Ten Most Important Clauses to be Incorporated in a Shareholders Agreement (SHA): Lawyers Advice
There are several factors that contribute to the smooth functioning of a company. These factors can include smooth internal relationships and functioning, expanding external networks, profit management, etc. However, the benefits accrued from proper handling of the above – mentioned factors can come to an abrupt halt if there is a breakdown in the relationships between the shareholders, shareholder bankruptcy or even death of a shareholder.
Therefore, it becomes useful to have a shareholders’ agreement in place to deal with such eventualities. A shareholders’ agreement (SHA) is essentially an agreement among the Company’s shareholders’ that describes how the company ought to be operated and it clearly defines the shareholders’ rights and obligations. In the case of Premier Hockey Development Private Limited v. Indian Hockey Federation (180 (2011) DLT 530), the Court held that the SHA was enforceable against both the company as well as the company as both of them were a party to the SHA and hence are bound by it.
Elucidated below are few of the most essential clauses that you should consider including in your SHA to ensure smooth functioning of your company.
Share Vesting Clauses: A vesting clause will ensure that the shares will only be “vested” with the shareholder when certain conditions are met. These could be productive or temporal targets. Only when these targets are met will the shares vest with the concerned shareholder. This will enunciate the shareholders to stay motivated to achieve the goals of the company.
Sweat Equity Shares Clause: Offering sweat equity shares is a common occurrence in start-up companies as there is often a shortage of funds to pay employees’ salaries. Sweat equity is provided to co – founders and key employees instead of offering capital. This will act as a strong incentive to such persons to stay committed to the cause of the company.
It the relationship between shareholders breaks down, there could arise several issues. Shareholders that do not agree with the policies of the company can turn into “bad apples” and sabotage the functioning of the company. Therefore, it is crucial to factor all these possibilities in while drafting the SHA to ensure that the company does not lose out.
Good and Bad Leaver Clause: Bad leaver clauses usually provide for situations where shareholders leave the company or are removed from the company due to various reasons. These include misconduct, fraud, not reaching a milestone, etc. The bad leaver clause will ensure that in such a case, the shares held by the shareholder are transferred to the company.
In contrast, a good lever clause provides for situations where a shareholder is forced to leave a company due to no fault of his own. In such a case, a good lever clause will ensure that they can retain their shares of the company. This is a useful clause to include in a SHA to prevent untoward termination of shareholder relationships.
Restrictions on Transfer of Shares: This is protective clause that can be included in a SHA. This will ensure that shares are not sold to undesirable third parties without first offering them to the existing shareholder or allowing the company to find potential shareholders. An inclusion of an independent valuation formula is also suggested to ensure that a fair valuation of shares can be arrived at.
In the case of V.B Rangaraj v. V.B Gopalakrishna (AIR 1992 SC 453), the Supreme Court held that restrictions on the transferability of shares should be mentioned in the Articles of Association of the company and if that is not done, the SHA will be unenforceable.
Rights to Restrict Activities and Appoint Directors: An inclusion of this clause will ensure that minority shareholder will not be deprived of representation on the Board of Director due to their minority standing. This clause will ensure that shareholders can appoint directors if they hold a minimum percentage of shares in the company.
Drag–Along and Tag–Along Rights: A drag along and tag along clause can be included into a SHA in order to ensure that minority shareholders are not cut out from future deals. A drag along clause will ensure that if a significant percentage of shareholders are in favour of undertaking a particular course of action (say 80%), then, the remaining 20% of shareholders have to acquiesce to the action. Similarly, a tag along provision will ensure that the minority shareholders are not deprived of their standing in the company, simply because they disagree with a particular course of action.
Similarly, a “restricted activities” clause will ensue that there is a requirement of a super majority of shareholder (75%) to approve and carry out certain restricted activities.
Anti–Dilution and Pre–Emptive Rights: Inclusion of this clause is a way to prevent unwanted shareholders from issuing additional shares in order to dilute the rights to existing shareholders. A pre–emptive rights clause will ensure that existing shareholder are given a share in any additional issue of shares in proportion to the shares that they already hold. The anti–dilution rights are powerful rights and are only granted to investors when the company is in a relatively weaker bargaining position.
In the case of Mafatlal Industries Ltd. v. Gujarat Gas Co. Ltd ((1998) 2 GLR 1436), the Hon’ble Gujarat High Court held that a pre-emption agreement which is not provided in the Articles of Association of a company is not enforceable.
Fundamental Disputes Clause: A fundamental disputes clause can be included to ensure that in case there is a dispute between the shareholders on the matter of additional funding, payment of dividend or any disagreement pertaining to the sale of the business, a provision for exit is provided wherein a one or more shareholders can buy out the other shareholders. The inclusion of this clause should be a last resort; however, it is still preferable to a deadlock which may occur.
Liquidation Preferences Clause: A liquidation preference clause lays down the pecking order according to which investors will recover their investments in the situation that the company goes into liquidation. Care has to be taken to ensure that no investors are given two times or three times their initial investments in the company. This will ensure that other investors will get their respective shares as well.
Hard and Soft Right of First Refusal: This clause will require any shareholder who is looking to sell his/her interest to a third party, to first make the same offer to the remaining shareholders. Only if the remaining shareholders refuse to buy the shares can the shares be sold to a third party. This will ensure that shares are kept within the original shareholders of the company.
A Shot Gun Clause: This clause will allow a shareholder to offer in sale his/her shares according to his/her terms and conditions. If the shareholder who receives the offer, rejects the offer, then the rejecting shareholder should offer to sell his/her shares according to the terms and conditions mentioned in the initial offer. This will ensure that shareholders have an exit strategy when existing triggering event do not apply.
If the above mentioned clauses are included into the SHA, business owners can protect their ownership interests. It will serve shareholder to consider the benefits that these clauses could offer before drafting a SHA.
Authored By: Adv. Anant Sharma & Vismay G.R.N.