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This blog is written by Akhil Gupta, 5th year Law Student at National University of Study and Research in law, Ranchi. He was a participant of our Mergers & Acquisitions Course.

Significant clauses of a Shareholders’ Agreement

A shareholders’ agreement is a contract that specifies how a company will be handled and operated amongst its owners. It often addresses matters like the duties and rights of shareholders, how directors are chosen, how decisions concerning the company’s activities are made, and how disagreements are settled. An agreement that governs the relationship between shareholders, the management of the business, share ownership, rights, duties, and the protection of shareholders is sometimes referred to as a shareholders’ agreement. A shareholders agreement serves to safeguard the interests of the shareholders by establishing a clear set of rules and regulations for the administration and operation of the business. It can aid in ensuring that the business is conducted fairly and openly and in averting misconceptions and shareholder disputes. A shareholders’ agreement may also be a helpful instrument for luring investors and establishing the credibility of the firm because it shows that the latter is well-organized and has a defined course for the future. By preventing future management from abusing present shareholders’ interests, the shareholder agreement helps safeguard their interests. The agreement aids in protecting specific actions, such as dividend distribution and the issuance of new shares or debt, if new management is appointed or another organization buys the business. 

The specific clauses of a shareholders’ agreement will depend on the specific needs and circumstances of the company and its shareholders. However, some common clauses that are often included in a shareholders’ agreement are:

• Purpose
• Shareholding
• Board of Directors
• Management & Control 
• Capital Contribution 
• Transfer of shares
• Deadlock
• Termination
• Governing law
• Confidentiality 
• Pre-emptive rights & Anti-dilution 

 

Let us understand each one elaborately: 

• Purpose  

This clause sets out the purpose of the shareholders’ agreement and the nature of the company. 

• Shareholding 

This clause sets out the details of the shareholding of each shareholder, including the number of shares held, the class of shares held, and any restrictions on the transfer of shares.

• Board of Directors

This clause sets out the composition and powers of the board of directors, including the number of directors, the process for appointing and removing directors, and the responsibilities of the directors. 

• Management and control

This clause sets out the roles and responsibilities of the shareholders in relation to the management and control of the company, and may include provisions on voting rights, decision-making processes, and the allocation of profits and losses.

• Capital contributions

This clause sets out the obligations of the shareholders to contribute capital to the company, and may include provisions on the timing and amount of capital contributions and the conditions under which additional capital may be required.

• Transfer of shares

This clause sets out the rules and procedures for the transfer of shares, including any restrictions on the transfer of shares, and may include provisions on pre-emptive rights, tag-along rights, and drag-along rights.

• Deadlock

This clause sets out the procedures to be followed in the event of a deadlock between the shareholders, and may include provisions on the appointment of an independent third party to resolve disputes. This situation arises when the shareholders are not able to come in consensus.

• Termination

This clause sets out the circumstances under which the shareholders’ agreement may be terminated, and may include provisions on the buy-out of shares and the winding up of the company. This clause addresses the situation wherein the shareholder leaves the Company. This happens after the essential milestones; the founders offer the investors to buy out or exist option from the business. Hence, through this clause the investors are provided with the exit formalities. 

• Governing law

This clause sets out the jurisdiction under which the shareholders’ agreement will be governed, and may include provisions on the resolution of disputes through arbitration or other alternative dispute resolution mechanisms.

• Confidentiality 

This clause sets out the obligations of the shareholders to maintain the confidentiality of sensitive company information, and may include provisions on the disclosure of information to third parties. 

• Pre-emptive rights & Anti-dilution 

Pre-emptive rights and anti-dilution clauses are provisions that can be included in a shareholders’ agreement to protect the interests of shareholders in a company. Pre-emptive rights give shareholders the right to maintain their ownership percentage in the company by allowing them to purchase additional shares of the company before they are offered to new investors. This can help to prevent dilution of the shareholders’ ownership percentage, which can occur when new shares are issued and the overall number of outstanding shares increases. An anti-dilution clause, on the other hand, is a provision that protects shareholders from dilution by adjusting the conversion ratio of their convertible securities (such as preferred stock or convertible bonds) in the event that the company issues new shares at a lower price. This can help to ensure that the value of the shareholders’ securities is not significantly reduced by the issuance of new shares.

• Restrictions on Transfer of Shares 

A restriction on transfer of shares clause is a provision that can be included in a shareholders’ agreement to limit the ability of shareholders to sell or transfer their shares in the company. This type of clause is typically used to protect the interests of the company and of the other shareholders by ensuring that the ownership of the company is stable and that new shareholders meet certain criteria. There are several types of restrictions on transfer of shares that can be included in a shareholders’ agreement, including: 

Right of first refusal: This gives the company or the other shareholders the right to purchase the shares before they are offered to a third party.

Drag-along rights: This gives the majority shareholders the right to force the minority shareholders to sell their shares along with the majority shareholders when the majority sells their shares to a third party.

Tag-along rights: This gives minority shareholders the right to sell their shares along with the majority shareholders when the majority sells their shares to a third party.

Restrictions on transfer to specific parties: This prohibits the transfer of shares to certain parties, such as competitors or individuals who do not meet certain criteria. 

• Non-Compete & Non-Solicitation Provision

Non-compete and non-solicitation provisions are provisions that can be included in a shareholders’ agreement to protect the interests of the company and the other shareholders by limiting the ability of shareholders to compete with the company or to solicit its customers or employees after they leave the company. Therefore, these provisions can be useful tools for protecting the company’s intellectual property and confidential information and for preventing the loss of customers and employees. However, it is important to note that these provisions may be difficult to enforce and may be considered unenforceable if they are overly restrictive. As such, it is important for shareholders to carefully consider the potential implications of including these provisions in a shareholders’ agreement. 

Understanding the Agreement through the lens of the Companies Act, 2013 

A shareholder’s agreement is not required by law, but it can be a useful tool for establishing a clear set of rules and guidelines for the management and operation of the company and for protecting the interests of the shareholders. It is important to note that the provisions of a shareholder’s agreement must not conflict with the provisions of the Companies Act, 2013 or with the articles of association of the company. If there is a conflict, the provisions of the Companies Act, 2013 and the articles of association will take precedence.  The Companies Act, 2013 does not specifically address shareholders agreements, but it does contain provisions that relate to the rights and responsibilities of shareholders in a company. These provisions include:

Section 47 & 48: This section outlines the rights and duties of shareholders in a company. It specifies that shareholders have the right to receive notice of and attend meetings of the company, the right to vote on resolutions put before the company, and the right to receive dividends and other distributions from the company.

Section 96: This section outlines the procedure for calling meetings of shareholders. It specifies that meetings of shareholders must be called by the directors of the company, and that notice of the meeting must be given to all shareholders.

Sections 107, 108, 109 & 110: These sections outline the procedure for voting at meetings of shareholders. It specifies that each shareholder has the right to one vote on each resolution put before the company, and that decisions of the company must be made by a majority of the votes cast.

Section 152: This section outlines the procedure for appointment of the directors of the company. It specifies that the appointment of directors must be approved by a resolution of the shareholders.

It is important to note that these provisions of the Companies Act, 2013 apply to all companies incorporated in India, regardless of whether or not they have a shareholder’s agreement in place. If a shareholder’s agreement conflicts with the provisions of the Companies Act, 2013, the provisions of the Companies Act, 2013 will take precedence.

CONCLUSION

In India, shareholders agreements are typically governed by state laws, and disputes related to shareholders agreements are typically heard in state courts. The Supreme Court of India may consider cases involving shareholders agreements if the case involves a federal issue or if the case has been appealed from a lower court. There are many clauses in the Shareholders Agreement, however, the above-mentioned are some of the most important clauses that a Shareholders Agreement must have. Therefore, it is pertinent to mention that shareholders agreement does not find its express mention under the Companies Act, 2013, however, it is governed under the provisions of the Companies Act, 2013 wherein certain rights & obligations are mentioned of the shareholders of the company. 

This blog post is written by Ms. Ritu Sajnani, Senior Legal Counsel, Coinswitch, Ex-AZB & Partners and Cyril Amarchand Mangaldas.

A Shareholders’ Agreement (“SHA”) seeks to regulate the relationship between the shareholders and the issuer company (the “Company”) itself. SHA particularly governs the rights, obligations, ownership of shares, privileges, voting and various protective provisions of the said shareholders.  

Key Clauses

1. Board of Directors: This clause deals with the responsibilities, rights, duties, and obligations of the Board of Directors (“Board”). It also includes the composition of the Board which prescribes the manner of appointment, the rights vested with the promoters to alter the Board size, and the voting rights of shareholders pursuant to the process of removal and replacement of directors.
2. Board proceedings: This clause stipulates the frequency of the Board meetings, the time interval permitted between both two meetings, the sitting fees of the directors, and the mode of carrying out the Board proceedings. The details regarding the appointment of chairman, constitution of a valid quorum for a Board meeting, the matters in which the quorum requirement is exempted or relaxed, etc. are also listed in this clause.
   

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1. Committees: This clause envisages those circumstances wherein the Board might have delegated powers to committees of specific directors and/ or officials for specific tasks. It also states aforementioned provisions like quorum and decision making to such delegated committees.
2. General Meetings: This clause provisions for the calling of a general meeting along with the mandate of holding a certain number of meetings each year, the quorum required for conducting these meetings and consequently, passing resolutions, sending notice particulars, and provision for holding an extraordinary general meeting.
3. Reserved Matters: This clause refers to a set of matters that mandate an additional layer of obtaining consent from a specific group of persons, in order to have a legally binding effect. A violation of this clause, or the failure to obtain the requisite consents, would render any decision made, action taken or resolution passed as void and invalid.
4. Exit: This clause confers an obligation upon the Company and its founders to provide a full exit with a stipulated exit period to its investors. Typically, exit can be in any of the following ways:

a) Initial Public Offering (“IPO”): In the event an exit is in the form of an IPO, this clause directs that it shall only be undertaken with the prior written consent of the investors’ majority, in consultation with independent merchant bankers and the statutory guidelines in force.

b) Company Sale: This clause envisages a situation wherein the Company fails to undertake a qualified IPO – in the event of which, it must typically undertake a company sale on the terms and conditions (including pricing) approved by the investors’ majority.

c) Third Party Sale: In the event, the Company fails to provide an exit in the stipulated exit period by way of an IPO or Company Sale, then the investors’ majority shall, by issuing a notice to the Company (Exit Notice), at any time subsequent to the expiry of the exit period, have the right to require the Company to appoint a merchant banker acceptable to them, to find a buyer for the shares held by the investors at a price that is the higher of: (i) Preference Amount; or (ii) Fair Market Value as on the date of the Third Party sale.

d) Buy Back: In the event, the Company fails to provide an exit in the stipulated exit period by way of an IPO or Company Sale or through Third Party Sale, then upon request of the investors’ majority, the Company, at its discretion, may propose by way of a notice (Buy Back Notice), to buy the shares held by its investors (on a pro-rata basis) at a price that is the higher of: (i) Preference Amount on an as-if-converted basis; or (ii) Fair Market Value as on the date of the Buy Back Notice, subject to applicable law in lines with the approval of the investors’ majority.

e) Drag Along Right: In the event, the Company fails to provide an exit in the stipulated exit period by way of an IPO or Company Sale or Third-Party Sale or through buy back or in case of default, the investors’ majority shall have the right and not an obligation to cause the transfer of all shares held by other investors or employees to a bona fide third party (not being an affiliate of any of the dragging investors) at the same price and same terms and conditions as may be offered to the dragging investors by the drag purchasers. 

7. Event of Default: It is a non-obstante clause wherein in the event of breach, the other parties shall be entitled to seek specific performance and such other rights and remedies as are available to them under applicable law.
8. Transfers: This clause fundamentally lays down the legal contours of transfer of shares by shareholders and investors by placing certain restrictions and conferring certain privileges. A transfer undertaken in violation of the agreement would be null, void and not binding on the parties and Company or any of the parties. Typically, the clause on transfers includes the following:

8.1 Right of First Offer (“ROFO”): A ROFO is a contractual obligation pursuant to which any investor intending to sell its share to a third person can only exercise such right after providing the right to purchase said shares to the promoter entity. The clause comprehensively regulates the procedure and manner in which the promoter entity may exercise their right. On the other hand, a Right of First Refusal provides non-selling shareholders with the right to accept or refuse an offer by a selling shareholder after the selling shareholder has solicited an offer for their shares from a third-party buyer.

8.2 Pre-emptive Right: This clause confers a contractual obligation upon the Company by virtue of which, in the event the said Company is desirous of issuing new equity shares, this clause mandates that the Company must provide the existing investors a right to participate in the proposed issuance by subscribing a quantum necessary to maintain their pro-rata shareholding in the Company on a fully diluted basis. 

8.3 Tag Along Rights of Investors: In the event, a promoter entity or its affiliates desire to transfer all or part of the equity securities held by them to another person, this clause confers a contractual right and not a mandatory obligation upon the investors to transfer its equity shares at the same price, terms and conditions, on a pro-rata basis, to the proposed transferee. 

8.4 Fall Away: This clause is a non-obstante clause which typically states that if the investors and/or its affiliates collectively cease to hold a prescribed number of equity securities or their shareholding falls below a certain threshold, typically all rights conferred upon them in the SHA will immediately and automatically cease to have effect.

9. Value Protection/ Anti-Dilution Rights: In the event, the Company intends to issue securities to any third party other than its existing shareholders, which has the effect of lowering the investor’s entry valuation or dilute their effective shareholding in the Company, this clause imposes an obligation upon the Company to take all steps necessary to ensure that the investor is adequately compensated and/or steps are undertaken by the Company in a form and manner satisfactory to the investor.
10. Most Favorable Clause: This clause confers an obligation upon the promoter entity that the Company shall not, without prior consultations with the investors, induct any new investor in the Company on terms which are more favorable than the existing shareholders’ rights granted to them under the transaction documents.
11. Information and Inspection Rights: This clause imposed an obligation upon the Company to furnish necessary documents like audited and unaudited consolidated financial statements, monthly reports, any updates on functioning and operations on the Company’s business, including any breach of representations and warranted to the investors for their perusal.
12. Liquidation Preference: This clause provides how the total proceeds from a liquidity event, shall be distributed between holders of relevant securities.

This blog post is written by Kartik Singh, a final year law student from National Law University, Odisha. He was a participant of our Mergers & Acquisitions Course. He is also an Incoming Associate at Trilegal law firm. 

What is Due Diligence?

Due diligence is essentially a background check to ensure that the parties to a deal have the information they need to proceed with the transaction. It is an examination and risk assessment of an anticipated commercial transaction. A thorough investigation is necessary to uncover misrepresentation and fraudulent activity in a significant business transaction. Due Diligence is the process through which interested parties who are planning to enter into a business deal exchange, review, and evaluate sensitive, legally binding, financial, and other material information. The phrase “due diligence” frequently refers to the thorough investigation and study carried out before signing a contract or starting a business with a party.

Due diligence-driven transactions have a better likelihood of succeeding. By improving the calibre of data available to decision-makers, due diligence aids in making educated decisions. The buyer can feel more certain that their expectations for the deal are accurate thanks to due diligence. Purchasing a business without performing due diligence elevates the risk to the purchaser significantly in mergers and acquisitions (M&A). To provide the buyer confidence, due diligence is carried out. Due diligence, however, could also work in the seller’s favour because a careful financial analysis might actually show that the seller’s company is worth more than was previously believed. As a result, it is usual for sellers to create their own due diligence reports before possible purchases.

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Need for a Due Diligence Report

In the framework of M&A activities, for instance, or to protect the value chain or to conform with restrictions and with laws on the combating of money laundering, bribery, and corruption, due diligence risk and adherence check tools assist businesses in protecting their interests. When it comes to due diligence, the adage “discovering skeletons in the closet before the deal is preferable than discovering them later” is applicable. The data gathered throughout this procedure must be published because it is essential for making decisions. The due diligence report clarifies how the business intends to increase profits (monetary as well as non-monetary).

It acts as a quick reference for realising the situation at the moment of buying, sale, etc. Getting a clear image of how the organization will function in the future is the ultimate goal. The main objective of this report is to accurately portray the firm’s future operations to the dealing party. Prior to the purchase being finalised, the primary objective of due diligence is to spot any warning signs. It assists in identifying potential threats in the future. For making decisions, the data obtained for this report is essential. The company might be able to negotiate if it finds any flaws during the due diligence process. The report aids the organisation in understanding how the target wants to generate additional revenue. It serves as a doomsayer, for instance, when determining the state of affairs at the time of sale or purchase.

When is Due Diligence Required?

The following transactions entail the requirement of conducting by the parties involved:

• Mergers and Acquisitions (M&A): Both the buyer and the seller’s perspectives are taken into account when performing due diligence. The seller concentrates on the previous experience of the buyer, the financial capabilities to complete the deal, and the ability to uphold commitments made, whereas the consumer investigates the financials, litigation, patents, and a wide range of important information.
• Partnership: Business alliances, business collaborations, and other types of partnering are subject to due diligence.
• Joint Ventures: Reputation of the combined company is an issue when two businesses join forces. It is crucial to comprehend the other company’s position and assess whether their resources are adequate.
• Public Offer: Decisions about public issues, disclosures in a prospectus, post-issue compliance, and similar problems are involved during the making of a public offer. Normally, these would demand careful consideration and thus, the process of due diligence is required.

Elements of Due Diligence Report

The various elements of a due diligence report are as follows:

• Financial Information: It comprises looking over copies of the last five years’ worth of audited financial statements, along with all associated notes and management’s analysis and comments.
• Corporate Records: A target company’s primary formation documents, such as the articles or certificate of incorporation and bylaws, are reviewed by legal counsel. Consider that the target company is a corporation or that the operating agreement and certificate of organisation, along with any changes, are a limited liability company.
• Debt: This involves analysing the seller’s debt in terms of loans, notes, cash advances, and security agreements; evaluating the lender relationship; and performing ongoing commercial code checks with each daughter company.
• Employment and Labor: This section includes the full names of all executives, employees, and directors, as well as information about pensions, stock plans, profit sharing, deferred pay, and other benefits or non-salary compensation. It also includes information about any ongoing labour and employment law cases.
• Legal: It includes copies of documents submitted to government authorities, including reports and licences, as well as information on any environmental duties and details of any legal disputes.
• Technology: The evaluation of the technology available to the organisation is a crucial issue to take into account. A required evaluation is one that helps determine future course of action.
• Agreements: All contracts made by the corporation and its subsidiaries, such as leases on real estate, partnerships, joint ventures, and agreements governing the marketing, commission, sales, and distribution of goods, among other important contracts.
• Effect of Synergy: The result of synergy Making decisions is aided by the creation of synergy between the target firm and the current business.

Types of Due Diligence

• Business Due Diligence: It entails investigating the participants to the deal, the prospects of the company, and the calibre of the investment. It entails a thorough investigation of the parties involved in a transaction, the future profitability of the firm, and the investment’s standard.
• Financial Due Diligence: Here, financial, operational, and commercial hypotheses are verified. The acquiring business can now acquire a company with much less difficulty, which is a tremendous relief. Here, a thorough review of accounting principles, audit procedures, tax compliance, and internal controls is conducted. It provides the acquiring company with a clear image of the value of the acquisition.
• Legal Due Diligence: It mostly concentrates on legal dangers, other legal matters, and the legal implications of a transaction. It looks for any legal obstacles or red flags. It encompasses both intra-corporate transactions and transactions between corporations. This diligence includes the currently existing documentation as well as several regulatory checklists.

Conclusion

The impacts and usefulness of a due diligence report are clear from the points above. Another compliance, carried out by numerous due diligence report service providers in India, is how the companies must follow the process. Companies must implement the aforementioned procedures in order for the transactions to be feasible; otherwise, it may be difficult for both sides to effectively finish the project agreement.

The due diligence report should give you the amount of assurance you want regarding the possible investment and any associated risks. The report needs to be able to give the acquiring firm enough information to prevent the signing of any onerous contracts that might compromise the current return on investment. No specific rule oversees this process because it is more of a diligence method than a compliance attempt. Each business must complete this crucial phase in order to make investments and assess its overall health.