A shareholders’ agreement is a crucial legal document designed to define the rights and responsibilities of all parties of an investment deal. It establishes clear guidelines for decision-making processes, ensuring that all shareholders understand their roles and obligations. This agreement helps prevent conflicts by outlining procedures for resolving disputes. It also clarifies ownership stakes and the distribution of profits. Additionally, it addresses key issues such as the transfer of shares, shareholder obligations, and company governance. By providing a structured framework, the shareholders’ agreement fosters transparency and stability within the company. It is essential for protecting the interests of all parties involved and ensuring smooth operations.
Key Clauses in a Shareholders' Agreement
a. Financial Terms
These are key concepts and metrics that define the financial structure and value of the company.
1. Valuation
Valuation is critical in determining the investor’s ownership percentage in the company. It can be calculated in two ways:
- Pre-money Valuation: The value of the company agreed upon before the investment is made.
- Post-money Valuation: The pre-money valuation plus the capital injected by investors during the investment round.
These valuations guide decisions on the share price, the number of equity shares to be issued, and the conversion ratios for any convertible securities.
2. Instruments
This term refers to the type of financial instruments issued to raise funds. Common instruments include:
- Equity
- Preference Shares
- Warrants
- Options
- Convertible Notes
Investors often prefer preference shares, which provide priority over other shareholders in liquidation events and protect their investment. Convertible notes are used when a company wants to delay valuation or defer it to a later date.
3. Shareholding
The Shareholders Agreement usually requires the disclosure of the company’s capitalization structure on a fully diluted basis. This includes all instruments held by founders, investors, and other shareholders. “Fully diluted” refers to the total number of equity shares that would be outstanding if all convertible securities were exercised and converted into equity. An investor’s shareholding percentage is determined by dividing their investment by the company’s post-money valuation.
4. ESOP Pool
ESOPs dilute investor shareholding. To avoid immediate dilution post-investment, investors typically insist on creating the ESOP pool on a pre-money basis. The size of the ESOP pool usually ranges from 5% to 15%, depending on the business’s nature.
5. Liquidation Preference
In the event of a company’s liquidation, preference shareholders are entitled to recover their invested capital before other shareholders. Liquidation events can include:
- Dissolution or winding up of the company
- Mergers, de-mergers, acquisitions, or changes in control
- Sale, lease, or transfer of company assets
- Sales resulting from a drag-along right
The liquidation preference clause defines when and how much capital will be returned to shareholders. Key terms include:
Rank: The order in which shareholders are paid in liquidation. Preference shareholders rank higher than common shareholders, giving them priority in receiving liquidation proceeds.
Participation: The extent to which preference shareholders participate in the remaining proceeds after their initial capital is returned. Participation can be:
- Capital Protection: Investors receive either their original investment or their pro-rata share, whichever is higher.
- Double Dip: Investors first receive their original investment and then share in any remaining proceeds with other shareholders.
- Enhanced Return: Investors receive either their investment with an agreed return or their pro-rata share, whichever is higher.
- Capital Protection: Investors receive either their original investment or their pro-rata share, whichever is higher.
The specifics of liquidation preferences are negotiable and vary depending on the transaction.
b. Valuation Protection
When a company raises funds by issuing new equity, the existing investors often face dilution in their shareholding. To safeguard against significant dilution, investors typically negotiate for specific rights in the Shareholders’ Agreement. These rights help them maintain their percentage of ownership and protect the value of their investment.
1. Pre-Emptive Rights
This right allows existing shareholders to buy additional shares in any new equity round to maintain their ownership percentage. The purchase terms will match those offered to new investors. If any shareholder decides not to exercise this right, the remaining investors can subscribe to the available shares.
2. Anti-Dilution Rights
Anti-dilution rights protect investors from dilution when a company issues shares in the future at a lower price than what the investors initially paid. This protection can come in various forms:
Broad-Based Weighted Average: The investor’s share price is adjusted based on the weighted average of all shares and convertible instruments, offering a balanced approach between protecting investors and maintaining fairness for all shareholders.
Narrow-Based Weighted Average: This method only considers preference shares in the adjustment, often resulting in a higher price per share than the broad-based method.
Full Ratchet: The most investor-friendly option, where the investor’s share price is reduced to match the lower price of the new shares issued, offering maximum protection against dilution.
3. Dividend Rights
Investors are often entitled to dividends, typically set at a nominal rate, such as 0.001%. Additionally, if dividends are paid to equity holders, investors holding convertible instruments may receive dividends on a pari passu (equal footing) basis.
c. Governance
Investors in a company often seek rights that allow them to participate in key decisions and ensure their interests are protected. These rights are typically outlined in the Shareholders’ Agreement, focusing on the company’s governance and decision-making processes.
1. Board Composition and Appointment
Qualified investors often have the right to influence decisions regarding the size and composition of the Board. Both founders and investors can appoint Directors, with titles like Founder Director and Investor Director, respectively. Investors usually insist that founders remain on the Board as long as they are employed by the company. The CEO is also typically included on the Board, with the responsibility of ensuring the company’s compliance with applicable laws. Additionally, investors can appoint a non-voting observer to the Board, who attends meetings on their behalf to stay informed without directly influencing decisions.
2. Board Meetings
Board meetings are generally required to be held at least once every quarter. Directors and the investor’s Observer must receive a written notice at least 7 days before the meeting, along with an agenda detailing the items to be discussed and any necessary supporting documents.
3. Shareholders’ Meetings
When the Board decides to call a shareholders’ meeting, they must provide at least 21 days’ notice before the meeting date. The notice should include the agenda to inform shareholders of the topics up for discussion or decision.
4. Voting Rights
Investors have voting rights on matters that directly or indirectly impact their interests. The number of votes an investor has is usually proportional to their ownership percentage. For example, an investor owning 10% of the company’s capital typically has 10% of the voting rights. Investors holding CCPS (Compulsorily Convertible Preference Shares) can also vote in shareholder meetings on an “as if converted” basis, meaning they vote as if their shares had already been converted to equity.
5. Reserved Matters
Investors often negotiate the right to approve or reject significant corporate decisions through affirmative votes. These reserved matters typically include:
- Mergers, restructurings, and consolidations
- Acquisitions of other businesses or assets
- Formation of joint ventures or partnerships, and creation of subsidiaries
- Entering into strategic alliances or offering exclusive rights to third parties
- Related party transactions, including those involving founders or other key stakeholders
- Approval of business plans or annual plans
- Changes to the vesting terms for founders and key employees
These provisions give investors a significant level of oversight and ensure that their interests are considered in the company’s most critical decisions.
d. Founder Commitments
Investors often place a high level of trust in the founders’ vision and ability to steer the company toward success. To protect their investment, they expect founders to make several key commitments, which are typically outlined in the Shareholders’ Agreement.
1. Employment Commitments
Investors are heavily reliant on the founders’ continued involvement in the company, as their departure can have significant negative effects. If a founder exits, not only does it disrupt the company’s operations, but replacing them often necessitates offering new options, leading to dilution of existing shareholders’ stakes. To mitigate this risk, investors insist that founders commit to staying employed with the company for a specified period, usually between three to six years.
Moreover, investors may require that some or all of the founders’ shares be subjected to vesting. In this arrangement, the founders’ shares are placed in an escrow account and are released in equal installments over time.
If a founder’s employment is terminated under specific conditions:
- With Cause: If terminated for reasons such as gross negligence, criminal offenses, or abandonment of duties, all unvested shares are transferred to an ESOP pool or an employee welfare trust.
- Without Cause: If terminated without cause by the Board’s unilateral decision, all restricted shares are released and retained by the terminated founder, subject to certain transfer restrictions.
- Death or Incapacity: In case of death or incapacitation, all unvested restricted shares are vested and passed on to the founder’s legal heirs.
2. Lock-In Period
Founders are often restricted from transferring any shares without investor approval. This lock-in period ensures that founders maintain their stake in the company, aligning their interests with the long-term growth of the business. As the company progresses through funding rounds, founders may negotiate for increased liquidity, with later-stage investors generally being more open to providing such liquidity.
3. Non-Compete Clause
Founders must agree not to engage in any activities that could directly or indirectly compete with the company’s business as long as they hold shares or for a specified period after their exit. This clause is crucial in protecting the company’s market position and ensuring that founders do not leverage their insider knowledge to start a competing venture.
4. Non-Solicit Clause
Founders are also required to agree not to hire or enter into agreements with current employees of the company for a certain period after their departure. This clause helps prevent the disruption of the company’s operations and safeguards its talent pool.
These commitments from the founders are essential in maintaining the stability and growth potential of the company, reassuring investors that their interests are aligned with those of the founders.
e. Provisions Relating to Ownership and Transfer
In a Shareholders’ Agreement, provisions relating to ownership and the transfer of shares are critical in maintaining the balance of power and ensuring that all parties’ interests are protected. Here are the key provisions:
1. Right of First Refusal (ROFR)
If any founder or shareholder wishes to transfer their shares, investors are given the first opportunity to purchase these shares before they are offered to external parties. This right allows investors to maintain their shareholding percentage and control over the company’s equity distribution. The purchase price and terms must match those offered to the third party. If the primary investors with ROFR decline, other investors have the option to purchase the shares under the same conditions.
2. Tag-Along Rights
Tag-along rights, also known as co-sale rights, allow investors to sell their shares alongside the founders or other shareholders if they choose to sell their shares to an external buyer. This ensures that investors can participate in the sale on a pro-rata basis, under the same terms and conditions as the primary seller. Tag-along rights protect minority shareholders by preventing founders from selling their shares without offering investors the opportunity to sell theirs as well.
3. Right of First Offer (ROFO)
Before the investment exit date, if an investor decides to sell their shares, the founders are granted the right to receive the first offer for these shares. The founders can also set the initial price for the shares. While investors are not obligated to accept the offer, they may agree not to sell the shares below the price set by the founders. This provision allows founders some control over who the new shareholders might be and at what price the shares will be sold.
4. Transfer of Shares by Investors
Generally, investors have the flexibility to transfer their shares without many restrictions, except for prohibitions on selling to competitors. If an investor chooses to transfer their shares, the founders are expected to cooperate in the process, which may include assisting with due diligence and providing necessary company representations and warranties to the potential buyer. This ensures that the transfer process is smooth and that all legal and procedural requirements are met.
These provisions ensure that the transfer of ownership within the company is conducted in a controlled and fair manner, protecting the interests of both investors and founders while maintaining stability in the company’s equity structure.
f. Investor Commitments
In a Shareholders’ Agreement, investor commitments are crucial in protecting the company’s integrity and ensuring that sensitive information is not misused. Here are the key investor commitments
1. Sale to Competitor
This provision prohibits investors from selling their shares to a competitor. Since investors often have access to confidential company information—such as performance data, strategic plans, intellectual property, and other sensitive records—selling shares to a competitor could compromise the company’s competitive advantage. This clause is designed to prevent competitors from gaining inside knowledge that could be used against the company, thereby protecting the company’s market position and intellectual assets.
2. Confidentiality
Investors are required to maintain strict confidentiality regarding the contents of the Shareholders’ Agreement, details about the parties involved, and any information related to the company’s finances, operations, and investment purposes. This commitment ensures that sensitive information is not disclosed to unauthorized parties, safeguarding the company’s business interests. However, investors may share this information with their investment bankers, accountants, legal counsel, or potential buyers, provided that these parties are bound by appropriate non-disclosure agreements. This allows investors to seek necessary advice and make informed decisions without compromising the company’s confidentiality.
These commitments are vital for maintaining trust between the company and its investors, ensuring that the company’s interests are protected while allowing investors to fulfill their roles responsibly.
g. Boilerplate Items
In investment agreements, boilerplate clauses serve as standard provisions that ensure all parties involved adhere to essential legal, financial, and operational standards. Here are some key boilerplate items commonly found in Shareholders’ Agreements:
1. Related Party Transactions
This clause is designed to protect shareholders by restricting the company and its subsidiaries from entering into transactions with “Related Parties” without obtaining prior consent from the shareholders. The term “Related Party” includes:
- Group Company: Any company within the same corporate group.
- Affiliate of the Group Companies: Any entity affiliated with the group companies.
- Founders or Directors (excluding Investor-nominated Directors): This includes any founder, director, or their relatives.
- Entities Owned or Controlled by Founders or Directors: Any entity owned or controlled by a founder, director, or their relatives.
This provision ensures that transactions involving related parties are transparent and do not unfairly benefit individuals with inside connections to the company.
2. Representations and Warranties
Founders are required to provide various representations and warranties to the investors, asserting that the company is in sound legal and financial standing. These representations typically cover:
- The company’s legal and financial position
- Ownership and protection of intellectual property
- Assets owned by the company
- Compliance with applicable laws and regulations
- Awareness of risks and liabilities
- Tax obligations
- Use of third-party intellectual property
- Compliance with existing contracts
This clause ensures that the information provided to investors is accurate and reliable. Any breach of these representations can lead to indemnification, where the founders may be held liable for damages incurred by the investors due to false or misleading information.
3. Conditions Precedent
Before the investment deal can be finalized, certain conditions must be met. These conditions typically include:
- Necessary Approvals: The company must obtain all required corporate, governmental, management, third-party, and regulatory approvals to the satisfaction of the investors.
- Due Diligence: Investors must complete a satisfactory financial and legal due diligence review of the company.
- Compliance with Law: The company must comply with all relevant legal requirements and customary conditions.
The agreement only takes effect once these conditions are fulfilled, ensuring that the investment is made under secure and compliant circumstances.
These boilerplate items are fundamental in protecting the interests of all parties involved, providing a framework for transparency, compliance, and accountability throughout the investment process.
h. Information and Inspection Rights
1. Information Rights:
Investors are entitled to receive detailed information on various aspects of the company’s operations, including:
- Financial Statements: Audited and unaudited financial statements, including cash flow statements.
- Management Information System (MIS) Reports: Regular updates on the company’s performance.
- Minutes of Meetings: Records of Board and Shareholder meetings.
- Significant Events: Information on any event that could substantially impact the business.
- Legal and Contractual Documents: Reports and documents related to litigation, material contracts, and governmental claims.
- Annual Budget and Business Plan Updates: Projections and updates on the company’s business strategy.
- Key Personnel Changes: Information on changes in the employment or terms of employment of key personnel.
- Compliance Reports: Regular updates on compliance with legal and regulatory requirements.
All requested information must be provided to investors within the agreed-upon timelines to ensure transparency and accountability.
2. Inspection Rights
Investors have the right to conduct comprehensive inspections of the company. These rights include:
- Access to Premises: Investors can inspect the company’s offices, premises, properties, and assets.
- Review of Documents: They can review material records, contracts, and other significant documents.
- Financial and Operational Information: Investors can request additional details regarding the company’s accounts, business, and operational matters.
- Examination of Books and Records: This includes the right to inspect books of accounts, documents of title, orders, judgments, licenses, and registrations.
- Consultation with Stakeholders: Investors can consult with employees, vendors, consultants, internal and external legal counsel, and internal and statutory auditors.
During these inspections, the company and founders are obligated to cooperate fully, providing necessary authorizations to facilitate the process.
i. Exit Rights
Investors typically invest with the goal of eventually exiting the company with a return on their investment. The Shareholders Agreement should clearly define the terms and conditions for such exits. Common exit strategies include:
1. Qualified IPO
Investors’ shares are listed on a qualified Initial Public Offering (IPO) on or before the agreed investment exit date. This ensures that investors achieve a benchmark return on their investments.
2. Strategic Sale
If the company proposes a strategic sale, it must notify investors about:
- The nature of the transaction.
- The identity of the purchaser.
- The timeline for closing the deal.
Investors can participate in the strategic sale with priority over other shareholders, without the need to provide extensive representations and warranties, except for the title to shares and their legal standing.
3. Liquidity IPO
If a Qualified IPO or Strategic Sale is not completed by the investment exit date, shareholders’ securities can be listed on a stock exchange through an offer for sale or a fresh issue of shares, providing liquidity to investors.
4. Buyback of Shares by the Company or Promoter
An alternative exit method involves the company or promoters buying back the investors’ shares. The buyback price should provide the investor with a minimum return and is subject to the company having sufficient cash and meeting regulatory requirements.
5. Drag Along Rights
In certain scenarios, investors have the right to “drag” the founders and other shareholders into a sale negotiated by the investors. Drag rights are typically invoked if investors remain shareholders after the exit period or if the company or founders commit a significant breach. In a drag sale, founders and other shareholders must sell their shares on the same terms as those determined by the investors.
Founders are expected to make their best efforts to facilitate an exit for the investors. If an exit opportunity does not materialize, the founders are not liable, unless they block a potential exit that the investors wish to pursue.
j.Dispute Resolution
To manage potential conflicts, the Shareholders Agreement should include a dispute resolution mechanism. The recommended approach is:
1. Mediation
As a first step, disputes should be resolved through mediation, which helps avoid costly litigation and addresses issues before they escalate.
2. Arbitration
If mediation fails, disputes are referred to arbitration. The arbitrator will render a decision or remedy in writing, which is binding on all parties.
A well-crafted Shareholders Agreement is crucial for aligning the interests of all parties involved in an investment. The agreement should be consistent with the company’s Articles of Association, as the Articles supersede the Shareholders Agreement. Any provisions not currently within the scope of the Articles will require amendments to ensure their validity.
While drafting such an agreement demands careful legal consideration, the time and cost involved are well worth the clarity and protection it provides. It is advisable to engage a skilled lawyer or experienced founder to help secure the deal and ensure smooth execution.
