This article is written by Shambhavi Singh, from Bharti Vidyapeeth. She is pursuing a Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from LawSikho.com. Here she discusses “How to draft a shareholders agreement”.

Introduction

We as a human being make everything binding by keeping a paper of some duties and responsibility among parties, a shareholders agreement is one of those papers that is kept among shareholders of the company. It holds rights, responsibilities, privileges and protections for the shareholders and sketches how the company will run. These agreements are made to avoid conflict and protect shareholders. It is an agreement between shareholders and the company, shareholders are the one who owns a share in the company and their percentage of stake in the company represents their part of ownership in the company. 

Lock-in points 

• It is an agreement between shareholders of the company, determining their rights and responsibilities and determining the framework on how the company will run.
• It is an agreement to protect the investment of the shareholders and their rights.
• Protect the company and minority shareholders.

What should be included in a shareholders’ agreement?

There are several clauses that should be there in the shareholder’s agreement which are:

• Instrument – equity, preference shares and hybrid securities.

1. Equity- it is the riskiest form of security if done in an early-stage company but it can be really fruitful if the company does well. Company’s good performance will help to raise the valuation of the company and hence increase in share prices.
2. Preference share-  preference share has an edge over equity shares in terms of getting dividend but only if the company has made a profit that year if not then the dividend will get accumulated and will be paid off when the company will make a profit.
3. Debenture- it is debt, a fixed amount of interest is paid irrespective of the company’s profit. It is a comparatively safer investment than preference and equity share.
4. Hybrid securities- are those types of security which are converted after a fixed period of time i.e. 5 to 6 years. Compulsory convertible preference share, compulsory convertible debenture, optionally convertible preference share and optionally convertible debenture are the following common hybrid securities.

• Liquidation preference- this clause is to save the venture capitalist. They should be paid first before any other shareholder including promoters. The same goes if the company sold at a profit, they are on the top-notch to claim part of the profits.
• Veto rights- investors have this right against any fresh issue of shares. This right is to protect their stake in the company.
• Pre-emption rights- existing shareholders can subscribe to fresh issues of share so that they can maintain their stake.
• Anti-dilution rights- they are only triggered if the company’s valuation has decreased. 
• Lock-in- founders are the brains of the company, this clause is put to restrict them from selling, assigning, pledging, transferring their share so that they are fully invested in the company.
• Execution of employment agreement- this is put in by the investors to keep the founders in full-time employment of the company.
• Non- compete for clause- this clause is put to prohibit the founders from engaging any other business.
• Reverse vesting- in this founder’s shares are taken away and founders have to earn as per the vesting schedule. This clause restricts the founder from leaving with their shares.
• Tag-along- it is put to protect the interest of minority shareholders where the majority shareholder wants to exit the company and sell all of their shares.
• Board representation- investors have the right to choose his representative to the board of directors of the company.
• Affirmative voting- it is voting used for reserved matters.
• Information convenient- investors require periodic information from the company about the balance sheet, cash flow statements, marketing plans etc.
• Right to inspect- shareholders of the company have the right to inspect the book of accounts and other documents of the company.
• Right of first refusal- this right ensures that investors have the first right to purchase the stake of the founders in case they want to exit the company.
• Representation, warranties and indemnities- representation and warranties are provided by the promoters and the investee. Its nature varies according to the sector. In case of breach of warranty, investors can ask to indemnify.
• Dispute resolution- a mediation or arbitration process can be useful when the parties are at a dispute over an issue.

Importance of a shareholders agreement

Importance for minority shareholders- minority shareholders is anyone who owns less than 50% of the total stake. Minority shareholders do not have voice or control over the company’s operation. Therefore, the control of the company often rests with only one or two of the shareholders. Generally, companies operate based on majority decisions. This happens even if any articles of association include provisions which protect the minority. But you can change this decision through the special resolution of holders owning 75% of voting shares. There are laws which offer minimal protection to minority shareholders. However, enforcing these can be quite costly.

Shareholders agreement acts as a shield for the minority shareholders. if any minority shareholder has the sample which needs the approval of all the shareholders for any decision then one has a vote with regards to significant decisions which affect the company. Some of the decisions are:

• Board of directors
• Accepting borrowings
• Issue of new shares 

Tag along provision is put to for the benefit of the minority shareholder as it protects them in a way that if someone wants to purchase a majority shareholder’s shares, that particular shareholder may only sell his shares if the buyer gives the same offer to all shareholders, even the minor ones.

Right of first refusal delivers the right to all the shareholders including minority one to buy the shares of the founders in case they want to exit the company.

Importance for majority shareholders- drag along provisions are put to safeguard majority shareholders when majority shareholder wants to sell their shares but one of the minority shareholders isn’t willing to agree this is where the “drag along” comes into the picture and enable the shareholder to sell their shares.

Shareholder agreement works as a document which legally restricts the certain set of shareholders and to abide by the provisions laid in it. Like in the case, the majority shareholder may prefer to prevent the minority shareholders from sharing confidential information of the company to leak out or any minority shareholder to set a rival company as these provisions can be put to keep the majority shareholders on the safe side.

Shareholders agreement must include information like the terms of transferring and selling, the price of selling and who they can transfer to.

Importance for equal shareholders- a provision for dispute resolution is just as in case of any dispute there would be chaos in the company and it will hurt the overall image of the company. Any member can suggest a shareholders agreement

When should a share agreement be put in place?

The best considered time is when the company is formed while issuing its first share. This is considered a positive attitude, and it helps in the understanding of shareholders’ expectations of the business. Any member can suggest a shareholders agreement as it requires no voting, but it needs consensus and its signatory by all the shareholders to make it valid. Shareholders agreement deals with intricate conundrum this may not have yet taken place, but by the time it does so, the agreement should be there to come out of the situation. A shareholders agreement is a document of consensus of the company and its shareholders. Without it could be disastrous in coming further future events of the company. It should be updated if there is a change in circumstance.

Several occasions when share agreement is essential are:

• When a company is formed.
• When any shareholder wants to sell his share or he dies.
• If money is borrowed from the shareholders.
• If the company launches a new model or product in order to operate the same
• Appointment or resignation of director shareholder.

Interest of the shareholders

The interest of the shareholders are equally important with the company’s growth as a motive of any shareholder is to gain some profit at a personal level and this should be kept in mind while drafting the agreement. Some of the interests are-

• Timing and the amount of the divided.
• The benefit to the directors.
• Relationship between suppliers and customers.

5 Steps to create a shareholders agreement

• Parties- identifying the parties who will be involved in the agreement. The details of the parties should be mentioned like contact details, the company’s name, address etc.
• Structure of the company- structure can be identified by dividing the segments of the company and the structure should include the size and type of the organisation, board of directors.
• Rights and duties- a shareholder agreement includes all the rights and obligations which the party is obligated to perform.
• Shares- the rules of transfer, resale of share should be laid in the shareholder’s agreement.
• Signatures- shareholders agreement should be signed by all the shareholders of the company.

Some Do’s & Don’ts

• Shareholder issues and management issues are both different.
• Return on capital and return on labour is different from each other.
• Roles of the directors, shareholders, managers should be distinct.
• Tax planning.

Termination of a shareholders agreement

Termination of a shareholder can be done in three ways:

• Mutual termination- this termination involves unanimous decisions of all the shareholders involved in the agreement. Reasons for all of them can differ but consent would be there for termination. Mutual termination generally occurs when the company is going to dissolve soon and shareholders want to sell their shares.
• Automatic termination- this kind of termination occurs when there is any kind of breach happening and there is no other way out. If in case there is a clause for resolving such breach in a particular manner then it would be resolved in that way.
• Leaving in the company- if one of the shareholders decides to leave the company then the agreement may get terminated. In such cases generally, specific provisions are there as “how to deal with it ?”.

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