Insight into a Shareholders’ Agreement

The terms of investment play an important role in determining the rights and responsibilities of the parties to the investment. While the term sheet is the start of an entire process of discussion and negotiation between the investors and the company, the Shareholders’ Agreement is a binding contract that governs the shareholders vis-a-vis the company and its shares. In this article we have tried to simplify the terms of a Shareholders Agreement. 

What provisions (usually) go into the Shareholders Agreement?

1. Financial Terms

a. Valuation: It is the value of the company determined to understand the investor’s shareholding percentage in the company. Valuation could be – (a) the pre-money valuation of the company, i.e., the value of the company as agreed between the investors and the company for the purposes of the transaction; or (b) the post-money valuation of the company, i.e., the pre-money valuation of the company plus the amount of money the investors will bring in during the round.

The price of the shares, number of equity shares to be issued, number of equity shares that the convertible securities will convert to etc., is decided based on the value of the company.

b. Instruments: The type of instrument against which funds are raised. Broadly speaking, a company issues – (a) equity, (b) preference shares, (c) warrants, (d) options, and (e) convertible notes. These can be issued as a single security or as a combination.

Investors typically buy stakes through preference shares. It gives them priority over the other shareholders in case the company goes into liquidation and protects their capital. Convertible notes are usually issued if the company wants to raise funds without going for a valuation or if it wants to push the valuation to a future date.

c. Shareholding: The Shareholders Agreement provides for disclosing the capitalization structure of the company on a fully diluted basis. This would include the instruments held by the founders, investors and other shareholders. Fully diluted basis refers to the total number of equity shares of a company that are outstanding after all possible sources of conversion such as preference shares, convertible debentures, convertible notes, stock options and warrants have been exercised and converted to equity. The shareholding percentage of an investor is the amount invested by the investor divided by the post-money valuation of the company.  

d. ESOP Pool: ESOPs dilute the shareholding of the investors. Therefore, investors insist on creating the stock option pool on a pre-money basis i.e., before making the investment, to avoid a dilution of their shareholding immediately post investment. The percentage of the ESOP pool usually ranges from 5% to 15% and is dependent on the nature of the business. 

e. Liquidation Preference: When a company goes into liquidation, preference shareholders are entitled to return of capital invested by them. A liquidation event can be – (i) dissolution or winding up of the company; (ii) merger, de-merger, acquisition, change of control; (iii) a sale, lease, license, transfer of the company’s assets; (iv) any sale pursuant to an exercise of the drag along right and so on. Liquidation often results in the shareholders losing the majority of their voting power in the company or control over the Board.

The liquidation preference clause provides the terms on when and how much of the capital will be returned to the shareholders in the event of liquidation. Standard terms are ‘Rank’ and ‘Participation’.

Participation may be in the form of:

(i) capital protection, i.e., investors receive the higher of their pro-rata share based on the percentage of their shareholding or the original amount of capital they have invested.

(ii) a double dip i.e., investors first receive the amount they have invested and the surplus is then distributed amongst all shareholders (including the investors) based on the pro-rata shareholding percent.

(iii) the investors receive the higher of the amount of capital invested with a return at an agreed rate or their pro-rata entitlement based on their shareholding. 

There is no hard and fast rule on what is actually negotiated and it varies from transaction to transaction.  

Rank is the order followed by the company for return of capital. Rank becomes relevant only if the proceeds available for distribution are not sufficient to meet all the liquidation preferences. The preference shareholders are ranked higher than the equity shareholders. This provides the preference shareholders the right to receive their share of the liquidation proceeds before the common shareholders.

2. Valuation Protection

In the event that the company proposes to offer equity in exchange for funds in a new round, the existing investors’ shareholding automatically dilutes to compensate for the new issue. More the number of outstanding shares, more the dilution in percentage shareholding. Therefore, to protect themselves against any excessive dilution, investors insist on securing rights that help them maintain their shareholding in the company. These rights could be in the form of:

a. Pre-emptive rights: This right allows the shareholders to purchase the shares of the new round to maintain their percentage shareholding as is before the new round. The terms of the purchase will be the same as that offered to the third party. If the shareholders choose not to exercise this right, the other investors can subscribe to such unsubscribed shares.

b. Anti-dilution right: In any future round, if the company issues shares at a price lower than the price originally paid by the investors in the previous round for the same class of shares, it results in the issuance of additional equity shares which is unfair to the existing shareholders. The anti-dilution rights protect the investors from such down rounds. The investors get protection in the form of an adjustment in the conversion ratio of their shares or issuance of additional shares at the new issue price.

There are three methods of anti-dilution:

(a) Broad based weighted average

(b) Narrow based weighted average and

(c) Full ratchet.

  • Under the broad based weighted average method, the weighted average is calculated considering the entire capital. The investors’ price per share is reduced based on the weighted average price of the new issuance and all the capital instruments issued by the company till date. This includes: preference shares, warrants, options and other convertible instruments, assuming that they have all been converted to equity shares.  
  •  Under the narrow based weighted average method, the weighted average is taken based on only the preferential share portion of the share capital. The investors’ price per share is reduced based on the weighted average price of the new issuance and the preferred shares in respect of which the anti-dilution protection is available. Since, only the preference shares are considered under this method, the resulting weighted average is higher than the average derived from a broad based weighted average method. 
  • Under full ratchet, the price per share is adjusted downwards to the same price as the price at which the new shares have been issued. 

 Of the three methods mentioned above, full ratchet is the most investor friendly and the broad based weighted average is the most common equity holder friendly.

The formula for determining the impact of the down round based on the broad based and narrow based weighted average anti-dilution protection is the same. It is the old price multiplied by the following factor:

[Equity shares outstanding before new round] + [Equity shares issuable for amount raised at old conversion price] divided by [Equity shares outstanding before new round] + [Equity shares issuable at new price]

The only difference in the formula between the two weighted average methods lies in the definition “Equity shares outstanding before the new round”. Under the broad based weighted average method, all the outstanding shares including convertible securities like options, warrants, and preference shares( presumed to have been converted to equity) are considered on a fully diluted basis whereas under the narrow based weighted average method, only equity and preference shares that convert to equity are considered. 

c. Dividend Rights: Dividend is payable, subject to cash flow solvency. Typically, a nominal dividend of 0.001% is agreed upon as the rate of dividend. In addition, if dividend is paid to equity holders, then dividend can be paid pari passu (same as equity shareholders)  to the preference shareholders. 

3. governance

a. Board: Qualified investors have the right to be consulted on decisions regarding the size and composition of the Board. Both the founders and investors can each appoint directors (Founder Director and Investor Director) to the Board. Investors also insist that the founders remain on the Board as long as they are in employment. The CEO of the company shall also be on the Board responsible for ensuring compliance of applicable laws by the company. Further, the investor can also appoint a non-voting observer to the Board to attend meetings on their behalf.

b. Board Meetings:  Typically, Board meetings are held at least once every 3 months in a financial year. A prior written notice, not less than 7 days before the date of the meeting has to be issued to the board members. Each notice of the board meeting should include the agenda for the meeting that sets out the items proposed to be transacted or discussed with necessary background or supporting documents attached.

c. Shareholders’ Meetings: As part of the governance, if the Board wishes to call for a meeting of the shareholders, they can do so providing a notice of the meeting at least 21 days prior to the actual date of the meeting along with the agenda of the meeting attached therein. If required the meeting can also be held at a shorter notice with the consent of the shareholders.

d. Voting rights: Investors are entitled to vote on matters that affect their rights directly or indirectly. The number of votes that the investors receive depends on the kind of security they own. Usually the voting rights are on a pro-rata basis. For example, if any investor owns 10% of the capital, they would have voting rights equal to 10%. CCPS investors can also participate in the shareholders meetings and exercise their vote on an ‘as if converted’ or ‘fully diluted basis’ as decided by the company.

e. Reserved Matters: Investors have the right to cast affirmative votes on significant decisions relating to the company like – (i)mergers, demergers, amalgamations, consolidations; (ii) acquisition of other businesses by way of purchase of shares, business transfer, asset purchase; (iii) creation of joint ventures or partnerships, creation of a subsidiary; (iv) any strategic, financial or other alliance with a third party which results in investments by the company; (v) approval of any business plan or annual plan; (vi) changes in terms relating to vesting of founders and so on.

4. Founder Commitments

Investors expect founders to make the following commitments:

a. Employment commitments: Most times investors invest in a company believing the vision of the founders and their ability to take the company to great heights. Therefore, an exit of a founder could cause serious repercussions not just on the investors but on the co-founders as well. This is because, when a founder leaves, he or she needs to be replaced and such replacement will need to be offered options. This will lead to an unfair dilution on the shareholding of other shareholders. 

Therefore, the investors insist the founders remain in employment for an agreed duration of time, typically ranging from three to six years. Investors also negotiate that some or all of the founders’ stock must be subjected to vesting. Under this, the founders’ shares are placed in an escrow account that is later released in equal installments on a periodic basis. 

During the said term, if the founders employment is terminated with cause on account of –

(i) gross negligence while performing duties; (ii) any offence involving moral deceit, dishonesty, embezzlement, misappropriation of property or fraud performed by the founder; or (iii) abandonment of employment etc.,  all unvested shares of the founder are transferred to the ESOP pool or an employee welfare trust as determined by the Board. If the termination is without cause on account of a unilateral decision taken by the Board, all unvested shares are forfeited and added back to the ESOP pool. In the case of death, physical or mental incapacity of the founder, all unvested shares are vested and transmitted to the legal heirs of such a founder.

b. Lock-In: Founders agree not to transfer any shares, without seeking the approval of the investors. With each passing round, founders can request for a higher amount of liquidity. Later stage investors are often more comfortable providing liquidity to founders.

c. Non- compete: As long as the founders hold shares in the company or for a period thereafter, the founders have to agree not to engage in any activity that could directly or indirectly create competition to the business being carried out by the company.  

d. Non-Solicit: The founders have to agree not to hire or enter into any agreement with individuals currently working with the company for the specific period of time as agreed in the agreement. This period typically ranges from twelve to twenty four months.

The noncompete and non-solicit clauses mainly protect the company’s interests, business and goodwill.

5. Provisions relating to Ownership and Transfer

a. Right of first refusal (ROFR):  In an event that any of the founders or shareholders of the company wish to transfer their shares, the other existing investors will have a right of first refusal i.e., the investors can purchase such shares on a pro-rata basis at the same valuation and terms offered to a third party buyer. If the investors who hold the right to ROFR do not exercise their right to purchase the shares, then other investors can take up on the offer. 

b. Tag along Right: A tag along or co-sale right is a right that enables the investors to sell their shares in proportion (pro-rata) to the shares sold by the founders or other investors of the company. The terms of the sale would be the same as that offered to the founders. 

c. Right of First Offer (ROFO): If any of the founders or other shareholders intend to transfer their shares, the existing investors of the company will have a right of first offer to purchase all or part of such shares being offered for sale. However, the selling shareholder can still transfer such shares to a third party, if the price quoted is higher than the price offered by the investors. 

d. Transfer of shares by investors: There are no restrictions as such on the ability of the investor to transfer all or any of the shares along with the rights attached therein, except restriction on sale to a competitor. If an investor wishes to transfer his or her shares, the founders have to co-operate and fulfil the necessary formalities to give effect to the transfer including allowing due diligence that may be conducted by the potential buyer. The necessary representations and warranties relating to the company must also be stated.

6. Investor Commitments

a. Sale to Competitor:  This term restricts the investors from making any sale of shares to a competitor. Since investors have the right to receive information and inspect the company’s performance and data; cast affirmative votes etc., any sale of shares to a competitor will result in the competitor gaining access to the company’s internal workings, strategies, records, intellectual property and other confidential data. This clause ensures to keep the competition at bay. 

b. Confidentiality: Investors have to ensure complete confidentiality of the contents of the Shareholders Agreement, information about the parties, company’s finance and operations, purpose of the investment etc. However, under appropriate non-disclosure terms, they may be permitted to disclose the content to their investment bankers, accountants, legal counsel or potential buyers if any.

7. Boiler-plate items

a. Related party transaction: This condition is imposed mainly to protect the shareholders by restricting the company and its subsidiaries from entering into any transaction with related parties without seeking their consent. “Related Party” here means – (a) a group company, (b) any affiliate of the group companies, (c) any of the founders or director (other than any director nominated by the investor) or any relative of such person; or (d) any person owned or controlled by a founder or a director or a relative of such founder or a director.

b. Representations and Warranties: The founders make various representations to the investors regarding the company’s legal and financial position, intellectual property, assets owned, risks, liabilities, taxes, use of third party IP, compliance with contracts etc. This clause asserts that these representations made by the founders are true and factual. At the same time, it also protects the company by getting a guarantee from the investors that no sensitive confidential information of the company will be breached to any third party. 

c. Conditions Precedent: Various conditions need to be satisfied prior to the closing of the investment deal. Typical conditions include – (i) the company obtaining the necessary corporate, government, management, third party, regulatory approvals; (ii) satisfactory completion of financial and legal due diligence by the investors; (iii) items relating to compliance with law and such other customary conditions.  The agreement will only come into force once these conditions are met.

8. Information and Inspection Rights

As long as the investors hold shares in the company, they are eligible to inspect and receive material information of the company. 

a. Inspection Rights: Investors have the right to – (i) inspect the offices, premises, properties and assets of the company; (ii) receive documents of material records, contracts; (iii) receive additional information on the company’s accounts, business and operational matters; (iv) inspect the books of accounts, documents of title, orders, judgements, licenses, registrations; (v) consult employees, vendors, consultants, internal and external counsel and internal and statutory auditors etc. At the time of inspection, the company and the founders have to extend cooperation to the investors providing the necessary authorizations to conduct such inspection. 

b. Information Rights: Investors have the right to receive information on – (i) the company’s audited and unaudited financial statements including cash flow statement; (ii) management information system (MIS) reports; (iii) minutes of the Board and Shareholders meetings; (iv) information on any event likely to have a major impact on the business; (v) information on any reports, documents received by the company relating to litigation, material contracts, governmental claims; (vi) annual budget and annual updates in the company’s business plan, if any; (vii) changes in the employment of key personnel or the terms of employment; (viii) compliance reports etc. All information has to be furnished to the investors within the set timelines.

9. Exit rights

Financial investors make investments into companies with the objective of selling their shares with a good return.  Therefore, suitable exit terms have to be discussed and captured in the agreement to ensure smooth exit. 

Investor’s exits are mainly in the form of:

a. IPO: Here, the investors’ shares are listed on a recognized stock exchange on or before the investment exit date. This ensures that the investor procures a benchmark return on their investments. 

b. Strategic Sale: The company offers to sell the entire stock of the company to a third party purchaser. If the purchaser chooses to buy only a portion of such stock, then the shares of the investors hold priority over the founders stock for such sale. 

c. Buy back of shares by the company or the founder: Another alternative to the above method is buying back all or a portion of the investors’ securities by the company. Such buyback should be at least equal to a price that provides the investor with a minimum return. A company buy-back is always subject to – (a) the company having sufficient cash and (b) the regulations relating to buy-back being satisfied.

d. Drag Along: Under this, the investors have the ability to drag the founders and other shareholders in a sale negotiated by the investors. Drag will be available only if investors remain shareholders after the exit period or the company or founders have committed some substantial breach. In an event of the drag sale, the founders and other shareholders shall be required to sell their shares on the same terms and price as that determined by the investor.  

The founders in an event of exit have to make best efforts to provide exit to the investors. If an exit does not materialize, the founders cannot be held liable. However, the founders will be in breach, if they block an exit that presents itself which investors desire to avail of. 

10. Dispute resolution

Appropriate dispute settlement mechanisms have to be provided to settle any controversies likely to arise in connection to the agreement in the future. As far as possible, consider mediation as a process to settle the disputes. This helps avoid costly lawsuits and resolve issues before they escalate. If this does not work, then the dispute shall be referred to and finally resolved by arbitration. The arbitrator should render the decision or remedy in writing pursuant to the dispute. 

All actions have to be performed within the scope of the articles of association. Provisions of the articles supersedes the Shareholders Agreement, therefore, any provision intended to be provided in the Shareholders Agreements which currently do not fall within the scope of the articles would require amendment to the articles for their validity.

Developing a Shareholders Agreement requires careful consideration of legal provisions and involves cost and time. However, a well drafted agreement always helps bring the parties of the investment on a common page ensuring clarity and smooth closing of the investment deal. Get a good lawyer or an experienced founder to help you with this. 

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