Overview
A shareholder is a person who offers capital for the growth & development of the business in exchange for the ownership of the company and return gets a certain percentage of the total shares of the company. In a true sense, they play a significant role in ensuring the growth & prosperity of the business by making the right decisions. In pursuance of such ownership, they also get certain rights and obligations towards the company. Therefore, it becomes imperative to protect their interests, as well as the company in case of any misuse or abuse of powers, is made by shareholders by regulating their activities through a legal agreement, known as a shareholder’s agreement.
Thus, a shareholders’ agreement is a legally binding agreement entered between the company & its shareholders that govern their rights and obligations while striving to create a balance between the parties and further ensures their participation in the crucial business decisions of the company.
Further, the agreement outlines the structure of the internal management of the company by laying out the terms & conditions related to the rights & obligations, transfer of ownership, exit options, and dispute resolution in case there is any dispute either between shareholders themselves or between shareholders & the company.
Apart from this, a shareholder agreement protects the rights of minority shareholders of the company so that every shareholder (either majority or minority) is treated fairly through equal participation in the business decisions. Also, it protects existing shareholders from decisions of future management in case the company is acquired or sold to any other business entity or person.
Shareholders Agreement- A Brief Understanding
A shareholders’ agreement is a contractual arrangement entered between the company & its shareholders and has gained huge popularity since the agreement is drafted explicitly to provide specific rights & impose certain restrictions on shareholders that are over and above those prescribed under the Companies Act 2013.
The agreement is regulated under the provisions of the Companies Act 2013 and provides for clauses such as shareholders’ rights and obligations, ownership of shares, privileges, and the internal management of business, voting powers, and various other insulative provisions including any pre-emptive rights that may become contentious in the future.
Articles of Association (AOA) vs Shareholder’s Agreement
It’s a known fact that the Memorandum & Articles of Association (MOA & AOA) are the primary charter documents for the Constitution of a company and come in standard format in nature. The AOA of the company connects a company and its shareholders in their capacity as shareholders and further prescribes their responsibilities as a director or an employee of the company, how the shareholders can exert their powers over the board of directors and the kind of business to be undertaken. However, when it comes to a comparison between the AOA & shareholder’s agreement, then the shareholder’s agreement overrides the AOA of the company. While an AOA could be drafted in a specific standardized format, there is enough flexibility in the shareholder’s agreement to be molded according to the requirement of shareholders.
While the MOA & AOA of the company are known as the public documents of a company, the shareholder’s agreement is a private document that contains confidential business information of a company. The agreement also defines disputes and contains mechanisms to be heard, discussed, and resolved in advance of any dispute that happens in the future in a cost-effective and timely manner. Therefore, the AoA and a shareholders’ agreement must be in harmony with each other.
Nevertheless, the shareholder’s agreement may contain a clause providing for the supremacy of the agreement over AOA so that the agreement overrides the AOA to guide the shareholders and the company in case of disputes.
Role of a shareholders’ agreement
As provided above, a shareholder’s agreement plays a key role in the functioning of a business entity as it binds the shareholders and the company together as one to work for the betterment of the company. Provided below are some points that describe the role played by the shareholder’s agreement in the successful business operations of a company-
i. Control of Decision making for the Business
Usually, it is the Board of Directors who is involved directly in the day-to-day business decisions of the company. However, where a shareholders agreement is in place, there are specified matters reserved which will need to be informed, discussed, and approved by the shareholders before being executed rather than the matter to be left at the will of the board of directors.
ii. Resolving Disputes Efficiently
No matter how smoothly the business is going on, there is always room for disagreements and disputes, which could be between shareholders themselves i.e. majority & minority shareholders, or between the board of directors & shareholders of the company. To avoid this situation, the shareholder’s agreement contains the mechanism for the resolution of the dispute and the preferred method of resolution such as arbitration or conciliation, and resultant consequences if any. Even if any dispute doesn’t occur, it helps to maintain a healthy relationship between the shareholders and the company
iii. Ensuring Business Stability & Growth
To have a successful business, a business needs stability above all other matters. It matters to creditors, financial institutions & potential investors who may be looking to invest in the company and may like to have a look at the business attributes. Thus, a shareholders agreement helps a company to have a healthy relationship amongst the shareholders.
iv. Specific shareholder rights
The shareholders’ agreement plays an important role in the reservation of specific rights for the shareholders in the protection of their interests and the interests of the company. The shareholder’s agreement empowers the shareholders to participate in crucial business matters such as the appointment of directors or financial status of the company, taking loans or making investments for the business, or any other similar information regarding the company.
v. Restrictions on Exit from the Company
It is only natural that a company has fewer shareholders who are generally founders/ employees or any other person making a crucial contribution to the business in the early years. Therefore, if the shareholders do not wish to allow any third party to become a shareholder in the company for a certain number of years, the shareholder’s agreement allows to put restrictions on the exit of the shareholder and in case he makes his exit, he could sell/transfer shares to any existing shareholders.
These restrictive provisions provided by the agreement to protect the legitimate business interests of the company including the element of protection that would not have been possible unless a shareholders’ agreement did not exist.
vi. Control over share transfers
A shareholders’ agreement contains provisions like share capital & transfer of shares including the pre-emptive rights to the shareholders. These provisions act as a shield to deciding whether the company should or not allow any outsider to determine who is acquiring ownership and holding shares in the company.
vii. Protection Against Breach
The shareholder agreement also provides for the conditions under which shall constitute the breach of the terms of the agreement and the legal consequences of committing any breach of the agreement.
What are the key clauses under the Shareholders Agreement?
i. Sale /Transfer of Shares
Equity shares of the company carry ownership rights of the company it is essential to put provisions related to the circumstances if a shareholder wishes to transfer or sell either a portion of his stake or all of his shareholding in the company. For which the parties may either mutually agree on certain pre-emptive rights related to the transfer of shares or prescribe any lock-in period to prohibit the transfer of shares till the expiry of the period and even after completion of the period the shareholder could be put under the obligation to transfer shares to the existing shareholders.
Further, a shareholders’ agreement must also cover other provisions concerning share transfer, such as the prohibition on the transfer of shares to any third party, legal consequences in the event of the death of a shareholder, etc.
ii. Functioning of the Company
Since a shareholder’s agreement is complementary to the Articles of Association of the company, the agreement must include guidelines or procedures to be followed in the daily business functioning to ensure sustainable and consistent workflow in the company. It could also contain procedures to create a favorable situation for the smooth operation of the company matters such as appointment, resignation, and removal of directors and their remuneration thereof.
iii. Raising capital for the Business
Since the shareholders have the right to get the audited financial statements and annual reports of the company their hold shares in, they can track the progress and the requirements for the growth & prosperity of the business. A shareholder agreement could contain a clause providing for the sources of funding that could be opted by the company including the manner of procurement of the funds for the business.
iv. Board of directors and Board meetings
Though, the Companies Act 2013 specifies the minimum number of board meetings and shareholder’s meetings to be arranged by the company. It is up to the shareholders to decide and agree on the number of meetings during the year including the annual general meeting for which the company shall be under an obligation to send a notice in advance.
Further, the agreement must provide for the decisions to be taken by the Board of Directors, and those decisions require the approval of the shareholders of the company. It may also include the manner of appointment of the board of directors, their applicable terms of service, and the disqualifications from appointment to the Board.
v. Valid meeting and quorum
A shareholders’ agreement must provide for the valid meeting and quorum requirements for the meeting. A valid quorum means the minimum number of shareholders who may be required to hold a valid meeting. A valid quorum must be decided following the provisions of the Companies Act, 2013.
vi. Rights of Shareholders
In pursuance of obtaining membership in a company, a shareholder is subject to various rights & privileges that need to be set out in the shareholder agreement. Some of which have been provided below-
- Right to call for a meeting;
- Right to vote in the meeting;
- Right to nominate the directors of the company;
- Right to approve the auditors for the company.
- appoint auditors for the company;
- Right to inspect books, registers, and records of the company and take a copy of the document, if required.
- Right to be informed and vote on the matters such as mergers, acquisitions, winding up, etc.
vii. Liabilities of the Shareholders
The shareholders of the company also get certain duties & obligations in pursuance of the shareholder’s agreement. In the case of public & private companies, the liability of the shareholders could be only be restricted to a specific amount of unpaid capital on the shares of the company. It comes from the fact that a company is a body corporate and is separate from its owners (shareholders).
viii. Minority Shareholders Rights
A minority shareholder is a person who owns lesser than 50% of the company’s total shares either individually or collectively. Since they hold lesser shares as compared to the majority shareholders, there may be times when their rights could be compromised due to lesser shareholding. Therefore, a shareholder agreement could provide for the rights of minority shareholders which could involve rights-
- Involve their participation in any case of Oppression and Mismanagement associated with the affairs of the company;
- To bring a class action against the auditors and directors of the company.
- The right to ask majority shareholders to sell the shares of the minority shareholders.
ix. Valuation of Shares
A shareholders agreement may contain provisions regarding the preferred method/approach towards the valuation of the shares of the agreement. However, if the shareholders are unable to assess the valuation of shares through the preferred approach in the agreement, the value could be assessed based on an arms-length price. In the absence of such an arms-length price, a valuation professional should be appointed by the Board of Directors shall determine the market value.
x. Pre-Emptive Rights
- Right to First Refusal– This clause in a Shareholder’s Agreement provides for the restriction on the transfer of the shares until & unless the shares are first offered to the existing shareholders and it is only after their denial, that they may sell/transfer shares to any third party.
- Drag Along with Rights- A drag along clause is a specific clause in the shareholder’s agreement that compels the majority shareholders to compel the minority ones to sell their shares in case the company is being acquired by any other business entity to purchase all the outstanding shares of the Target Company and the same is acceptable to the majority shareholders. It usually takes place when majority shareholders are in favor of a share sale deal all of the shareholders (including the minority) are obligated to sell their shares at prices and terms & conditions provided in the offer.
- Tag-Along Rights – Tag-along rights are also known as co-sale rights, and are generally like the contractual obligations aimed to protect the interests of a minority shareholder typically in venture capital deals. It obligates the majority shareholders to ask the minority shareholder to join the transactions and sell their stakes in the company at similar prices and terms offered to majority shareholders. It is appropriate to note that a tag-along clause is only used in cases if minority shareholders do not desire to continue as shareholders with the third party.
xi. Buy-out Rights
Normally, the Shareholders Agreement also contains provisions related to Buy-out rights to shareholders to empower the existing shareholders to buy shares from any shareholder in case of any incompetency such as death, disability, bankruptcy b, or marital dissolution. This clause may also contain another key provision called expulsion, where the existing shareholders may collectively expel any undesirable shareholder and acquire his shares.
xii. Reserved matters
A shareholder agreement may also specify certain matters that cannot be passed without getting the approval of all shareholders including majority support (more than 75% of the total shareholders) as all the shareholders must be allowed to equally participate in crucial business decisions to decide if any are prejudicial to their investment. Such reserved matters may include decisions like alteration in the MOA clauses, alteration of share clauses, payments of dividends, etc is included.
xiii. Exit Provisions
The shareholders must discuss and provide provisions related to the exit of any shareholders either due to the happening of any circumstances or if any shareholder wishes to leave voluntarily in the agreement. Some of the reasons for the compulsory exit of a shareholder may include-
- Fails to fulfill any condition or does not contribute the agreed minimum time and/or effort to the Company on an ongoing basis, as agreed by partners, and continues to do so despite being notified by other partners;
- Commits any material breach of this Agreement;
- Commits gross misconduct or any serious or persistent breach of any obligation to the Company or any Associated Company of the Company;
- Convicted under a criminal offense by a court of competent jurisdiction.
The agreement may also provide for the mechanism to be followed for such an exit by the shareholder. For instance, if 3/4 of the total shareholders pass a resolution for his exit, it would be considered approved.
xiv. Amendment and Termination
Finally, a shareholder’s agreement must be flexible enough to be amended or terminated in case of any circumstances such as dissolution of the company, etc. Therefore, shareholders must discuss and agree on the procedure to be followed for amending or terminating the shareholder agreement.
Things to be kept in mind while drafting a Shareholder’s Agreement
i. Since a shareholders agreement is a guiding document for the shareholders as well as the company, it should be precise but clear in language with no place for ambiguousness.
ii. The rights and obligations of the parties i.e. shareholders and the company should be provided in simple & clear language.
iii. It should always be kept in mind that any shareholder might want to leave the company, therefore provisions related to exit & transfer of ownership must be set out clearly.
iv. The provision related to dispute resolution including the preferred method of resolution, place, governing law, jurisdiction, etc should be determined in advance.
v. The language-related to restrictions on the transfer of shares must be clearly defined with the procedure.
Conclusion
It takes a lot of effort and mutual understanding between the shareholders during the negotiations and while drafting a shareholders agreement. For this, the rights & obligations of each party involved must be considered. It is also crucial to consult a legal advisor or undertake the services of a legal consultant before drafting a shareholders’ agreement. A shareholder’s agreement provides a mechanism to protect the company from losses and helps to protect its interests. However, to ensure that, it should be drafted in a way as to create a perfect balance between the interests of shareholders are in line with the company.
