Transaction case study: we get by with a little help from our friends…

Answer

Transactions often require wearing many ‘hats’ and assisting clients to navigate through a myriad of legal issues with commercial implications – both in relation to the business itself and clients’ interest in the business (vis-à-vis other stakeholders). In doing so, it’s critical to prompt clients to consider as many of these points upfront so that their fullest intentions and interests are both negotiated and documented from the outset. This case study seeks to illustrate that core process of navigation carried out by transactional lawyers.

Scenario

John and Sally decide to go into business together to sell jeans at a market stall. You’re their friend and they’ve asked you to help them navigate their arrangements and bear witness to their final agreement.

Breakdown

Where to start? It can seem like there’s a lot to unpick here. But broadly, best to categorise based on ‘levels’ (ie, ‘structure’). In this scenario, there are two such ‘levels’. The business (under the hood) and the arrangements between John and Sally (above the hood).

Let’s get down to business…

What key things do John and Sally need to consider in order to sell their jeans? Your role here (under the hood) is to help them to think through as exhaustive a list as possible so that the business doesn’t have any ‘gaps’. For example, the jeans need to come from somewhere, so assuming for now John and Sally are picking these up ready-made:

• Jeans – the ‘product’.
• Some‘one’ to sell John and Sally the jeans – the ‘supplier’ – pursuant to a supply contract.
• Some‘where’ for John and Sally to sell their jeans – the market stall – the ‘site’ – pursuant to a licence/lease.
• Some‘one’ to buy the jeans from John and Sally – the ‘customer’– pursuant to a customer contract (including in this case, the terms and conditions of sale).
• Permission to sell the jeans from the site – the relevant ‘permit’.
• A joint ‘person’ (which in legal terms can include a company vehicle) to enter the contracts, enter the licence/lease and receive the benefit of the permit, for example.
• Money to buy the jeans to begin with:
  • Money that John and Sally aren’t required to pay back to the payor ever – gift.
  • Money that John and Sally are ‘required’ to pay an equal amount of back to the payor perhaps with a fixed percentage increase (ie, given £10, pay back £10 (+ £0.50) – ‘debt’ (+ interest)).
  • Money that John and Sally aren’t required to pay back unless they make a sufficient profit, at which point they’ll then be required to pay a portion of that profit to the payor – equity.

All’s fair…

One meaning of equity is ‘fairness and justice’. In corporate terms, by equity we mean the ‘ownership interest in a business’. But these two points often come together. What could a fair arrangement look like between John and Sally in relation to their business? What are some of the key areas they need to run through?

Governance

Who runs the business? Do John and Sally need to have equal decision-making powers on everything?  What if they disagree?

Let’s say John is a fashion designer and Sally recently completed a finance degree. How should decisions be fairly determined? A couple of examples:

1. Each party could have an ultimate say over matters in their area, such that:
   • John has a weighted vote to finally decide matters relating to the product, the supplier, the customer and the site arrangements, for example; and
   • Sally has a weighted vote to finally decide matters relating to the finances of the business – for example, how much is spent on stock, how much profit they take out of the business and  how to raise money (eg, gift, debt or equity).
2. Alternatively, the initial decisions could be made by each party over matters in their area (eg, matters relating to product for John and raising money for Sally) with the other party acting as the ultimate decision maker once the inputs from the initial party have been considered.

Economics

If there are any profits, how should these be split, 50/50? If John and Sally provided monies to start off with, would that make a difference? Would the ingoing ‘intent’ of John and Sally as to how the monies get repaid make a difference?

Let’s say John provided £700 and said he was fine to lose it all – he just wanted a share of any future profits and Sally provided £400 and said the same as John with respect to £300 but said she needed to be repaid the balance of £100 within six months as she’d borrowed that £100 from someone else. What would be a fair split then? Here are a couple of examples:

1. Repay £100 to Sally and then split the balance of any profits 70% to John and 30% to Sally.
2. Alternatively, if Sally had received a gift from her parents for her birthday and managed to repay the £100 loan that she had borrowed from elsewhere thus no longer needing her £100 back, would that mean it’s fair for the profits be split 700/1100% to John and 400/1100% to Sally? Would it be fair for it to happen simply on Sally saying that she didn’t need the money or would John need to agree?

Liquidity

Should John and Sally be locked into the business forever? What if one wants to leave before the other? What options would be available to them? Should these be determined up front?

Let’s say John decides he wants to refocus on designing versus the sale of jeans in two years’ time and the business has value at that point. Here are some examples:

1. John and Sally could agree at that time to close the business. Sell the assets and split the proceeds.
2. John and Sally could look to sell the business as a going concern to someone else and again, split the proceeds.
3. What if Sally doesn’t want to sell? Perhaps she could offer to buy John’s share? At what price – the original cost, market value or somewhere in between?
4. What if John doesn’t want to rely on a wind-up, full sale of the business or for Sally to make him an offer, should he be able to force Sally to buy his share?
5. What if John has a friend from design school who’s quite eager to take John’s place in the business? Should John be able to transfer his share in the business to his friend? Does Sally’s view matter?
6. What if John has a non-designer friend who’s eager to take John’s place in the business?  Should John be able to transfer his share in the business to that friend? Does Sally’s view matter?

Ultimately, there’s no right or wrong answer and there are many other key topics to also be considered (eg, should John be able to make his own designer jeans for sale on the side?). The answers to these questions depend on the facts and also how strongly each party feels about one point over another. It’s highly unlikely that John and Sally will be in business on the same terms forever. Your role here (above the hood) is to ensure you ask the right questions upfront and help them to consider as many of the hypothetical scenarios/change events as possible. The more the parties openly discuss these points and their own expectations ingoing, the less likely they are to fall out and have a dispute during the life of the business and outgoing.

Fatema Orjela is a partner and Arjun Sehgal is an associate at McDermott, Will & Emery UK LLP.