In the fast-paced business world, a shareholders’ agreement is a vital guidebook that outlines how stakeholders with a common vision navigate challenges together. This strategic document addresses corporate governance, decision-making, and dispute resolution, serving as a contractual compass. Its clarity and organization become crucial as businesses evolve, ensuring everyone is on the same page. Shareholders’ agreement clauses are not just legalities; they’re tools for successful teamwork, offering foresight to mitigate challenges and protect everyone’s interests. Whether you’re an entrepreneur, investor, or legal expert, understanding these clauses goes beyond paperwork — it’s about shaping a business’s future through collaboration, shared responsibilities, and long-term planning
The following are the common clauses in the Shareholder’s Agreement:
1. Board of director:
This provision covers the Composition and Committees of the Board, allowing the addition of an investor’s director, appointment of officers, and formation of committees as needed by law. The Responsibilities and Size of the Board section outlines powers, board size, and voting procedures. The Removal and Vacancy clause establishes procedures for director removal and outlines the process for a director to vacate their office.
2. Board Meetings, Notices & Quorum:
This provision outlines meeting frequency, notice delivery methods, and minimum directors as per law, and covers quorum, agenda modification, and procedures for voting and resolutions, including circular resolutions
3. Shareholder’s Meetings:
The Shareholder’s Meetings clause in an agreement establishes a transparent framework for shareholder interactions. It covers meeting frequency (e.g., annually, quarterly), notice procedures, and agenda items for shareholder consideration. The clause also defines voting rights, sets quorum requirements, and outlines decision-making mechanisms. It includes provisions for dispute resolution arising from meetings and addresses any other relevant matters essential for the company’s operation. Additionally, the Reserved Matters section mandates unanimous consent for critical decisions, safeguarding investments by ensuring agreement on matters like altering articles, acquiring key assets, or incurring debt.
4. Transfer of shares:
a. Promoter Lock-In: In this clause, the promoters are bound not to transfer their holding in the company until some specific period, this ensures the safety of the investor.
b. Deed of Adherence: When a company already has a shareholders’ agreement in place and a new shareholder is added, rather than creating an entirely new agreement, the new party typically adheres to the existing agreement through a deed of adherence. It helps maintain consistency of terms between all the shareholders and the company. The shareholder’s agreement includes the draft of the same.
c. Right Of First Offer (ROFO): When an existing shareholder decides to sell his shares. The existing non-selling shareholders have the right to offer the selling shareholder to buy the shares. The selling shareholder has the option to either reject or accept the offer. If he chooses to refuse the offer, he is free to transfer the shares to the third party, provided the other clause for lock-in is fulfilled. This clause is beneficial to the shareholder who is selling the shares.
d. Right Of First Refusal (ROFR): Like ROFO, when an existing shareholder decides to sell his shares. The non-selling shareholders have the right to either accept or reject the offer given by the selling shareholder. This clause provides a benefit to non-selling shareholders as the entry of third-party purchasers is less likely to happen.
e. Tag Along And Drag Along Rights: When the shareholders of the company have a difference of opinion regarding the sale of shares then these rights act as the dispute resolution strategy. When the majority of the shareholders (where the majority percentage is defined in the agreement) which are called Drag- right holders want to sell the shares to a third party, then the minority shareholders (Dragged shareholders) have to go along with the majority shareholders. The shareholder’s agreement sets out the process to exercise the rights opposite to Drag Along rights, Tag- Along right gives the option to minority shareholders to tag along with the majority shareholders who are going to sell their shares. This is beneficial to the minority shareholders as they can have the same terms and price as the majority shareholders on the sale of the shares; which in an individual capacity would not be possible.
5. Vesting of Founders Shares:
This clause relates to the transfer of the shares by the founders as defined in the agreement. This sets out the procedure, if the shareholder leaves either on good or bad grounds then how it should be dealt with.
a. Good Leaver: As the name suggests, when the founder holding shares in the company either leaves or terminates the company without any technical or any legal breach or omission, he may be required to sell the shares to existing shareholders or to the company at market price or any other price as set out in the shareholder’s agreement.
b. Bad Leaver: If a shareholder is terminated due to a substantial breach of their contract, misconduct, or before reaching a significant milestone, they are obligated to transfer their shares back to the company. The transfer will occur at either the price they initially paid for the shares or their market value, whichever is lower.
6. Shareholder’s Rights:
a. Information and inspection rights: This clause sets out the procedure and rights of the shareholders to have information about the reports, and books, as mentioned and agreed in the shareholders agreement. The inspection procedure such as the notice and time is also mentioned in the agreement.
b. Pre-Emptive Rights: When a company issues new shares or plans to sell existing shares, existing shareholders with pre-emptive rights have the option to buy their proportionate share of these shares, preventing dilution of their ownership. This mechanism allows current shareholders to participate in the company’s growth and ensures that they are not unfairly marginalized by the introduction of new shareholders. The specifics of pre-emptive rights are typically outlined in a company’s articles of association or a shareholders’ agreement.
c. Affirmative voting Rights (Decision Making): In a shareholders’ agreement, affirmative voting rights are provisions that specify certain important decisions or actions requiring the explicit approval or affirmative vote of designated shareholders. These rights ensure that specific shareholders, often those holding a significant stake or playing a critical role in the company, have a direct say in crucial matters.
d. Anti-dilution rights: This right ensures that the value of shareholders’ investment does not decrease in case of an increase in the share capital of the company, i.e. Dilutive shareholding remains unchanged. Generally, the company uses the weighted average method instead of the full method. Certainly, anti-dilution rights carry significant leverage and may be extended to investors when a company or its founders find themselves in a comparatively less favourable negotiating position. Anti-dilution clauses, akin to pre-emptive rights, allow a shareholder to receive new shares automatically without the obligation to make a payment.
e. Right to Dividend: The distribution of the profits as generated by the operations of the company, in compliance with the applicable laws with prudent financial management is considered a dividend which is one of the rights of the shareholders.
7. Event of Default:
The company may set out the list of events that can be considered as the event of default and the procedure for further proceedings that can be done as a result of the event. Events of default can include termination of all founders, liquidation, Fraud, etc.
8. Non-Compete & Non-solicitation:
Both clauses are designed to safeguard the interests of the company and prevent potential conflicts of interest that could arise if shareholders were to compete directly or poach key resources.
a. Non-compete clause: This clause prohibits shareholders from engaging in or starting a business that competes with the company. It aims to prevent shareholders from using their insider knowledge or influence to establish or support a competing venture during their tenure with the company and for a specified period after leaving.
b. Non-solicitation clause: This clause restricts shareholders from actively recruiting or soliciting employees, clients, or suppliers of the company for their own or another business. The goal is to protect the company’s relationships and workforce from being disrupted by departing shareholders seeking to draw them into a new venture
9. Fundamental Disputes & Dispute resolution:
The shareholder’s agreement outlines how disputes are defined and managed, including details on arbitration, location, notices, and associated costs, with reference to statutory laws.
10. Liquidation preference:
Liquidation preference in a shareholders’ agreement determines the order in which shareholders get paid if the company is sold or liquidated. It safeguards certain investors, like preferred shareholders, ensuring they recoup their initial investment before others. For instance, with a 1x preference, they receive at least what they invested before other shareholders. This mechanism provides a safety net, common in venture capital, protecting investors in case the sale proceeds are insufficient to cover their original investment. The terms of the liquidation preference, such as the multiple and participation features, are specified in the shareholders’ agreement.
11. Miscellaneous clauses:
In addition to the previously mentioned clauses, there are common provisions such as confidentiality, ensuring agreement confidentiality. Enforceability addresses the agreement’s effectiveness. Termination specifies the end date, usually when the shareholder no longer holds shares. Other clauses cover Waiver, Severability, Governing Law, Expenses, etc.
Conclusion:
In conclusion, the clauses in a shareholders’ agreement form the foundation for successful collaboration in a dynamic business environment. Beyond legalities, they represent foresight in navigating challenges and fostering cooperative relationships. The narrative in these clauses speaks to a story of strategic partnership, shared responsibilities, and a roadmap for sustained growth. As businesses evolve, the wisdom in these clauses remains essential for a collaborative journey marked by resilience, foresight, and mutual benefit.
Authors:
Simran Pathan | Associate Consultant | Email: simran.pathan@masd.co.in
Varsha Dhake | Manager | Email: varsha.dhake@masd.co.in
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