This article is written by Shreya Raj, pursuing Diploma in M&A, Institutional Finance and Investment laws (PE and VC transactions) from LawSikho. She is a Legal and Policy Analyst in the Office of MP Shri Rajeev Chandrasekhar.

“Every moment in business happens only once”

-Peter Thiel (From Zero to One)

Entrepreneurs build businesses seldom realizing the importance of legal documentation that Investors intend to enter into with the intention of clipping the wings of the founders. A businessman (or woman) will look to exponentially expand his/her business and the most important component of such an exercise comprise money. Funding is a rather difficult challenge but those who start a business and look for funding are aware that they will need to get funding or investments to be able to expand their businesses.

An investor will look at investing in a business which looks promising and holds a bright future for itself. An investment into a business may be a great way to expand an investor’s wealth, amidst the complicated web of legal regulations. Entrepreneurs starting a business in their young age, sans experience, often commit the mistake of blindly trusting the angels who invest in their business.

In this article, we shall see how we simplify the web of intricacies in a special agreement that every founder of a business has to enter into – a Shareholders’ Agreement. When people come together and set up a company with family or friends or seek investments, it is easy for them to assume that everything will fall in place and trust will guide them through the way. But such a perfect assumption could only be comparable to a mirage. A shareholders’ agreement is one of the most important documents that founders enter into with shareholders/investors, i.e. third parties.

On one hand, the entrepreneur or the founders want an agreement which is a simple document (maybe one to three pages) and which simply mentioned that his company is receiving money for issuing certain shares at a specific price and valuation. On the other hand, the commercial intent of an investor is to ensure that his investments reap good results with minimum obstacles. To achieve the same, he would like to include certain mechanisms that will work in his favour so that he can get good returns from his investment. Many a time, they are to ensure that he can at least get the investment that he made, back, be it without a return if the company does not perform well.

To achieve this purpose, a few specific clauses are included in the Shareholders’ Agreement (SHA) which provides certain rights to the investors and puts certain obligations on the founders of a company. They tend to start with strict and burdensome clauses but a founder can negotiate and make it into a ‘win-win’ clause.

Below are five clauses that are included. Let us now understand each of these clauses from a founders’ perspective.

Liquidation Preference Clause

This clause gives a right to the right owners to have a preference in the dividends and other proceeds of the company. This takes place on the happening of a liquidation event. The investors would want to exercise this right on many events like merger, acquisition, sale, Initial Public Offering (IPO), change in control of the company, bankruptcy and so on where investors will be treated preferentially over other shareholders’ in the re-payment of investment money and other proceeds. The founders should never agree for granting this right other than in the event of winding up or bankruptcy. They should also be wary of granting interest on the invested money on the occurrence of the liquidation event and exclude a profitable exit from the list. Founders must deeply analyze the provision of liquidation event and restrict it as far as possible

Anti-dilution Clause

This is one of the most dangerous clauses. The investors usually go for this clause to protect their investments in the company. Under this provision, if fresh shares are issued to another investor, they usually ask for a non-dilution of the percentage of their shareholding. This would mean that the shareholding of the founders would get diluted and they would lose their say in the company.

Veto Rights

The matters in which investors may get veto rights are critical to the independence of the founders in the company. The founders would like to avoid giving the investors a right to veto the fresh issue of shares so that the company can take more funding without having to give up controlling rights of the founders. Under an SHA, investors are most likely to ask for a veto right against a fresh issue of shares which means that no fresh shares can be issued to any third party without the consent of the investors. The founders would not want to give this right to the investors.

On the other hand, the founders should ensure that when investors exercise their exit option, the founders have a say or a veto right so that the investors do not sell their shares to a competitor at whatever price may be offered to them. The founders would not want the competitors to buy the shares of the investors as it would be detrimental to the company’s growth and performance.

Drag along and Tag along rights

These are the transfer restrictions that an SHA generally includes. It is a provision under which the investors get a right to either tag along with the founders if they are selling their shares at the same value thereby preventing them from completely selling off their shares or drag them when the investors are selling their shares thereby forcing the founders to sell their shareholding to a third party. This clause can completely oust the founders from the company and this is something that the founders would definitely want to avoid.  It is therefore in the interest of the company and the founders that the founders are not granted unrestricted drag along rights or tag along rights.

It is important for the founders to negotiate the complete transfer restriction on their set of shares. A clause which puts a complete restriction (a lock-in provision) on the founders to sell their shares only after a certain period of time, should be avoided as long as the founders keep their majority stake intact. This will allow some freedom to the founders to manage their personal cash flow requirements arising from their assets.

Another important clause in the ROFO – Right of First Offer. Both ROFO and ROFR (Right of First Refusal) give the founders the first right over the shares of the founders. The founders should try to negotiate for ROFO as in this case the investors do not know what amount a third party is agreeing to pay to the founders for his shares. The investors need to state the offer price and if that is unsatisfactory for the founders, they can sell it to third parties.

Pre-emptive (and mop-up) rights

A pre-emptive right grants the existing shareholders’ a right to subscribe to fresh shares in the proportion of their shareholding so that their shareholding percentage is not diluted. The founders would not like to give the pre-emptive rights to the investors, because the investors can keep subscribing to the shares and gain complete control over the company. The founders can get a special resolution passed to exclude granting pre-emptive rights to shareholders/ investors.

Another important provision is the reverse vesting. This clause, generally favorable for the investors forces the founders to relinquish their rights over their shares and be parked in a trust. The shares may vest back in the founders (the founders will have to re-earn them) as per a vesting schedule. This clause prevents founders from leaving the company with their shares and in turn help investors from losing their investments. But such a term is against the interest of the founders. Other clauses may be inserted to protect the interests of the investors and ensure the commitment of the founders. But such a clause makes a founder work for his own investment in the company. If the founder is fired or terminated for any reason mentioned in the agreement, or if he leaves on his own, he will lose his right over the unvested shares.

Any founder must try to avoid unnecessary interference in the day to day workings of the company by the investor’s representative in the board. Not all the matters must require their approval except for matters that fall in the reserved list. Another matter that the founders must remember is that they should refrain from transferring ownership rights over the intellectual property and trade secrets to investors as it could be misused by the investors. The investors can share the information of one company with another company thereby removing exclusivity in operations, performance and growth in a company.

From the discussion of the above few clauses, we know that a shareholders’ agreement is a very important document which should be carefully negotiated and well drafted keeping the rights of not just the founders but every stakeholder reasonable. It is upon the parties to negotiate and get favourable clauses drafted in the SHA. A piece of sound legal advice becomes a sine qua non for all the stakeholders because one bad call on a key provision could spell disaster for a founder, an investor or even the business. It is in the interest of the parties that they make themselves aware of the industry practices and legal implications of the clauses in an agreement.

 Students of Lawsikho courses regularly produce writing assignments and work on practical exercises as a part of their coursework and develop themselves in real-life practical skill.