Deconstruction of Shareholders’ Agreement

Synopsis: A Shareholders’ Agreement is an important private agreement to regulate the sale and purchase of shares. In this article, the SHA has been broken down to understand the important clauses and their importance.

Shares are portions of a company’s capital which are issued by the company in exchange for cash, in order to raise its capital for business purpose. According to Section 44 of the Companies Act, 2013 (‘the Act’), shares shall be movable transferable property as per the regulations laid down under the Article of Association (AoA) of the company, subject to restrictions.

As per the Section 43 of the Act, a company limited by shares can issue two types of the shares i.e. equity shares with voting and differential rights to the dividends, and preference shares.

Equity shares are those which entitle the shareholder to the distributable profits of the company. Equity shareholders share profits or losses incurred by the company. There are 2 types of equity shares – with voting rights, and the differential rights as to dividend, voting or otherwise.

Preference shareshave preferential rights over the dividends before the dividends are paid to the equity shareholders. The preference shareholders are entitled to receive the dividend at a fixed rate which does not change unlike that of the equity shares. E.g. A company has earned a net profit of Rs. 1,50,000 and dividend rate on 1000 preference shares of face value Rs. 100 is 10%. The net profit is first divided among preference shareholders at Rs. 10 as dividend and the remaining Rs. 50,000 will be distributed amongst equity shareholders.

What is a Shareholders’ Agreement (SHA)?

As soon as the shares are invested, the investors own a portion of the business and play a role in the day-to-day business activities of the company. The owner holding a ‘unit of ownership’ in the company’s stakes are called shareholders of the company. In order to protect the interest of these investors, the shareholders decide upon the several aspects such as the sharing pattern, pricing, and other technical aspects.

As the name suggests, Shareholders’ Agreement is an agreement amongst some or all the shareholders of the company. It basically lays down the relationship between the shareholders, describes their rights and liabilities and protects their interests.

Major clauses in a Shareholders’ Agreement

Shareholders’ Agreement is an important document for an organisation/body corporate which inter alia governs the assignment of rights, obligations, duties, and providing a legal remedy in case any legal disputes arise between the parties. Since SHA aims to protect the financial interests of the shareholders, it contains some unique clauses which regulate the transfer of shares. Here are some of the important clauses that should be captured in a SHA –

  1. Call Option and Put Option

These are generic terms and widely used in a SHA. This clause is an option for the buying and selling of the shares.

  • Call option is used to call upon the other party to buy his securities or assets;

E.g. If A and B are two investors in a joint venture company, A may have a call option over 26% of the shares held by B, which he can exercise once the limit on Foreign Direct Investment (FDI) is raised. This means that once the FDI cap is raised, A has a right to purchase 26% of the shares held by B. If A exercises this right, B cannot decline to sell the shares to A.

  • Put option is a right to purchase the shares. Typically, this right is triggered upon the occurrence or nonoccurrence of certain specified events in the future. An option may be exercised at a predetermined price or at a price determined on the basis of a prescribed formula. It is a right and not an obligation.

E.g. If A has a put option over 14% of his shares in case of the occurrence of a certain event, Once this contingency occurs, and A exercises his put option, B cannot decline to purchase A’s shares.

  1. Pre-emptive rights

Pre-emptive right with respect to the transfer of shares is essentially a right to impede the transfer/sale of shares to a third party, and the demand that such shares be transferred/sold to agreed parties/shareholders. 

  1. Right of First Refusal (RoFR) and Right of First Offer (RoFO) 

These are key clauses under the SHA and are contractual rights that are given to the non-selling shareholder.

  • Right of First Refusal provides the right to refuse or accept the share being sold by the selling shareholder. This obligates the selling shareholder to offer the shares to the non-selling shareholder and only if the latter refuses, the former can sell his shares to a third party.

E.g. If there is a RoFR in favour of B granted by A, then A is first required to offer his share to third parties and obtain a price from them. A is then required to approach B with the price offered by third parties. If B can match or better the price offered by third parties, A must sell his share to B. If B is not interested in purchasing the asset or cannot reach an agreement with A, A is free to sell his shares to third parties.

  • Right of First Offer provides the selling shareholder the right to offer his shares at a predetermined price to the non-selling shareholder. If the latter refuses to purchase, the former is free to sell to a  third party even at a higher price.

E.g. A and B are two shareholders in a private company with a RoFO in favour of B granted by A. If A decides to sell his shares, he must first offer them to B at predetermined price, and in case B refuses, A can sell the shares to a third party at a higher rate.

  1. Forced rights: Tag along and Drag along

These clauses are also called a forced right which protects the interests of both the majority and minority shareholders and is also an exit clause.

  • Drag along serves to protect the interest of majority shareholders. It gives the rights to the majority shareholders to force the minority shareholders into selling their shareholdings to a prospective third party at the same price and rights as a majority shareholder.

E.g. There is a bidder who would like to buy the entire company, and the majority shareholders holding more than 50% of the company agree to sell their shares. The majority shareholders can ‘drag along’ the remaining minority shareholders and require the minority shareholders to sell their shares so that the bidder is able to purchase the entire company.

  • Tag along protects the interest of the minority shareholders. It gives the right to the minority shareholders to have their shares bought at the same price on the same terms as a  majority shareholder. It imposes restrictions on the majority shareholders from selling their shareholdings to an outsider without making an offer to the minority shareholder at the same price, terms, and conditions.

E.g. Investor A holds 75% of the shares, while investor B holds 25%. If investor A sells his shares, B’s shares might lose value and he will also have to deal with changes when a new entity owns the majority of the shares. With tag along rights, investor B can sell his shares at the same price as investor A and get the same return on the investment. If the person or company buying the majority shares does not offer to buy the remaining 25% of the shares, it breaks the tag along rights agreement.

  1. Drafting of the voting rights and issuing of new shares

Voting rights are essentially the rights of the shareholder to have a say in the appointment of directors, company policies and procedures and other matters relating to company finances.

  1. Confidentiality

This clause should be detailed and carefully drafted in order to prevent any data leaks or information that is crucial, proprietary and confidential in nature.

  1. Deadlock

Deadlock is a situation when the parties may have a dispute and there is no room for any further negotiation or adjustments, or a situation may arise wherein it is difficult to run the business, and the parties would like to terminate the SHA. Some examples of deadlock are insolvency of the company, cancellation of the requisite licenses, change in the existing laws that render the company null, material breach of obligations, material default, or a dispute between the parties.

A deadlock resolution provision usually has 2 parts –

  • The first one deals with the way to resolve the deadlock, which usually is by undertaking consultations or escalating the issue to the designated representatives who are usually the senior/top management.
  • The second part provides for an exit when a deadlock cannot be amicably resolved by consultation.
  1. Non-compete

This clause prevents and limits the shareholders and directors from engaging in competing business or offer the idea or Intellectual Property to competitors or rivals.

Advantages of a Shareholders’ Agreement

If the company has more than one shareholder, it is advisable to have a SHA because –

i. It widely outlines the rights, liabilities, duties, obligations, restrictions, withdrawal, dividend policy applicable to shareholders.

ii. It regulates the sale and purchase of the shares.

iii. It equips the Directors with proper guidelines on transfer, issuance, sharing of profits and rights.

iv. It provides a guideline on control the removal, contracting or employing the executives and the terms of business needs.

v. It provides a resolution mechanism, in case of a dispute.

Difference between Shareholders’ Agreement and Articles of Association (AoA) and Memorandum of Association (MoA)

MoA and AoA are the charters formed at the inception of the company. They are documents which define the rights and liabilities of the directors of the company and they are the guiding means by which the shareholders exert control over the Board of Directors. Shareholders’ Agreement is an arrangement amongst the shareholders of the company which defines the rights and liabilities of the shareholders and controls operations of the company.

The AoA (read with MoA) and SHA are generally in conflict with each other majorly in two defined areas –  issues relating to the management of the company, and issues relating to the transfer of shares. AoA has a supremacy over the provisions of the SHA in case of disputes.

AoA (read with MoA)SHA
AoA is available for the public inspectionSHA is a private arrangement by and among the shareholders of the company
The AoA binds and applies to all the shareholders of the company. SHA binds only the parties between/amongst whom such arrangement is agreed

Importance of a Shareholders’ Agreement

A Shareholders’ Agreement is not a mandate under Indian laws. However, it is a document that creates relationships, casts responsibilities, and outlines the rights, protection clauses, exit and authoritative clauses which are essentially technical and legal in nature, having a great practical impact. It is a private agreement between the shareholders of a company and has high importance because it regulates the sale and purchase of shares which affects the company’s value.

It is advisable to hire an experienced legal professional to draft the SHA, at the inception of the company. While a SHA does not guarantee prevention of risks, like any agreement, it provides certainty about the commercial understanding between the parties, the course of action under various circumstances, dispute resolution process and consequences of a breach of the agreement.

DISCLAIMER: The information provided in this article is for educational purposes only. The same cannot be construed as legal advice.

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