This article is written by Nirali Shah who is pursuing a Diploma in Advanced Contract Drafting, Negotiation and Dispute Resolution from LawSikho.

Shareholders’ Agreement

As the name depicts, it is an understanding or agreement between the shareholders. In simple terms, the aim of the Shareholders’ Agreement is simply to protect the interest and investment value of the shareholders. This also includes the management and administration of the Organization.

A Shareholders’ Agreement can also be termed a Stockholders’ Agreement, is an arrangement between the company’s shareholders that explains how the company should be controlled, operated, managed and also outlines the shareholder’s powers/ rights/ duties and obligations.

This agreement provides in detail the rights and obligations of the shareholders, regulations to manage the sale of share(s) or transfer of share(s), protecting the interest of the shareholders (majorly protection to the minority shareholders) and the organization, how the management’s important decisions are to be taken and operations. The procedure for appointment of directors and the requirements of quorum during the Board and Committee meetings, financial and risk management, determining the matters/ agenda requiring the special resolution or providing veto rights to certain classes of shareholders, restrictions on the transfer shares freely, stating the obligations of each shareholder towards the organization.

One must consider a shareholders’ agreement as guidelines or rule book for the organization and the shareholders, to protect their investments.

Reasons to enter into a shareholder’s agreement

• To protect the investments of the shareholder’s
• To establish a fair relationship between the organization and the shareholders;
• To set out the regulations how one shareholder can transfer his share(s) to another shareholder;
• To regulate deadlocks and potential disputes between the shareholders and solutions to resolve them;
• To define the various course of action on the death of a shareholder.

Shareholders’ Agreement is in place to supplement the company’s Articles of Association (AOA). Some mandatory clauses or provisions must be included in the shareholders’ agreement, but the rest is for the shareholders to decide their personal goals and industry-specific objectives:

• To map out management strategies; 
• To manage debt arrangements or govern loans;
• To set the impact of capital raising on voting power;
• This agreement is to provide clear guidance at certain times of change and/or uncertainty.

Although some clauses appear to be onerous on the promoter shareholders, if rationalized and negotiated appropriately, a well-balanced Shareholder’s Agreement, tailor-made to suit the commercial necessities of parties, is easily achievable.

Key elements/clauses to be included in the shareholder agreement

Parties

1. Who are the parties to the Shareholders’ Agreement?
2. Should the company have a party to the Shareholders’ Agreement?
3. Who is investing in the company/ organization? Is it an angel investor / private equity investor/ venture capitalist?

Investment

1. How much is the investment that is being made?
2. What shall be the valuation of the investment to be made?
3. What instruments can be subscribed by the investor?
4. What Conditions Precedent are required to be satisfied by the company prior to the Closing, for the investors to subscribe the shares/ securities?
5. In which manner the investor pays the subscription money?

Capital structure

1. What are the different classes of securities available?
2. What rights will be associated with each class of securities?
3. If the company issues new shares, will they be first preferred or offered to the existing shareholders? And in which ratio?

Management rights

1. What rights are granted to the various classes of shareholders?
2. 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?
3. Will the investor have a right to appoint a Representative/ Nominee Shareholder to the Board?

Special rights to appoint Directors and supermajority Clause

These clauses are especially introduced to protect the minority shareholders’ interests. Generally, minority shareholders cannot block the passing of ordinary resolutions, for example: the removal or appointment of board directors since they have no power to influence the composition of the board of directors. To mitigate such restrictiveness, this clause enables a minority shareholder to remove or appoint a director. Also, shareholders may opt for a supermajority clause, that requires certain major decisions can only be passed with the consent of major shareholders, say for example shareholders owning 75% share capital. This prevents minority shareholders’ voices from providing them with higher bargaining power in the organization.

Transfer of shares

1. How will the share transfers be restricted? If allowed, what shall be the compliance to be complied?
2. Will it be mandatory to an existing shareholder intending to transfer his shares to a third party, to offer those shares to the other existing shareholders on a pro-rata basis? 
3. Will the majority shareholder(s) have the right to compel the minority shareholders to sell their shares to a third party (such event known as ‘drag-along right’)?
4. 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) (such event is known as ‘tag-along right’)?

Dividend

1. Will dividends be payable? 
2. If payable every year or interim, what will be the policy for the same? On what basis will the dividends be paid out?

Right to information and inspection

1. What are the obligations on the company to provide information sought by the shareholder(s)? 
2. How will this information be made available to the shareholder or will it be on a monthly, quarterly or annual basis?
3. What kind of inspection or visitation rights are available with the shareholder(s)?

Exit

1. What ways will the investor(s) can exit the company? 
2. Within how many years should the investor(s) be given an exit from the company? 
3. What will be obligations on promoters, if they are unable to provide an exit opportunity to the investor(s)?

Share Vesting Clause

Share vesting basically means that the promoters or founders do not own the shares until some conditions are fulfilled. This benefits the company in multiple ways, including postponing the pay out of cash and encouraging retention. The conditions and details of how shares are vested are known as ‘Terms of Vesting’, which should be clearly stated in the agreement to avoid disputes. 

Pre-emptive Rights and Right of First Refusal Clause

These are some highly-valued protective clauses sought by shareholders, these clauses serve to protect existing shareholders from the involuntary dilution of their stake in the company. Any new issuance of shares which is termed as ‘Pre-Emptive Right’ or outgoing shareholder’s shares which is termed as ‘Right of First Refusal’ must first be offered to existing shareholders before they can be sold to a third party.  Some clauses are clearly unfavorable to the founders, hence it is strongly recommended that these rights be put in writing.

Termination

1. What will be the list of events that will trigger the termination of the Agreement? 
2. Which clauses will survive despite the termination of the Agreement?

Governing law and dispute resolution

1. The performance of the Shareholders’ Agreement shall be governed by the laws of which State?
2. In case a dispute arises between the Shareholders, what will be the mechanism for settling the dispute? 

Deadlock Resolution Clause

1. A pre-agreed dispute resolution mechanism must be constructed towards overcoming or avoiding the deadlocks in both 50:50 owned companies. When shareholders with equal standing are unwilling to compromise or unanimous consent cannot be attained, the company arrives at a deadlock situation. This would force a completely functional business into a standstill position, if the shareholders cannot compromise and move forward as one team. The shareholders’ agreement should define, ahead of time, what constitutes a deadlock.
2. Some other widely recognized clauses pertain to drag-along rights, debt and equity capital arrangements and liquidation preferences.

Restrictive provisions

1. Will the shareholder(s) be restricted or compelled to disclose any information as ‘Confidential Information’?
2. Will the shareholder(s) be forbidden to carry out any business which competes with the similar business of the company? 

Confidentiality

1. A company may place a mandatory obligation on the shareholder(s) to not communicate or use or disclose any information pertaining to the affairs, business, customers, operations, clients or suppliers of the company. 
2. It is important to carefully define as to what constitutes ‘Confidential Information’ and in which certain circumstances is the disclosure of such Confidential Information permissible.

Non–Compete Clause

1. All agreements must invariably contain certain clauses imposing non-compete obligations on the shareholders of the company. 
2. one needs to be mindful of the fact, while drafting the non–compete clause that the restrictions which this clause seeks to place upon the shareholder(s) are reasonable. This is especially relevant as unreasonable restrictions are unenforceable, as per Section 27 of the Indian Contract Act, 1872. 

Closing actions

Closing Actions can be termed in various ways, depending on the transaction. Some ease of reference can be provided as:

• the sellers’ closing actions and the purchaser’s closing actions, must be taken together to complete a transfer transaction;
• the taking by the applicable selling shareholder(s) of all necessary or appropriate actions to transfer the applicable interests to the applicable purchasing shareholder(s), with such selling shareholder(s) warranting against all encumbrances against such interests.
• the payment by such purchasing shareholder(s) to such selling shareholder(s) of the applicable purchase price in XXX in immediately available funds.

A Condition Precedent is included prior to closing action clause, is a condition which must be satisfied by a shareholder to a transaction, failing which the other shareholder or party is not bound to close the transaction.

While it is impossible to provide an exhaustive list of all the types of Condition Precedent that a shareholder may be required to compel, some of the more common Condition Precedents could be:

• Obtaining consent of banks;
• Promoters approvals;
• Approvals from other selling shareholders;
• Restructuring;
• Curing defects to title;
• Regulatory approvals.

At or prior to closing actions, one must go through from all sides and will go through all Condition Precedents as set out in the Shareholders’ Agreement and ensure that these have been satisfied. The Condition Precedent must be included in the checklist required for closing. If all Condition Precedents are satisfied, then both sides are definitely bound legally to close.

The possible variations or sample of closing actions clause

1. The purchaser shareholder shall have executed and delivered all agreements, certificates and instruments and shall have taken all such other actions required of purchaser shareholder under clause XXX.
2. At the Closing Date, the following actions shall be affected in the stated order
3. Closing Actions means the actions set out in schedule XXX collectively or individually.
4. Closing Actions means the closing actions set forth in Schedule XXX.
5. Each of the actions required to be taken by seller shareholders pursuant to Section XXX or otherwise to affect the transactions contemplated hereby shall have been duly performed and complied with, and buyer shareholder shall have received satisfactory evidence of any and all such actions.
6. At Closing, the Sellers and the Purchaser shall take the following actions (the “Closing Actions”) simultaneously.
7. Each Party shall cooperate and coordinate with the other Parties in providing such information and which may provide assistance as may be reasonably requested by another Party in connection with the consummation of the Closing Actions.
8. Each of the Sponsor Parties and each other Investor shall have tendered performance of the Document Closing Actions applicable to it.

Key takeaways

• A Shareholders’ Agreement is a negotiation situation or arrangement between the company’s shareholders (particular class or all classes) that describes how the company should be controlled, managed and operated and also, outlines shareholders’ rights and duties.
• This agreement is projected to make sure the treatments to the shareholders are fairly and their investments are protected.
• It also allows shareholders to carry out decisions about how third-parties may become future shareholders and also, how shall secure the interests of minority shareholders.
• In a practical scenario, it can be typically considered as a safety net, which intends to protect the shareholder against the various contingencies that may arise in the course of the business.
• Closing Actions, it is important to note – all payments, deliveries, documents and other transactions relating to the closing action shall be interconnected or inter-dependent and none shall be effective until and unless all are effective.

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