Article by Avant Group - Stories from the Law Desk: Chapter 4 – I hate to say it, but all partnerships fail

Stories from the Law Desk: Chapter 4 – I hate to say it, but all partnerships fail

Posted: 15 July 2022

The harsh reality of life is that for a variety of reasons partnerships, (including shareholders of companies, marriages, JV’s etc.) at some point fail.

Partners in a business venture may have a falling out and wish to dissolve their relationship, or it could be that one partner has lost interest in the business, or perhaps the partnership may fail due to ill health, old age or the death of a partner. At some point a partnership will inevitably fail.

Our firm is currently dealing with a real example of shareholder dispute which will most likely lead to the business’ failure. We need to disguise the real facts of this matter and the parties involved, however for the purposes of this discussion, we have a client who along with 2 others has set up a food processing business in Australia servicing the dairy industry. The business has 3 equal shareholders. Let’s call them David (our client), Adam, and Nathan. Adam and Nathan ran another food processing business which was not doing well and decided after a conversation with David that the three of them would set up a new venture (for this discussion XYZ Foods[1]). David has the technical knowledge required for this business, Adam has the cash and Nathan offered to work in the business on a daily basis. So far, so good. Each is bringing something unique to the business, namely cash, skills and sweat equity.

The business required $2Million in capital and a premises in which to undertake the endeavour. Adam facilitated the purchase via a commercial lease agreement for the equipment and David and Nathan were asked to guarantee the equipment finance. They were unaware that Adam actually put the agreement into his name. The trio were able to set up the facility in a premises owned by a related entity to Adam. David did not seek professional advice at that time.

XYZ Foods has been trading for four years and David has instructed us that he thinks the business has been profitable for the last two years.

Allegedly to save set up costs and at that stage, unknown to David, we have uncovered that the new business actually used the corporate structure of Adam and Nathan’s previous business.

After about 12 months of trading David began asking for financial statements from Adam and Nathan, but either they were unavailable or when he irregularly did get them, he didn’t seek advice from his professional advisors as to their interpretation.

After four years of trading the business relationship between the shareholders has deteriorated to the extent of the business failing. Nathan isn’t pulling his weight in the business and can’t be relied upon. David has now realised that the equipment finance payments are going to pay off equipment which will eventually be owned outright by Adam. Rental for the premises was never agreed and now there exists a liability for 4 years of rent payable to Adam’s related property group. The old business’ accumulated losses have been mixed with the new business and the balance sheet shows that XYZ Foods has liabilities exceeding assets.

Our client David has worked for 4 years to achieve absolutely no financial benefit and in fact may be worse off due to him guaranteeing the equipment finance payments.

It sounds, and is, a complete mess. It is too late now to rectify the situation to any great extent however let’s look at what should have been done when this business was set up. 

1) New corporate structures should have been set up for the proposed business. One for the trading arm and one to hold the equipment assets. This will ensure clean balance sheets and eliminate the possibility of a claim arising from the trading of the old business (e.g. unpaid tax, litigation from a prior unhappy customer, past employee claims etc.). Separating the trading arm from the holding company aims to ensure that in the event of failure of the trading entity, the assets of the business are somewhat protected. It is important to note that the holding company should not guarantee the financial performance of the trading entity otherwise this asset protection is lost.

2) While everyone is enthusiastic about the new business, formal shareholder agreements should be drafted and importantly these agreements should detail what each party brings to the table and their commitment to same. The agreements should outline the process to be undertaken in the event of unresolved shareholder conflict. For example, this could include that an independent valuer is appointed, and the business put up for sale at the valuation amount, with the first option to purchase available to the remaining shareholders.

3) A hire agreement should be established between the trading entity and the holding entity where the trading entity has a right as bailee[2] only to use the equipment at a set cost per month.

4) A purchase money security interest (PMSI) should be registered on the personal property security registration (PPSR) for the equipment hired to the trading arm. This assists in the protection of the equipment in the event of the trading arm’s failure and appointment of a liquidator who may attempt to seize and sell the machinery.

5) The machinery purchase or lease should be established in the name of the holding company, (not in the name of one of the shareholders).

6) A lease should be established between the trading entity and the landlord so the parties know exactly what they are committing to in terms of the duration and cost of occupancy. Generally it is best to have a long lease with many short option periods to provide security of tenure but allow flexibility if the tenant wishes to relocate. E.g. an 18 year lease consisting of 6 periods each of 3 years.

In summary, taking the time to consult with your financial and legal advisors at the commencement of any proposed business endeavour may result in an expense which at the time, when there is an abundance of good will between the partners, appears unnecessary, but the costs of not doing so by far outweigh the initial expenses. Just ask David.

[1] XYZ Foods is a fictitious name and has no relationship to any real company.

[2] A bailee is an individual who temporarily gains possession, but not ownership, of a good or other property.

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This article is not legal advice and should not be relied upon as legal advice. All articles from Apres Legal are intended to provide informative information. Legislation and case law may have been simplified and/or paraphrased. If you would like legal advice based on your current circumstances, you should contact Apres Legal.