Disclaimer: This post is a personal reflection and does not constitute legal advice. Every situation is different — if you need legal advice, email me at [email protected].
In my last post about the journey from Term Sheet to Drawdown, I highlighted how internal bank guardrails can freeze a facility. One specific point—“Shareholders Don’t Approve Loans, Directors Do”—struck a chord, especially with several founders. That piece showed how banks require board resolutions (not shareholder approvals) to authorise credit facilities, because shareholders own the company but directors manage it. These are two different legal hats. The confusion between them doesn’t just matter for borrowing; it matters for all founder decisions.
It reveals a fundamental tension amongst SMEs, specifically with founders who are transitioning from "One-Man Bands" to growing teams.
I am currently advising on a deal where a founder is bringing in new partners. These aren't just cash investors; they are key team members being compensated with equity—classic "sweat equity." The commercial intent is clear, and I am helping them navigate this transition.
We are shifting from a confusion between equity and management to one where these two hats are separated. Whether you are seeking a bank loan or issuing sweat equity, founders need to understand that in the eyes of the law, "The Boss" doesn't exist. There are three distinct legal hats. In a startup, you often wear all three, but you must know which one you are wearing and when.
The Shareholder Hat
First, you have the Shareholder Hat. This is the hat of ownership. You wear this because you own a stake in the company. Your reward here is profit—dividends and capital growth.
Owning shares doesn’t give you the right to run the company. Nor does it obligate you to work for it. Legally, a shareholder can do absolutely nothing while collecting dividends. Your power is strictly limited to "Constitutional" matters, like changing the company name or—most importantly—appointing the people who do run the company, i.e., the directors.
The Director Hat
This brings us to the Director Hat. You wear this only because the Shareholders appointed you. When you have this hat on, you have the "Management Power" to sign contracts, hire staff, borrow money, and set the strategy. But you also have a fiduciary duty to act in the best interest of the company, not yourself, and the director is personally liable.
I’ve seen founders getting confused with the shareholder hat and director hat, where they think it’s the shareholder’s responsibility (and duty) to set the company strategy. But even when the shareholders and directors are the same people, it is the hat they wear at the specific time of the decision that matters.
The Employee Hat
Finally, there is the Employee Hat. You wear this to execute the work, and your reward is a salary (and sometimes equity). This is where the "Sweat Equity" model often breaks. Sweat equity simply means giving someone shares in exchange for their work and expertise rather than cash—common in startups where founders can’t yet pay competitive salaries.
Corporate law and employment law are separate. Owning shares does not replace an employment or consultancy contract. If you want a shareholder to do work for the company, they need a contract setting out what their role is. Without one, you can't hold them accountable to deliverables, and—crucially—the Intellectual Property (IP) they create might belong to them, not the company.
Why Not Just Keep It Simple?
You might be wondering, "Why do we need all these hats? Why not just form a Partnership or be a Sole Proprietor?"
The problem with those "simple" structures is that the hats are glued together. In a Sole Proprietorship or Partnership, there is no separation between "You" and "The Business." You are the owner, the manager, and the liable party all at once. If your partner runs up a debt, you are also personally liable for it. You cannot separate the "Investor" from the "Manager."
A company allows you to separate and silo these roles. It allows you to have an investor who only provides cash (Shareholder), a manager who only runs the business (Director), and talent that only executes (Employee).
Why "Good Enough" Structures Fail
You might think, "We are all friends, does the paperwork really matter?"
It matters when you try to scale, and it definitely matters when things go wrong. If you don't separate these hats, you cannot solve conflict.
For example, what happens if a co-founder stops working but holds 20% of the equity? If you relied on a "handshake" partnership, you are stuck. You cannot "fire" a partner easily.
But if you structured it correctly, the answer is simple: You fire them as an Employee (stop paying their salary) and remove them as a Director (stop them from making decisions). However, they keep their Shares—because that is their property—unless you have a mechanism to buy them back.
This is where the Shareholders’ Agreement becomes your most vital document. It is the rulebook that tells you how to take the hats off when things go wrong—spelling out who can be removed as director or employee whilst keeping their shares, how shares can be bought back, and what happens if someone leaves. Without it, you’re trying to solve a three-hat problem with only friendship as your answer.
Disclaimer: This post is a personal reflection and does not constitute legal advice. Every situation is different — if you need legal advice, email me at [email protected].