Introduction

A simplistic understanding of a shareholders’ agreement (SHA) is that it is a corporate pre-nuptial agreement. Legally speaking, an SHA seeks to regulate the relationship between some or all of the shareholders and the company itself. An SHA typically lays down various commercial rights, management rights and exit rights available to the shareholders. It also regulates the procedure for transfer of shares, valuation of shares, dividend policy, to name a few. In essence, it provides pragmatic guidance for the functioning of the company by balancing the interests of the investor vis-à-vis the promoter.

Understanding the commercial intent

The SHA is a highly negotiated document as the parties to the agreement have varied commercial intents while entering into one. Hence, careful thought must be given while drafting an SHA to ensure that the investors’ liquidity concerns are appropriately balanced with the business interests of the promoters and the company.

Download Now

Investor’s Perspective

An investor is someone who receives some stake in the company, in return for investing in that company. However, an investor may or may not be involved in the day-to-day functioning of the company. Hence, in order to safeguard the value of the investment that has been made in the company, it is judicious and advisable to enter into an SHA. The various rights granted to the investor under the SHA are useful for checking opportunism on part of the promoters. Other key considerations are exit momentum and exit mechanisms, which allow for maximum value realization.

Promoter’s Perspective

The promoters of the company are looking for funding and investments in order to grow the company, increase market reach, etc. However, though the promoters require the money to expand operations, they intend to dilute their shareholding to the least possible extent. Furthermore, the promoters also wish for operational flexibility as regards the day-to-day management of the company and the use of the available money. Hence, the promoters would be desirous of entering into an SHA which is not onerous on them and which has the least restrictive covenants. Another key consideration that the promoters are usually mindful of while entering into an SHA is that if the SHA, entered to prior in time, is not well-balanced in favour of the promoters, then the subsequent investors would also seek similar rights, if not more.

Key Questions to be asked while drafting an SHA

One can only draft an agreement which successfully captures the true intent of the parties if one is aware of what the parties seek to achieve through the agreement. A lawyer should always understand the commercial considerations and expectations of the parties to the contract. This is only possible if the lawyer asks the right questions and ensures that responses received by the client are meticulously incorporated in the agreement. While this process is highly subjective and lawyers are expected to tailor the drafting of each contract to the needs of the respective parties, yet every shareholders’ agreement should provide for certain fundamentals to avoid any gaps and prevent potential disputes.

The author has attempted to identify all the crucial questions that ought to be asked by a lawyer tasked with drafting an SHA.

[Usually, an SHA is executed between the founders or promoters, existing investor(s) and incoming investor(s). All shareholders have to be a party to the SHA. However, ESOP holders, even if they have vested equity in the company cannot be a party to the agreement.]

[It is always advisable to make the company a party, especially so if the SHA imposes certain obligations upon the company. In this situation, the agreement can be enforced against the company based on contractual principles.]

[Answering this question is fundamental as different kinds of investors have different needs, motives and expectations. Dealing with angel investors is different from dealing with a private equity investor or venture capitalist.]

Capital structure

Transfer of shares

Management rights

Right to information and inspection

Restrictive provisions

Termination

Governing law and dispute resolution

Understanding the SHA through the prism of its key clauses

Shareholders’ agreements, not being mandated by the law, are entered into and executed simply at the will of the parties. In this backdrop, it can be understood that though not necessitated by the law, parties prefer to enter into an SHA as a matter of commercial prudence.

The author has sought to analyze certain key clauses from the lens of the benefits which they seek to provide the right-holder while buttressing the commercial intent of the right-holder.

Clauses regarding Share Transfer

Now, let’s understand the different motivations for securing this right:

All start-up’s and growth companies require new funding. Now, each funding round that takes place will have an overall impact on the shareholding pattern of the existing investor. Each investment round can either be an ‘up-round’ or a ‘down-round’. Now, in case of an ‘up-round’, although the equity stake of the existing investor reduces, the overall value of the shares held by the investor increases due to an increase in the valuation of the company. However, in case of a ‘down-round’, not only does the investor’s ownership over the company decrease but also the value of the investment goes down. This is where anti-dilution protection kicks-in.

Anti-dilution protection is triggered when new shares are issued by the company at a price which is lower than the price at which the shares were purchased by the existing investor. Essentially, it protects the investor from the dilution of equity stake due to down-round financing.

Promoters also must recognize that to prevent their holding from getting diluted over time, it is essential to secure anti-dilution rights. If the SHA does not provide for this, it could lead to disastrous effects for the founder, wherein a situation may arise that a founder could lose control or eventually be ousted from the very company he started. A glaring example of this would how Eduardo Saverin, the co-founder of Facebook, was eventually ousted from Facebook, by diluting his stake to less than 10%.

Clauses concerning Management Rights

Confidentiality

Non–Compete Clause

Dispute Resolution Clause

Clauses concerning Exit Options

  1. Initial Public Offering
  2. Third-Party Sale
  3. Buyback of Securities
  4. Call Option
  5. Put Option

Conclusion

The SHA finds its purpose well in protecting the interests of the shareholders by providing them specific rights, over and above those, provided by the Companies Act, 2013. It is typically like a safety net, which seeks to protect the investor against the various contingencies that may arise during the course of the business. It is a given that an SHA inspires investor confidence and can help the company secure further investments. Although some clauses appear to be onerous on the promoters, if rationalized and negotiated appropriately, a well-balanced SHA, tailor-made to suit the commercial necessities of parties, is achievable.

LawSikho has created a telegram group for exchanging legal knowledge, referrals and various opportunities. You can click on this link and join:

Follow us on Instagram and subscribe to our YouTube channel for more amazing legal content.