This article is written by Neha Deshmukh who is pursuing a Diploma in M&A, Institutional Finance and Investment Laws (including PE and VC transactions) from Lawsikho.

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. 

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.

Parties Who are the parties to the 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.] Should the company be made a party to the SHA? [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.] Who is investing in the company? Is it an angel investor or a private equity investor or a venture capitalist?  [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.]

Investment How much of the company is being diluted?  What is the investment that is being made? At what valuation is the investment made? What instruments are being subscribed to by the investor? Is the investor subscribing to securities in the form of equity, preference, debenture, convertible note or hybrid? What Conditions Precedent have to be satisfied by the company prior to the Closing, for the investors to subscribe to the securities? How should the investor pay the subscription money?

Capital structure What are the different classes of shares which will be subject to the SHA? What rights will be associated with each class of shares? If the company issues new shares, will they have to be first offered to the existing shareholders in the proportion of their present holding in the company?

Transfer of shares What will be the restrictions on share transfers? Will any requirements have to be complied with to transfer such shares? Will it be mandatory for an existing shareholder, who intends to transfer his shares to a third party, to offer those shares to the other existing shareholders on a pro-rata basis?  Will the majority shareholder(s) have the right to compel the minority shareholders to sell their shares to a third party, at the same terms and conditions as those offered to the majority shareholder(s)? (This is commonly known as the ‘drag-along right’) Will the minority shareholder(s) have the option of selling their shares along with the majority shareholder(s) when an offer has been made to the majority shareholder(s)? (This is commonly known as the ‘tag-along right’) What kind of restrictions can be imposed on the transfer of founders’ shares? How can the investor possibly deter a founder from exiting a company? Even if a founder were to exit the company, what mechanism is to be adopted to ensure proper functionality of the business? Will the shareholder(s) be permitted to encumber any of their shares?

Management rights What set of rights are going to be granted to the various shareholders? Will any investor have a right to appoint a director to the board, and if so, how many? Will the investor have the authority to remove or replace that director? Will the investor have a right to appoint a representative to the board (Board Observer)? Which decisions will require the prior consent or approval of certain investor(s)?

Right to information and inspection Will the company be obligated to provide certain information to the shareholder(s)? If yes, then how will this information be made available to the shareholder(s)? Will it be on a monthly, quarterly or annual basis? What kind of visitation and inspection rights will be given to the shareholder(s)?

Dividend Will dividends be paid out? And if so, what will be the policy for the same? On what basis will the dividends be paid out?

Restrictive provisions Will the shareholder(s) be restricted from disclosing certain information defined as ‘Confidential Information’? Will the shareholder(s) be forbidden to carry out any business which competes with the business of the company? If yes, what constitutes competing business? What is the duration of this restriction? Over what geographic area does this restriction apply? Exit In what way will the investor(s) exit the company?  Within how many years should the investor(s) be given an exit from the company?  What will happen if the promoters are unable to provide an exit opportunity to the investor(s)?

Termination The happening of which events will trigger the termination of the SHA?  Which clauses of the SHA will survive despite the termination of the SHA?

Governing law and dispute resolution The SHA and its performance are governed by the laws of which State? In case a dispute arises between the parties, what will be the mechanism for settling the dispute?

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

• The SHA lays down a mechanism for regulating as well as restricting (to a certain extent) the transfer of shares as the company usually wishes to control what shareholders can do with the shares of the company. Thus, well-drafted clauses regarding the transfer of shares allow new investors to step-in by providing an exit opportunity to some existing investor, while effectively regulating the transfer of stake in the company. 
• An investor may have several motivations to invest in a particular company. One such motivation typically arises from the confidence in the promoters and the management of the company. And therefore, to ensure that they continue to hold some stake in the company and remain invested in the vision of the company, it is common to find a Founder Lock-In clause in the SHA. One thing that the founders need to watch out for is that this duration of lock-in can be reset every time a new funding round takes place. The duration of each founder lock-in period can vary depending upon the size of the investment being made and the stage at which the investment is being raised. The benefit of a founder lock-in is twofold – first, to ensure that trusted management continues to run the company and second, that in any case, the investors are never faced with a situation wherein they are required to manage the affairs of the company. Furthermore, though usually lock-in restrictions apply only to the promoters, however, depending upon the bargaining power of the parties, these restrictions can be imposed on the investors as well. 
• Rights incorporated in the SHA such the Right of First Offer (ROFO) or the Right of First Refusal (ROFR) allow the continuing shareholders an option to purchase the shares from the exiting investor, in order to consolidate their control over the company. Inclusion of either of these rights’ in the SHA serves dual benefit – first, it allows the continuing shareholder to maintain control over the entry of a new shareholder, and second, it addresses the liquidity concerns of the exiting investor. Whether an SHA should include the ROFO or ROFR would depend upon the circumstances in which the parties are placed and the commercial interests that they seek to secure.
• Anti – Dilution Rights acquire great prominence in an SHA from the underlying commercial interest that a subsequent issue of shares should not dilute an investor’s or promoter’s stake in the company. It involves issuing fresh shares to the existing shareholders in order to maintain their stake in the company. 

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

• • Investor: 

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. 

• • Founder/Promoter: 

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

• Investors always seek to secure certain participatory rights in the governance of the company, in which they invest. One of the rights could be in the form of board nomination, i.e. appointment of one or more nominee directors, commonly referred to as Investor Director(s), by the investor, depending upon their stake in the company. Usually, the SHA provides for certain quorum requirements mandating the presence of the Investor Director. Furthermore, this investor director is usually equipped with affirmative voting rights or veto rights upon reserved matters, as specified under the SHA. 
• Sometimes, the investor may also choose to appoint a person as a Board Observer, in a non-voting capacity, to attend meetings and track the business of the company. All these rights, taken cumulatively, definitely allow the investor to participate in the management of the company and ensure a fair deal of information symmetry. 

Confidentiality

• A company may place a contractual obligation on the shareholder(s) to not communicate or use any information relating to the business, affairs, customers, clients or suppliers of the company. 
• When drafting this clause, it is important to carefully define as to what constitutes ‘Confidential Information’ and in what circumstances is the disclosure of such Confidential Information permissible. 

Non–Compete Clause

• All SHA’s invariably contain clauses imposing non-compete obligations upon the promoters of the company. Such clauses ensure that the promoters of the investee company do not engage in any activity, which would in effect, be identical or similar to the business carried out by the company. 
• The promoters, whom this clause seeks to restrict, should ensure that this clause defines with sufficient clarity as to what constitutes a ‘competing business’. While the investors will be looking to define it widely, in order to encompass a range of activities; the promoters should try and negotiate a narrower clause, so as to limit the restrictions that are placed them. 
• While drafting the non – compete clause one needs to be mindful of the fact that the restrictions which this clause seeks to place upon the shareholder(s) are reasonable. This is especially pertinent as unreasonable restrictions are unenforceable, as per Section 27 of the Indian Contract Act, 1872. 

Dispute Resolution Clause

• The SHA does well to pre-empt a suitable resolution mechanism in case disputes arise between the parties. The dispute resolution clause lays down the governing law and also specifies the mechanism which the parties have to adopt in case a dispute arises. A pre-decided resolution policy goes a long way in overcoming deadlocks and ensuring the functionality of the business. 

Clauses concerning Exit Options

• Every investor, while making an investment in a company, is also keen to devise an exit strategy that will provide the investor with an assured exit from the company and a return on the made investment. Furthermore, from an investor’s perspective pre-deciding an exit policy is important to provide for a smooth exit from an unprofitable or non-performing investment. Usually, an exit can be structured by following any one or more of the following options:       

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

• There may arise a situation, where even before the investor exits, the company is involved in events such as acquisition, merger, consolidation, demerger, substantial sale of assets or shares, winding-up proceedings, or even change in control. Any such event generally falls under the definition of ‘Liquidation Event’ under an SHA. An SHA usually provides the right of Liquidation Preference to an investor upon the occurrence of a Liquidation Event. As per this right, upon the happening of the Liquidation Event, an investor is entitled to not only receive the investment amount, but also a certain agreed percentage of proceeds, in preference over other shareholders. An investor will always try to secure the value of the investment made and this clause ensures that an investor will get the assured returns even if a Liquidation Event occurs. From a promoter’s perspective, two considerations gain prominence in this regard – first, to ensure that careful negotiations take place to determine as to which happenings would qualify as a Liquidation Event, and second, to try to settle on a narrow definition of Liquidation Event, in order to minimize the happenings that trigger the payment of Liquidation Preference. 
• Clauses concerning the exit options may seem disproportionately balanced in favour of investors. However, it is important to understand that the commercial intent behind these clauses is essentially to protect the value of the investment and to ensure an exit momentum. 

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. 

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