Essential Pre-Requisites of a Shareholders Agreement: Lawyers Advice
A Shareholders Agreement (SHA) which is also called a Stockholders Agreement is basically an agreement which safeguards the interests of the shareholders of a company as it is a contract between the shareholders and the management of a company outlining various important elements which protect the existing shareholders, the minority shareholders’ and also the future shareholders’ which could be in form of seed financing investors or angel investors. It includes terms like shareholders’ rights, responsibilities, liabilities, and obligations, etc. It also specifies about the pre-emptive rights which allow the existing shareholders to participate during the time when new shares are offered.
The agreement also includes sections that outline the fair and legitimate pricing of shares when the decision is taken to sell the same. It also allows shareholders’ to have the option of a right of first refusal when it comes to accept or reject the shares of the outgoing shareholder.
While the Articles of Association (AoA) are the basic constitutional documents for all companies which lays down the rules of functioning of a company they are mostly a standard document. Whereas a SHA provides in detail what would be the legal remedy in case of any legal disputes arising in the future. Although in articles of association, there would be few terms of SHA but it might not be exhaustive hence it would limit the potential of providing protection to the shareholders’. Since the SHA contains no standard format as such it makes the scope of the agreement large to fit the specific needs and requirements of shareholders’.
Additionally, a SHA is a private agreement that makes it appropriate to include confidential matters. Furthermore, a SHA can prove to be a less expensive way to protect the interests of the shareholders’ against the potential legal disputes by providing a proper outline and procedures while dealing with dispute resolution mechanisms. It is pertinent to note that the articles of association supersede a shareholders’ agreement as held by the Delhi High Court in World Phone India Pvt. Ltd. & Ors v. WPI Group Inc., USA  178 Comp Case 173 (Del). Also, in Vodafone International Holdings BV v, Union of India & Anr (2012) 6 SCC 613), it clarified the decision of the courts when there is a conflicting provision between a SHA and the AoA. The restrictions imposed under SHA provisions, though in proper compliance with the applicable laws, are to be enforceable only when incorporated in the AoA.
Few Important Clauses in a SHA are:
- Structure of the Management- This clause specifies the role of the management, the director’s remuneration, when and how a director is to be appointed or removed under what circumstances, the rules and regulations, when the board meeting needs to be conducted, etc. A SHA will normally state the number of board members along with their details like names, etc.
- Transfer of Shares- One of the major clauses in this type of agreement is the method of transfer of shares. For example, if there are new angel or seed investors who would decide to transfer the shares to any third party, the shareholders may not necessarily like such an arrangement of transferring the ownership to the competitors of the business then to avoid such a scenario there could typically be a share transfer restriction clause in an agreement. A SHA may include different methods of share transfers like for instance, shares which may be allowed to be transferred from one existing shareholder to another existing shareholder or such type of share transfer where through an assignment or pledge whether directly or indirectly be transferred to some creditors, trustees in insolvency or bankruptcy proceedings or another type of transfer would be a type of automatic transfer which could come into effect on a shareholders’ death, termination (in case he is an employee), temporary or permanent disability, etc. In V.B. Rangraj v. V. B. Gopalakrishnan, AIR 1992 SC 453, it was held that a restriction on the transfer of shares contrary to the articles of association of a private company was not binding on the private company or its shareholders.
- Buyback Right & the Right of First Refusal- This clause mentions about the buyback rights whereby any transfer other than a transfer that is permitted, the company will have the exclusive rights to purchase those shares. If such a provision is mentioned in a SHA, the valuation mechanism for such a buyback should be specified in the SHA. A SHA also provides the shareholders’ a right called rights of first refusal which means when the company refuses the option of buyback rights or only partially exercises them, the other shareholders’ of the company will have the first priority right to buy those shares which would be in proportion to their existing share ownership. A detailed clause of rights of first refusal and the transaction method should be mentioned in the SHA agreement.
- Tag-Along Rights- This clause mentions that when the majority shareholders’ sell their shares, it becomes imperative for the other shareholders’ or the minority shareholders to have the rights to tag-along with such a sale and such rights basically exist to protect the shareholders so, if the majority shareholder sells its shares, it gives the other shareholders the right to tag-along and join the sale which could benefit them as they have invested in the company as well. Thus, although such rights provide protection to the shareholders’ they do not create any obligation on their part to compulsorily sell shares together with a majority shareholder.
- Drag-Along Rights- This clause provides that the majority shareholder can force minority shareholders’ to sell their shares and participate in the sale of a company. Such a scenario normally takes place when there is a company merger or acquisition because buyers usually prefer to have complete control of a company. The advantage of such a clause is that the minority shareholder can seek the same price, terms, and conditions as any other seller so that they are not in any loss which may otherwise be unattainable.
- Management Report & Company Financials- Being a shareholder of a company allows them to subscribe to the company’s financial and management reports that are usually published annually. Sometimes, majority shareholders’ may have an access to the reports that are published on a monthly or quarterly basis.
- Shareholders Non-Competition & Non-Disclosure Obligations- Often the shareholders have access to a lot of company’s confidential information like the trade secrets, financial details, and other sensitive information. Hence in order to avoid such misuse of the information being leaked to any third party, a SHA can include non-disclosure and non-competition clauses that would restrict shareholders from divulging information. Non- compete clause will restrict them from working for the competitors and a non-solicitation clause that will restrict the shareholder from doing business with any company or person that was or is a client of the company.
- Additional shareholders and their deeds of Accession- In the event where the company raises capital allowing new shareholders to invest in the business, or where an existing shareholder wants to transfer shares to any third party, such new shareholders must be bound to the SHA. For such an inclusion, a SHA should clearly state that any new shareholder or transferee must be included in the SHA prior to the transfer of shares. Hence, such a transferee or share purchaser would be required to sign an agreement deed whereby they agree to accept all the terms of the SHA. Such a document is a ‘deed of accession’ or ‘deed of adherence.’
- Dividends- As the shareholder invests money in the business he would be concerned about how to receive profit from the company. The shareholder document should therefore state clearly the structure of how each shareholder is going to receive profits. Often different shareholders hold a different variety of shares and hence have different rights attached to the same. When such data are documented properly it can result in preventing disputes, when dividends are paid eventually.
- Exit Strategy- The shareholder agreement must identify the proper structure of an exit strategy. It could either be a buy-out, sale, or listing.
- Default- The shareholders agreement should list various circumstances where there could be a default and what would be the consequences of such default by a shareholder, like for instance in case of default whether that shareholder would be forced to transfer their shares, and if so what would be the criteria of valuation.
- Deadlocks and Disputes- In case of a deadlock or a dispute that cannot be resolved at ease, provisions should be stated in the shareholder agreement which can also be “shotgun” provisions; where a specific party asks for a price which he is willing to buy-out or be bought out by the other shareholders. Other provisions might include call and put options or even a forced shutdown or winding up of the company.
Hence, by creating a robust shareholders agreement and outlining proper framework for the protection of the shareholders, the company’s disputes can be resolved in a simplified matter. Also, by the way of every shareholder acknowledging the agreement, it assumes accountability on them and binds them to follow the rules and regulations of the company which eventually helps in the development and smooth functioning of the company.
Authored By: Adv. Anant Sharma & Emilia Chettiar