A Shareholders Agreement (SHA) is vital for the long-term growth of company because it not only contains the relation between shareholders but also the necessary obligations. In general, having a Shareholders Agreement seem not necessary but once difference of opinion arises between shareholders, the first resort is the Shareholders Agreement where all the rights and responsibilities are defined. It is prepared to supplement the Article of Association (AOA) of the Company since the AOA or Company Laws are restricted only to functioning of a company.

Earlier Shareholder Agreements were not given importance which caused many controversies. However, with change in time, investors are becoming aware of it and taking necessary steps to save their money and time invested to establish a business. The nature of a Shareholders Agreement is protective which makes it effective in resolving disputes between shareholders, if occurs.

What is a Shareholders’ Agreement?

A shareholder agreement is a written and a binding arrangement between the shareholders of a company to protect their investment and establish a fair relationship between them. The Shareholders’ Agreement can also govern how the company will run by incorporating important terms relating to the company along with rights and obligation of the shareholders. It is drafted in such a way that makes it becomes beneficial for both majority as well as minority shareholders.

What makes Shareholders’ Agreement so important??

  1. It explains the Relation between all or a specific class of shareholders
  2. It sets out the rights and entitlements of Shareholders who are parties to the Agreement
  3. It protects an element of protection to the minority shareholders
  4. It regulates the important decision taking mechanism
  5. It regulates the sale of shares of the company (Exit mechanism)

Most important clause of a Shareholders’ Agreement:

  1. Pre-emptive Rights Clause: Pre-emptive rights are enforced when the new shares are issued by the company. Pre-emptive Right requires the company to issue the newly issued shares of company to the existing shareholders in proportion to their existing shareholding before offering them to non-existing party. This clause is incorporated to save the existing shareholders from involuntary dilution of their stake in the company.
  1. Restriction on Transfer: This is a general clause which requires a seller of a share to inform his wish to the company in writing and obtaining written permission of all the existing shareholders. This clause not only restricts the right to transfer the shares but also defines the valuation method and other conditions pursuant to a transfer.
  2. Right to appoint Directors: Company Laws gives power to majority shareholders of the company to appoint Directors and minority shareholders get no seat on the Board. Shareholders Agreement may set up a mechanism to appoint directors by minority shareholders till they hold specified numbers of shares.
  3. Right of First Refusal Clause (ROFR): A high-valued and frequently used clause that makes the shareholders confident about safety of their investment. When one party to the agreement wish to sell their shares to a third party, they are required to give the notice of such sale to the other existing shareholders (Transfer Notice) detailing the complete terms & conditions. Existing Shareholders get a right but not obligation to buy those shares on the same conditions on which the seller was willing to sale those shares. If all the existing Shareholders refuse to buy those shares on the condition specified by third party, then only the seller can sell it to such third party.
  4. Drag-Along Right: Drag-Along Right is an important clause as sometimes it becomes beneficial and sometime detrimental to the minority shareholders. However, it is drafted in such a way as it becomes beneficial to both classes of Shareholders. Under Drag-Along, when the majority shareholders wish to sell their shares to a third party, they can force the minority shareholders to join them under the same price & terms to ensure a clean exit.
  5. Tag-Along Right (Co-Sale Right): It gives a right to the minority shareholders to join the majority shareholders in case the majority shareholders wish to sell their shares to a third party. Tag-Along Right is beneficial to the minority shareholders because minority shareholders can force the majority shareholders by joining them on same price & terms and minority shareholders don’t need to find another better deal.
  6. Non-Compete Restriction clause: This is commonly found in the Shareholder Agreement which restricts the existing shareholders from carrying out any rival activities during and after their tenure as a shareholder. The rationale behind such restriction is the Trade Secret and company’s intellectual property which is crucial for a business. Not having a competition clause may become a disaster for a company in future.
  7. Dispute Resolution Clause: Dispute is inevitable in todays’ scenario and it makes important for a Shareholders Agreement to include a Dispute Resolution Clause or a Deadlock Resolution Clause. This clause-set out the manner in which a dispute would be addressed and will be resolved ensuring win-win situation to all parties. It may include “Put Option” or “Call Option” clause whereby the shareholder has a right to “buy or sell” their stake to other existing shareholders at a pre-determined price.
  8. Liquidation Preference: This is one of the most notorious clauses used by venture capitalists. Liquidation Preference clause gives the investors a preference in recovering their investment in if the company is dissolved or sold. Sometimes the investors may demand for 2x or 3x preference which means they get a right to recover twice or thrice of what their investment is. This results in other shareholders receiving small amount upon an exit.