Small business owners are often caught between the need to house their business operations in a legal entity which affords limited liability, and a desire to avoid the legal and administrative difficulties that come with registering and maintaining a legal entity.
Prior to 1 May 2011, being the date upon which the Companies Act 71 of 2008 (“the New Act”) came into effect, the majority of small businesses looking to house their operations within a limited liability entity chose to register a closed corporation.
Closed corporations were perceived as being simpler to run and administer, and were certainly cheaper in that their financial statements were not required to be audited, whereas under the previous Companies Act, No. 61 of 1973 (“the Old Act”), the financial statements of private limited liability companies were required to be audited.
Closed corporations have a number of draw-backs of their own, however. For one thing, the ‘good-faith partnership’ concept upon which the closed corporation is based does not always align with the realities of member relations in the commercial world.
Perhaps more importantly, however, closed corporations do not adequately cater for more nuanced membership arrangements, in that the membership interest in a closed corporation always carries the same rights and obligations. A closed corporation is unable to offer different categories of membership interests carrying different rights, in the same way that a company is able to issue different classes of shares.
The two most important considerations for small business owners are generally (1) keeping costs down, and (2) freedom from excessive paperwork. Before the introduction of the New Act, small businesses owners had to choose between housing their business in a company so as to enjoy a more sophisticated share structure at the cost of appointing an auditor, or foregoing nuanced share structures and housing their business in a closed corporation.
With the introduction of the New Act, however, the major obstacle to housing one’s small business in a company has been removed, in that a private company is no longer required to have its annual financial statements audited, unless it chooses to do so, or unless it meets certain criteria relating largely to business size.
The abolition of the requirement for a company to have an auditor is greatly helpful to small businesses, since they are now able to house their business operation in a company, with all the flexibility around share capital that a company offers, without the prohibitive expense of auditors’ fees.
In addition, the New Act has simplified certain of the administrative rules previously associated with companies. Under the New Act, companies may store documents in electronic format, give notice of meetings electronically, and electronic signature of documents is permitted. These changes suit smaller businesses and start-ups, which tend to be digitally-based and seldom deal with documents in hardcopy.
On top of this, the New Act contains more extensive and detailed provisions than the Old Act in relation to the manner in which shareholder and directors’ meetings are to be held, and the process by which shareholders and directors make decisions. Whilst the Old Act contained some guidance in this regard, the detail was generally to be found in a company’s articles of association. The New Act is much more comprehensive, which means there is no need to replicate those provisions in the company’s memorandum of incorporation (MOI), and the MOI may accordingly be a simpler document.
A characteristic of many smaller businesses is that their shareholder numbers are small, and there is frequently a 100% overlap between shareholders and directors. Even where the shareholders are themselves legal entities, the board nominees of those shareholders are generally the principals behind the entities.
The result is that the founders of small businesses find the distinction between shareholders and directors puzzling, and they do not understand why the company cannot be run by the directors alone, since in their minds the directors and the shareholders are the same people.
Against this background the scope afforded by the New Act for directors’ powers to be almost as extensive as those of shareholders, whilst shareholders retain final control of the company, align well with how small businesses like to work.
Depending on the content of the MOI (which in itself is a shareholder decision), the powers of the board of a small business may be extensive, including the power to affect the share structure of the company. This affords the board a wide discretion to run the company without constantly reverting to shareholders, which makes particular sense where the board and the shareholders are for all intents and purposes the same people.
At the same time, it is always open to shareholders (and to shareholders alone) to take back greater control from the board, by amending the MOI to restrict the board’s powers. Once a small business reaches a certain level of maturity, or takes on additional shareholders which do not enjoy board representation, it makes sense for the distinction between the board and the shareholders to be more strongly drawn, at which point the shareholders may resolve to amend the MOI, thereby circumscribing the board’s powers.
Even whilst the board has wide powers in terms of the MOI, the New Act reserves certain key powers for the shareholders alone, including the requirement that at least 50% of the board must be elected by the shareholders, and the power to remove directors from the board.
As mentioned earlier, one of the key drawbacks of the closed corporation for small businesses was the inability of a closed corporation to provide for membership interests having different rights for different members, in other words, different classes of members’ interest. Many people assume that because a business is small, or a start-up, it has no need for membership interest carrying different rights. This assumption is incorrect. Start-ups receiving equity investment from third party investors find the ability to issue different classes of shares very useful.
For this reason, the removal of the obstacle to housing a business in a company (namely the requirement to appoint an auditor) has been greatly beneficial to small businesses, since for the first time they are able to offer investors a chance to own equity in the company, whilst reserving control, at both a shareholder and a board level, for the founding shareholders.
In addition to this, the flexibility that the New Act affords around the percentages required for an ordinary and a special resolution means that even where there is only one class of shares in a company, shareholders can arrange the percentages in a manner which they consider appropriate, provided of course that there is always a 10% difference between the percentage required to pass an ordinary resolution and that required to pass a special resolution.
The New Act, although still in its infancy, has brought positive changes for small businesses, which the judicial interpretation and refinement to which the New Act will certainly be subject with time, will no doubt improve upon.
Sarah has a BA from Stellenbosch and a BA Hons and LLB from UCT. She was admitted as an attorney in early 2010 after having completed her articles at ENS. She worked as an associate in ENS’ corporate commercial department for two years, before leaving last year to focus on her own commercial practice. Sarah joined Caveat Legal during April 2012.