The A to Z of the Shareholder's Agreement; The Do's and Dont's

In a startup or a new business enterprise involving more than one individual who contribute financially or otherwise, it pays to ensure that their contribution is acknowledged in a secure and accountable manner. "Shareholder's Agreement" (SHA) is one way in which such a security can be awarded to all stakeholders. Shareholder Agreement provides the exact ownership stake each partner will enjoy along with incumbent

obligations. Even non-company contents like management rights, licensing intellectual property etc. are commonly included in the shareholders’ agreements.Some Salient Aspects of a Good Shareholder's Agreement Include:

1. Nomination of Directors etc.: The agreement may allocate the rights to certain stakeholders to be a director on board as well as decide the composition of the Board.
2. Roles and obligations of each shareholder.
3. Financing requirements, quorum requirements and veto rights.
4. Representation & Warranties from the Company.
5. Restrictions on transfer of shares (right of first refusal, right of first offer).
6. Forced transfer of shares (tag-along rights, drag-along rights) and curtailing of further issue of shares.
7. Defining Shareholding Threshold: There can be a minimum shareholding a party must have to enjoy the rights as under the Shareholding Agreement.
8. Determining and allocating special rights to certain shareholders: For instance if a venture capital or private equity invests in an enterprise, they would seek preferential treatment unless one is a Google or Facebook!

Mechanism for Regulating Share Transfers

Shareholder Agreements offers a mechanism to the founding members of a company to regulate (and sometimes restrict) the shares allotted to the stakeholders. Though the restrictive covenants do not carry much favour by courts unless they form part of the company's bylaws, yet they offer a way in which owners of a company can invite and incentivize talent - all the while regulating the flow of actual stake. The policies of a company, and sometime even ownership, can be jeopardized in an unregulated scenario.

Some clauses in this regard often found in a Shareholders' Agreement to regulate the transfer of shares are:

1. Right of First Refusal: Under this clause, holders of share wanting to sell and monetize them must first offer them to stakeholders who hold the right of first refusal (usually existing shareholders). Only when the latter refuses or cannot buy those shares can the seller sell them to a third-party.
2. Right of First Offer: This clause enables a preferential option to certain stakeholders in which the prices of the shares are fixed beforehand. The shareholder who wants to sell his/her stake shall first offer the shares to the holder of the right of first offer holder at the fixed price. Upon refusal, the seller can sell them to a third-party.
3. Drag-along Rights: Under this clause the shareholders agree that when one of them (holding the Drag-along right) sell his/her shares to a third-party, all other shareholders will be dragged to sell to the same third-party. While it may sound odd to have this clause, please note that this ensures complete exit.
4. Tag-along Rights: On the lines of Drag-on rights, here the other shareholders enjoy a right to tag-along with the seller and sell their shares to the same party.
5. Buy-back Rights: These give the company the right to claim back the shares of a certain shareholder on withdrawal or death of the shareholder.
6. Call Option: Call option gives its holder the right to buy a certain number of shares at a predetermined price ('strike price') between the date of purchase and the options expiration date.
7. Put Option: Put option gives its holder the right to sell a specified number of shares at a predetermined price ('strike price') on or before the expiration date of the contract.
8. Anti-Dilution: A shareholder given shares at price X enjoys the right to receive additional shares at no extra cost if the company decides to issue to another person at a price lower than X. This is done to offset the price difference.
9. Pre-emptive: Under the pre-emptive right, the Company has to offer any future shares that may be issued, first to the Shareholder (on a pro rate basis) before offering it to any other party, as well as allow the shareholder to maintain his/her shareholding pattern. 

Legal Validity & Enforceability of the Shareholder's Agreement

International view is split but to a large extent inclined towards favouring SHA as long as they are not found to be detrimental to the minority stakeholder's rights. 

In the leading case of  Russell v Northern Bank Development Corporation Ltd [1992] BCC 578; [1992] 1 WLR 588] the House of Lords found that though a company cannot deprive itself of its power to alter its constitution, the members of the company could agree in a shareholders’ agreement as to how they will exercise their rights. The US Courts have largely accepted shareholder agreements. Blount v Taft [246 S.E.2d 763 at 769 (1978)]

In India Shareholder's Agreement have gained popularity and currency only lately with bloom in modern forms of businesses. We do not have fixed laws relating to them, nor is the case-law uniformly inclined in a direction. “Freedom of Contract” and other legal principles affect their enforceability.

The landmark decision of the Supreme Court in V.B. Rangaraj v. V.B. Gopalakrishnan, AIR 1992 SC 453, [1992] 73 Comp. Cas. 201 is often a guiding light in the context of shareholders’ agreements. Most of the other judgments have come from High Court especially Mumbai High Court; Mumbai being the financial capital of India. In the case of Messer Holdings Limited v. Shyam Madanmohan Ruia, [2010] 159 Comp. Cas. 29 (Bombay High Court) provided a more liberal interpretation and recognised the rights inter se among shareholders in case of restrictions on transfer of shares.

So what is the sticky point we are talking here? It is about the regulatory clauses as described above which have been seen as negative covenants and have been often frowned upon by the courts. These covenants are thought to be violation of specific laws, for example, Securities Contracts (Regulation) Act. They are seen as problematic as they can be instruments for groups of shareholders to circumvent the normal scheme of the company’s legislation or the company’s constitution in its Articles of Association. 

 It will be pertinent to note that there are two major legislation umbrella which protects shareholders' rights: one emanating from Indian Contract Act 1972 and other more powerfully from Companies Act 1956. Courts tend to favor those clauses in Shareholders' Agreement:

• If they are not found to contravene any Company legislation
• If they find mention in the bye-laws of the Company (Read Articles of Association).

So it makes sense to custom draft the Articles of Association (AoA) while incorporating your company. Sadly, in a large number of cases it is seen that people ignore it and tend to agree to blind replication of standard formats. Such cut, copy and paste work will almost surely fail to encompass your intended policies.

Can A Shareholders' Agreement Bind a Third Party?

Private companies are like close-knit families. They tend to enjoy the assurance and comfort to control what they do; be it the internal relation between the stakeholders or forging ties with third parties. Normally under the current Indian Law, it binds the two parties under it. In order to make it binding on a third-party company regulated matters must form part of public domain - i.e., it must reflect in company bylaws (visible to public). This gives fair notice to others.

These useful insights into the Dos and Don’ts of the shareholder's agreement was given by EasyLaw (www.easylaw.in) an online legal & business services company assisting entrepreneurs and start-ups with a range of solutions from incorporating their companies to drafting of all important business and legal documents.To know how to ensure better protection in your Agreement and to read the complete article HERE.