Articles of Association Are Not a Formality

Most Czech limited liability companies (s.r.o.) have articles of association drawn from a notary's template. At incorporation that is understandable: it is quick, cheap and meets the legal minimum. The trouble starts when the business takes off, when the shareholders (in Czech law, the společníci of an s.r.o.) stop agreeing or when one of them leaves.

That is when you find that the articles you signed five years ago make no provision for the situation you are in, and that putting it right will be expensive and slow.

In practice, we keep running into five points where standard templates most often fail.

¶ 1. Share transfer: general meeting approval can block a minority shareholder's exit

Under the Czech Business Corporations Act, a shareholder may freely transfer a share to another shareholder, but to a person who is not a shareholder only with the approval of the general meeting, unless the articles of association provide otherwise (Sections 207 and 208). The articles of association can make a transfer conditional, restrict it, or exclude it.

The template usually says: "Transfer of a share to a third party requires the approval of the general meeting." It sounds reasonable. But what does it mean in practice?

If you are a minority shareholder and want to sell your share, the majority shareholder can block the transfer at the general meeting. The other shareholders do not have to buy your share, and then your only option is the courts: you can apply to have your participation in the company terminated if you cannot fairly be expected to remain (Section 205 of the Business Corporations Act). Such proceedings, however, take a long time and the outcome is uncertain.

What the articles should contain: drag-along or tag-along rights, a clearly defined pre-emption right with the price set by an independent valuer, or at least a time limit after which the share can be transferred even without approval.

¶ 2. Profit distribution: who decides and by what majority

The template usually just refers to the statute, under which the general meeting decides on profit distribution by simple majority. That works as long as both shareholders are of one mind.

But imagine the company is making money, one shareholder wants the profit paid out and the other wants to reinvest it. With a 50:50 vote, nothing gets decided. The profit stays in the company and nobody determines what it will be used for.

It is worse still when the majority shareholder keeps blocking profit payouts to the minority shareholder. The minority shareholder carries part of the risk and has put capital into the business, yet receives nothing.

What the articles should contain: rules for a minimum profit distribution (for example, a requirement to distribute at least 50% of net profit unless the company has a legitimate reason to reinvest), a qualified majority for decisions to retain profit, or a right for the minority shareholder to demand a payout when certain conditions are met. Any such payout must still pass the statutory test in § 40 of the Czech Business Corporations Act: profit cannot be distributed if equity would fall below the statutory threshold or if the payout would make the company insolvent.

¶ 3. Managing director or general meeting: who holds real power

The template typically assigns business management to the director and strategic decisions to the general meeting. In practice, though, the line between the two is blurred.

Can the director sign a contract worth CZK 5 million (roughly EUR 200,000) on their own? And one worth CZK 50 million? Can they take out a loan, sell a property or hire a manager on a higher salary than their own?

If the articles set no limits, the director has essentially a free hand in running the business. The general meeting can approve general policies, but it may not give the director instructions on business management unless the director asks for them (Section 195(2) and Section 51(2) of the Business Corporations Act).

What the articles should contain: financial thresholds up to which the director decides without general meeting approval, a list of decisions that require the shareholders' prior consent (acquisition and disposal of real estate, loans above a certain amount, entry into joint ventures), and rules for appointing and removing the director, including safeguards for minority shareholders.

Bear in mind, though, that such limits only work inside the company. They cannot be relied on against a business partner, even if they have been published (Section 47 of the Business Corporations Act). A contract the director signs above the limit still binds the company, and the director is then personally liable for any resulting loss.

¶ 4. Death or departure of a shareholder: what happens to the share

Nobody wants to think about this area, which is why templates deal with it only minimally.

If a shareholder dies, their share passes to the heirs. The articles can prohibit or restrict the passing of the share to the heirs, for example by making it conditional on the approval of the other shareholders. If they do not, your new business partner could be someone you have never met and who knows nothing about how the business runs.

Divorce raises a similar problem. A share acquired during the marriage usually forms part of the spouses' community property (společné jmění manželů), unless the shareholder acquired it by gift, by inheritance or from separate property (Section 709(3) of the Civil Code). It may then be awarded to the other spouse in the settlement.

Then there is the shareholder who simply stops caring about the business: loses interest, moves abroad, stops responding. They still hold the share and do not vote at general meetings, yet key decisions cannot be taken without their consent.

What the articles should contain: an obligation for heirs to offer the share to the remaining shareholders at a predetermined price or a price set by a valuer, a mechanism for buying out the share of a shareholder who is inactive for an extended period, and a procedure for when a shareholder divorces.

¶ 5. Deadlock: two 50:50 shareholders with no tie-breaking mechanism

The most dangerous situation arises when two shareholders with equal stakes stop agreeing on where the business should go. One wants to expand, the other to consolidate. One wants to bring in an investor, the other does not. One wants to replace the director, the other wants to keep them.

With equal votes, the general meeting passes no resolution and the company grinds to a halt. The law offers only last-resort remedies: the court can terminate a shareholder's participation in the company (Section 205 of the Business Corporations Act), or dissolve the company and order its liquidation because of irreconcilable differences between the shareholders (Section 93(c) of the same Act). Both take a long time, and neither will save the business.

What the articles should contain: a mediation clause as the first step, a rotating chair with a casting vote, a "Russian roulette" clause (one shareholder offers to buy the other out at a certain price, and the other must either sell or buy at the same price) or a "Texas shoot-out" clause (both shareholders submit sealed bids and the higher bidder buys the other's share), or a decision by an independent expert named in advance for selected operational issues.

¶ When to revise the articles

If you have not updated your articles since incorporation, the best time to revise them is now. After that, whenever circumstances change: a new shareholder joins or an existing one leaves, the business grows significantly, its business model changes or an investor comes on board.

Revising the articles costs in the order of tens of thousands of Czech crowns. A dispute between shareholders costs hundreds of thousands to millions and takes years.

The articles of association set the rules of the game between shareholders. If those rules were written from a one-size-fits-all template by someone who does not know your business, it is only a matter of time before they turn out not to fit your situation.

Not every company needs thirty pages of articles. But every company with more than one shareholder needs articles that settle the five situations above in advance, because once they arise, the shareholders will no longer agree on the rules.

If you are considering a shareholder coming in or leaving, read Business partnership: how to part ways. When buying a company, due diligence is essential, and on contract clauses in general I recommend Five contract clauses nobody reads.