Change of business: A legal checklist
A quick summary
Businesses change over time. With changes, founders and leaders should consider whether stakeholder communications or some type of stakeholder or legal approval is required.
What you need to do will depend on the stakeholders involved in the business. A company with a limited number of stakeholders can pivot without much legal consequence. A more widely held, financially backed or listed entity will have many more legal factors to consider.
For example, Companies Act obligations require all major transactions to be approved by special resolution. There are also common contractual obligations in investment agreements, shareholders’ agreements and banking/finance documents that generally restrict a company from changing its business. Breaching these obligations could result in severe legal consequences.
Pivoting into a new sector or industry can also require government licensing or registration, or be banned outright. A quick Google search can give some indication.
We recommend that businesses considering a pivot start with good, open communications with the stakeholders, and do not overlook any applicable legal requirements.
Imagine a situation
You run a business selling widget A. It goes well, and you make good money from it. Word also gets around to family, friends, some angels and VCs that you are making good money selling widget A. They offer you an irresistible pile of cash to scale the business to sell even more widget A. You take the money. For a while, things go well. Everybody is basically happy.
And then things change. You are hit by a pandemic where the demand for widget A disappears. Once the pandemic ends, you are hit by an economic shitstorm where everyone’s dispensable income is squeezed. Nobody is buying widget A anymore. Everybody is basically unhappy.
You still have a lot of money from when the business was going well and some of the money from the investors. You think now that widget B is the hot new thing. You have an intuition that everyone will buy widget B. This can make a lot of money. Things should work out.
Can you stop selling widget A and start selling widget B?
You can pivot, but check the legalities
The answer depends. It’s easy if you are the only stakeholder in the business, for example, you are the sole director with no external financing. You can do whatever you want, and introduce radical changes or do other things with the business at any anytime. But pivoting is not so straightforward if others are involved. Business partners, investors, financiers, and even wider stakeholders such as employees may resist change. Pivoting can get you in legal trouble and relationships can sour. In most instances, it is a communication issue. Talking through the reasons for change with key stakeholders before implementing any change is of course recommended.
And then there are legal considerations. Here's a checklist of common statutory and contractual restrictions:
Major transaction – The pivot may involve selling the company’s assets and/or buying new assets. If the value of the disposal or acquisition is more than half of the assets of the company, then the change will be deemed to be a “major transaction” and require approval by a special resolution of the shareholders. The special resolution threshold is generally 75% of the votes of the shareholders entitled to vote and voting on the question.
If you don’t get the major transaction approval when you need one, you have breached the Companies Act obligation and will expose your business to shareholder suit. The unapproved transaction could be seen as conduct deemed to be unfairly prejudicial to minority shareholders, putting you and the company at risk of legal action and the courts ordering some sort of relief order. On the other hand, let’s say you do go through the process of obtaining a major transaction approval. There’s no guarantee that every shareholder will approve the new deal. The ones that vote against the deal will have a right to be bought out at fair value. So there is a risk that even if you go through all the legal motions, you are at risk of loss basically to buy out the disapproving shareholder.
Reporting obligations – Extra rules apply to you if you are a financial reporting entity under the Companies Act. This might be the case if you have 10 or more shareholders or the business meets some financial thresholds for financial reporting purposes. This can require you to prepare an annual report that is sent out to the shareholders and the auditors. These must include, so far as the board believes is material and will not be harmful to the business, any change during the relevant accounting period in the nature of the business of the company. So if you pivot and you are a reporting entity, you need to tell the shareholders about it. This doesn’t prevent you from doing the pivot, per se, but you will need to tell everyone about the change.
Director’s duty of care – Finally, there is a rule under the Companies Act that says a director of a company when exercising powers or performing duties as a director, must exercise the care, diligence, and skill that a reasonable director would exercise in the same circumstances taking into account the nature of the company. There is also a duty to act in the best interests of the company - which often includes the interests of the shareholders - when exercising powers or performing duties. Directors considering new directions for their business should be mindful of these duties. For more information on directors’ duties, check out this article.
Use of funds obligation – Investment or subscription agreements quite often will include a use of funds obligation on the company. It makes sense. Investors want the investee company and founders to keep doing what they are doing and scale with the investment money. But at the same time, they want to make sure that the company commits to using the investment money for a particular purpose. Deviating from that purpose could constitute a breach of contract. Changing the nature of the business completely may be one of these instances.
Change of business approval – Shareholders’ agreements often feature a list of reserved matters (check out our FAQs on shareholders’ agreements). The basic idea here is that most company actions require board approval; boards are appointed by majority shareholders; investors often have minority positions but want some say in company decisions as they are handing over cash to the company; and so the parties agree on a list of key company actions that higher approval thresholds. This list often includes any change in the nature of the business of the company. The approval threshold might be a unanimous board approval or some shareholder approval threshold. Any change without the required approval would be unauthorised.
Financial covenants and undertakings – Loan or facility agreements with external financiers will almost always include a borrower’s promise that it does not change its business, except with the consent of the financier. This is a critical requirement of the financier which makes the loan based on due diligence undertaken on the existing business. Any unconsented change in business could result in the entire loan amount being repayable immediately.
NZX Listing Rules – NZX-listed companies are subject to additional restrictions on changing their business. First, any proposed change may be deemed to constitute “material information” of the issuer that needs to be disclosed immediately to the market. Any transaction that would significantly change the nature of the issuer’s business must also be approved by the shareholders. If the transaction is a “backdoor or reverse listing”, the transaction may be viewed as a new listing and needs to meet the initial quotation requirements.
Illegal products or services – Check whether selling new goods or services is legal. This will be sector-specific and a quick Google search should indicate whether what you are proposing to do is fine. For example, the sale of tobacco or alcohol products will be prohibited unless you comply with strict legal and licensing requirements. Selling and exporting greenstone, paua meat, wildlife, antiquities and some works of art are illegal under the customs law too. Pivoting into a new sector such as financial services or banking will require registrations or licensing that may be cost-prohibitive. If unsure, check with your lawyer.
The basic premise is that businesses will need to change over time. A company with a limited number of stakeholders can nimbly pivot without much legal consequence. But a more widely held, financially backed or listed entity will have a few more factors to consider. Although good communication will help with the legality of a change, it is important to consider statutory or contractual restrictions that can apply. We recommend that businesses considering a pivot start with good, open communications with the stakeholders, and do not overlook any applicable legal requirements.
What next
If you have any questions regarding this article, get in touch with Joshua Woo.
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Disclaimer
This publication should not be construed as legal advice. It is necessarily brief and general in nature. Please seek professional advice before taking any action in relation to the matters discussed in this publication.
