated and costly for such a person to exit (or to be exited) from a business when things go awry.

In this article, we explain the common risks and issues associated with the same person simultaneously holding these roles, and how a structure like this can be future-proofed.

The ‘hats’

It is a legitimate structure and often essential for a person to be both an employee and shareholder of a company, particularly in New Zealand’s predominantly small business economy. Depending on their expertise or ownership stake in a company, that person may also be a director. For example:

• A person may own or part-own and work in the business being run by the company.
• A person may be a long-standing or key employee of the business who has bought into or earned some ‘sweat equity’ in the company which owns the business.
• In a start-up scenario, a skilled person may be attracted and paid to work in the business partly by way of being issued shares in the company which owns the business. 
• In larger or specialist businesses, employees may be aligned and incentivised by participation in employee share schemes that link their performance to the company’s performance.

Although these roles may be held simultaneously, they are technically separate and distinct, with different rights, obligations, entitlements, applicable law, and documentation. If conditions change, or relationships sour, and these roles are unlinked, undocumented or poorly documented, and have competing rights and obligations as a result, dispute and impasse can easily ensue.

The problem

The fundamental problem is that things change. People move away, get sick, retire, perform poorly, breach agreements, need cashflow, have children, or simply have a change of heart or priorities. Business partners fall out, have disparate visions, variable personal circumstances, and unequal commitment to the business. More broadly, economic, social, and political conditions change, technology advances, consumer preferences evolve, sales and profit fluctuate, along with a myriad of other known and unknown factors. 

Amidst inevitable change, businesses need to anticipate and prepare from the outset with an agreed set of protocols to manage the departure of an individual in the position of an employee, shareholder, and potentially director. In the absence of a defined pathway, protracted and heated disputes can arise, and it is usually too late to retrofit a mutually acceptable outcome. 

Planning for this requires an intentional process to ensure the various issues are addressed and documented up front in complementary employment agreements, shareholders’ agreements, the Constitution of a company, terms of issue of shares, and the like. This is because the separate fields of employment law and company law do not provide for the unwinding of these overlapping roles. 

The issues

If a company does not have effective evolution and exit provisions in place for a concurrent employee, shareholder and director, numerous issues can arise, including the following common obstacles:

• Absent or inadequate employment agreement: It is not uncommon, particularly in start-ups, for employment relationships to be poorly documented or not documented at all. Not only does this create liability for the company as there is an obligation to have a written employment agreement, poorly defined roles and responsibilities can create significant issues as a business looks to grow or restructure.
• Intellectual property rights: Without an employment agreement in place, it may be questionable as to whether the company actually owns the work produced by a person in the course of their role, particularly in the case of intellectual property rights such as source code, designs, methods, and the like. Where a company’s main asset and value is software or proprietary design, this is a major problem. As a related point, even if ownership by the company could be established, if no non-compete provisions are in place, the person could immediately recreate the intellectual property in competition with the company.
• Shareholding not contingent on employment and vice versa: New Zealand law does not allow for employment at will. Should an individual (or related interest) sell their shares, unless there is good reason (serious misconduct, poor performance, redundancy, etc), there is no legal right to terminate that individual’s employment. This can create issues where the other shareholders want to cut ties with a person but cannot legitimately terminate their employment (and it can be very costly to secure an agreed exit). The reverse also applies in that an employee may resign or be legitimately terminated, but there is no legal right to force that person to sell their shares in the company. However, a shareholders’ agreement can displace the above and bind these two positions together as further described below.
• Conflicts of interest: Interests of owners and employees do not always align. For example, a shareholding interest, especially a significant interest, will likely drive a desire to maximise shareholder value which will not always be in alignment with promoting desired employment terms and conditions.
• Absent or inadequate Constitution: Certain provisions of the Companies Act 1993 can only be negated or activated via a company’s Constitution. For example, unless otherwise provided for in a constitution, pre-emptive rights will not apply to the transfer of shares by a shareholder. In the absence of these provisions, a shareholder can sell their shares in the company to anyone, including a competitor of the business or some other person who the other shareholders may not want to suddenly be in business with.
• Absent or inadequate Shareholders’ Agreement: A tailored shareholders’ agreement is intended to reflect how exactly the company will operate and how shareholders and the company will relate to each other. For example, among other things, it should set out shareholder rights and responsibilities, pre-emptive rights on the issue and transfer of shares, decision-making processes, management structure, non-competition and non-solicitation obligations, dispute resolution provisions, exit provisions and share valuation mechanisms. As mentioned above, it should also include customary default and enforcement provisions, which may include a shareholder ceasing to be employed by the company. In the absence of a shareholders’ agreement between a company and its shareholders, they will be at the mercy of the Companies Act 1993, which is unlikely to be helpful and certainly specific to a company’s circumstances.
• Conflicting documents: Conflicting provisions across documents can be unhelpful and create inconsistencies between roles. For example, the same person may be subject to a six-month restraint as an employee, but a two-year restraint as a shareholder. On occasion, this will be legally appropriate as it demonstrates the different capacities or interests being protected, but, at times, this may be problematic for individuals as the restraints are askew and could be triggered at different times. For example, an employment restraint will normally come into effect when an employee leaves, whereas the shareholder’s restraint will come into effect when the individual sells their shares.
• Inability to sell shares: Even if a shareholder is entitled to, and wishes to, sell their shares, there may not be a market for them, and if there is no pre-existing sale and value mechanism, they would essentially be ‘stuck’, being unable to realise the value of the shares. Further, if their employment has come to an end, they will also be unable to influence the fortunes of the company.
• Entrenched directorship: If a shareholder has an entrenched right to appoint a director, that shareholder can directly influence the operation and decision-making of the board. This could be highly problematic for the running of the company in the event of disagreement or termination of an employee who is also a shareholder and director.
• Partial resolution: The parties may wish to sever their relationship, but resolution of only one or other of the employment or shareholder elements can be negotiated. For example, the employee may cease to be employed by the company but continue as a shareholder and/or director with information rights and voting rights on shareholder and/or board matters. They could then agitate amongst the shareholder base and/or at board level. Depending on their level of shareholding and the number of directors on the board, they may also be able to block company decision-making.
• ‘Horse trade’: In circumstances where there is no clear and uncontested way forward for either party, the matter will need to be negotiated and resolved between them. This will generally involve mutual concessions and trade-offs in order to achieve a mutually tolerable outcome, possibly at an unwelcome cost to the business.
• Dispute and impasse: Any combination of the above can create dispute, uncertainty, and could result in an impasse between the various stakeholders and an uncomfortable status quo prevailing.

As illustrated by the examples above, the implications of this issue can be far-reaching, complicated, and volatile. This is to say nothing of the time-cost dealing with the fallout, while stabilising and continuing to run the business. At best, the company and individual parties could be hamstrung in seeking to achieve their goals, and at worst, trapped and held to ransom.

If the parties are unable to achieve a resolution through negotiations, parties will often be left with a need to seek professional legal advice to help broker a settlement deal. This can be costly in terms of fees, management time and focus, as well as mental and emotional expenditure, and reduced company morale. On the bright side, it is possible to mitigate all this with a bit of thought, effort, rigour, and legal advice at the front end.

The fix

As company structures, set-ups, roles, and relationships between the parties involved are unique, there is no single paint-by-numbers solution available. Rather, it must be carefully considered, crafted, and documented, ideally at the outset of the arrangements, whether upon formation of the company, inclusion of a new shareholder, an employee also becoming a shareholder, or any similar development. However, there are similar conceptual themes that can be applied to the issues, which your lawyer can help you with.

As an initial step, we recommend that parties have frank commercial discussions to ascertain how the arrangement is intended to work in practice, any terms or timeframes/lock-in periods, payments, wind-up/termination provisions, and the like. Your lawyer will be able assist with framing this discussion and identifying any gaps or other issues that you may not have considered.

Once there is commercial agreement, a term sheet recording the agreed arrangements should be produced by the parties. This does not have to be fancy, formal, binding, or in any particular form; it just has to contain the clear intent and instructions of the parties. The term sheet will then need to be documented by your lawyer for binding legal agreement. This may include preparing documents or amending existing ones for signing by the parties.

Businesses should plan to protect against the risks that arise out of managing change to ensure it can secure the orderly exit of a person from a company with minimal impact on the ongoing operation of the business. While this can be an iterative process that attracts up-front cost and effort, it is effectively a protective insurance policy against a foreseeable risk. Like insurance, the premium is a fraction of the cover.

The upshot

Sound legal advice at the outset, with a view to producing tailored structural documents to suit a particular business arrangement, can assist in responding to foreseeable issues or challenges that can arise.

Ultimately, this is about corporate and governance best practice and the need for frank engagement between business partners before entering into new arrangements.

If you would like assistance with employment law, company structuring or restructuring, advice on your position, or help to broker a way forward, please get in touch with the contacts listed with this article or your usual Dentons relationship manager.

This article was written by Sarah Gibbs, Senior Associate in our Corporate and Commercial team, and Charlotte Evans, Senior Associate in our Employment team.